The Austrian School 2 goods of the lowest order. Eugen von Böhm-Bawerk (1959 [1889]) introduced the similar notion of “maturity classes” to capture this temporal element in the economy’s production process. He stressed the point that an increase in the economy’s growth rate must entail an increase in activity in the earlier maturity classes relative to (concurrent) activity in the later maturity classes. Böhm-Bawerk was possibly the first economist to insist that propositions 9. The Austrian School about the macroeconomy have firm microeconomic foundations. In an 1895 essay, he wrote that “One cannot eschew studying the microcosm if one wants to * understand properly the macrocosm of a developed economy” (Hennings, 1997, Roger W. Garrison p.74). Ludwig von Mises (1953 [1912]), who is generally credited for using marginal utility analysis to account for the value of money, was also the first to recognize the significance of credit creation in the context of a decentralized, time- consuming production process. The capital theory originated by Menger and the Mr. Keynes's aggregates conceal the most fundamental mechanisms of change. (Hayek, 1931) theory of money and credit set out by Mises was developed by Friedrich Hayek (1967 [1935]) into the Austrian theory of the business cycle. Lionel Robbins (1971 9.1 The Mengerian Vision [1934]) and Murray Rothbard (1963) applied the theory to the interwar episode of boom and bust. Eventually, the insights of these and other Austrians gave rise to a The Austrian school is best known for its microeconomics and, in particular, for its full-fledged capital-based macroeconomics (Horwitz, 2000 and Garrison, 2001). role in the marginalist revolution. In the early 1870s, Carl Menger, along with French economist Léon Walras and English economist William Stanley Jevons, 9.2 The Intertemporal Structure of Capital reoriented value theory by calling attention to the marginal unit of a good as key to our understanding the determination of the good’s market price. With marginality Hayek greatly simplified the Austrian vision of a capital-using economy by central to the analysis, microeconomics was forever changed. It is less widely modeling the economy’s production activities as a sequence of inputs and a point recognized, however, that a viable macroeconomic construction also arises quite output. Each element in the sequence is designated a “stage of production,” the naturally out of the marginalist revolution in the context of Menger’s vision of a number of stages posited being largely a matter of pedagogical convenience. This capital-using market economy. simple construction was first introduced as a bar chart with the individual bars Modern macroeconomics makes a distinction between factor markets (inputs) arrayed temporally, their (equal) widths representing increments of production time. and product markets (outputs). Intermediate inputs and outputs are rarely in play. By The length of the final bar represents the value of consumable output; the attenuated contrast, the economics of the Austrian school features a production process—a lengths of the preceding bars represent the values of the goods in process at the sequence of activities in which the outputs associated with some activities feed in as various stages of production. inputs to subsequent activities. The eventual yield of consumable output constitutes Figure 9.1 shows ten stages of production arrayed from left to right. (In the the end of the sequence. Menger (1981 [1871]) set out the theory in terms of “orders original Hayekian rendition, five stages were arrayed from top to bottom.) The of goods,” the first, or lowest, order constituting consumer goods and second, third, specific number of stages is not intended to quantify any actual, empirically and higher orders constituting producers goods increasingly remote in time from established detail about the economy’s production process but rather to capture our general understanding that in many instances the (intermediate) output of one stage is used as an input to a subsequent stage. That is, vertical integration—and, * certainly, complete vertical integration—is not the norm. Hayek’s “stages” do not Roger W. Garrison, Professor of Economics at Auburn University, Auburn, Alabama (USA), is the translate cleanly into “firms” or “industries.” Some vertically integrated activities author of Time and Money: The Macroeconomics of Capital Structure (London: Routledge, 2001). He gratefully acknowledges helpful suggestions offered by Lane Boyte and Sven Thommesen during the may be carried out within a single firm. An oil company, for example, may be preparation of this chapter. engaged in exploring, extracting, refining, distributing, and retailing. A paper manufacturer, for another example, may be supplying paper for blueprints and for 3 Modern Macroeconomics The Austrian School 4 greeting cards, thus operating simultaneously in different stages. And there are economy works to coordinate production activities with consumer preferences and obvious deviations from the strict one-way temporal sequence: Coal may be used in hence in our understanding of what might go wrong with the coordinating the production of steel while steel is used in the production of coal. (This is the mechanisms. The use of multiple stages of production gives full play to marginalist supposedly telling counter-example offered by Frank Knight in his critical thinking. Austrian macro is micro-friendly. The pattern of resource allocation can be introduction to the English translation of Menger’s Principles.) Still, as with all modified in systematic ways, changing the temporal profile of production activities. simple models, this Austrian model of the capital structure is notable not for its A marginal decrease in late-stage activities coupled by a marginal increase in early- many sins of omission but rather for the essential truths that are captured by its stage activities has important implications for the economy’s overall growth rate. construction. Significantly, a related pattern of marginal changes gives rise to boom and bust. Means are employed to achieve ends, and those means are temporally prior to Changes in the intertemporal pattern of resource allocation have a claim on our the corresponding ends. Production moves forward through time. Valuation, attention, according to the Austrians, even if these marginal changes cancel one however, emanates in the reverse direction. That is, the anticipated value of an end another out in some conventional macroeconomic aggregate such as investment attaches itself to the means capable of achieving that end. This is Menger’s Law. spending (in all stages) or total spending (by both consumers and the investment The demand for the factors of community). production and hence for the outputs The pattern of resource allocation associated with intertemporal equilibrium of the intermediate stages of exhibits a certain uniformity in terms of the value differentials that separate the production is a derived demand. The stages of production. The difference in the value of the output of one stage and the direction of valuation is implicit in value of output of the next stage reflects, among other things, the general terms of Menger’s designation of intertemporal exchange, expressed summarily as the market rate of interest. With a consumption goods as “goods of the given rate of interest, excessive stage-to-stage value differentials would present first order.” The market values of themselves as profit opportunities which could be exploited only by reallocating goods of the second, third, and resources toward the earlier stages of production. In the limit, when all such profit higher orders are ultimately derived opportunities have been competed away, the relative prices of inputs used in the from the anticipated value of the various stages are brought into line with the equilibrium rate of interest. A summary -Figure 9.1 The intertemporal structure of production first-order goods. But even with the graphical rendering of the intertemporal capital structure takes the form of a triangle doctrine of derived demand fully in encasing the sequence of stages that constitute such an intertemporal equilibrium. play, those values entail a systematic time discount consistent with the temporal The Hayekian triangle in Figure 9.1 keeps the many complexities of capital theory remoteness of higher-order goods. at bay while keeping in play the overall time element in the production process. The Austrian vision puts the entrepreneur in a key role. At a minimum, the The extreme level of simplification warrants some discussion. First, we note entrepreneur operating in some particular stage of production must anticipate the that the triangle’s hypotenuse, which tracks the value of the yet-to-be completed demand for his own output, assessing the profitability of his activities with due consumables, rises linearly from no value at all to the full market value of the attention to the cost of borrowed funds. Longer-run planning may require gauging consumables. Yet, we know that the interest rate is expressed in percentage terms the strength of demand several stages forward, including ultimately the demand for and, starting from some initial input value, allows for compounding. Clearly—and the consumable output. Speculative activities may consist in part in the movement contrary to the Hayekian triangle—such percentage value differentials implies that of resources—in response to a change in credit conditions—from