In episode 57 of the InFi podcast, I summarize some of the strengths and weaknesses of various economic schools of thought when it comes to explaining the business cycle in market economies. This post accompanies my verbal commentary. Full disclosure, I end with the Austrian School’s theory, developed by Ludwig von Mises and elaborated by Friedrich Hayek, because that is my personal favorite and the closest to what I view as the true explanation.
The Classical School: Say’s Law
The classical economists include such luminaries as David Hume, Adam Smith, and David Ricardo. (They arguably include Karl Marx as well, which surprised many of my undergrad students when I taught History of Economic Thought.) On the topic of business cycles, a central premise is what we now call “Say’s Law,” named after the great French economist, J.B. Say.
I’ve devoted an entire podcast episode to fleshing out what Say actually meant. But for our purposes: Even back in Say’s time, it was common for people to explain a business slump by reference to a “lack of spending” or saying that consumers were “hoarding money.” Or equivalently people might say that businesses across the board had overproduced, leading to a “general glut” of goods piling up on the shelves. If this really were the problem, then an obvious solution would be for the government to somehow stimulate spending, or to spend more itself.
In reaction to this type of analysis, Say argued that it was too shortsighted. For one thing, it was a mark of economic progress to say that businesses in all lines were producing more than, say, 100 years earlier. That’s what it means for the standard of living to rise. We want a “general overproduction.” The problem occurs only if some sectors produce too much while others produce too little. Then we could improve things by cutting back on the overzealous sectors while expanding the ones where the output is desired more highly. But surely this kind of subtle problem isn’t due to “a lack of spending” or “money hoarding.”
More specifically, Say abstracted away from the temporary role that money played in transactions. Ultimately, if (say) the farmer wants a pair of shoes from the cobbler, the way the farmer “demands” the shoes is by first supplying more eggs to the market. By selling his eggs, the farmer earns the money with which to buy the shoes. So if the cobbler can’t understand why his shoe sales have slumped, the answer isn’t, “Your potential customers need more money,” but rather, “Your potential customers need to produce more.” This analysis is what led Keynes in his 1936 General Theory to dismiss Say’s Law as the claim that “supply creates its own demand.” (To be clear, that wasn’t an actual quote from Say, and taken at face value, it’s clearly false.)
In general, the classical school had many great insights about the operation of an economy. But two of their greatest weaknesses were (a) they had a faulty theory of value, based on cost, which would later be replaced by the subjective marginal utility approach, and (b) they abstracted away from money and viewed the economy as a series of barter transactions.
In a world with no money, it would be literally impossible for there to be a “general glut,” where every merchant was trying to sell more units of his or her goods than customers wanted to buy. For example, if the farmer were directly trying to trade eggs for shoes, it’s not mathematically possible for both the farmer and the cobbler to think there was insufficient demand for their product. At a given exchange ratio of eggs for shoes, if the farmer wanted to sell the farmer more eggs than the cobbler wanted to buy, that is the accounting flipside of saying the farmer wanted to buy more shoes than the cobbler wanted to sell (at that barter price). So it can’t be that both farmer and cobbler think there is a “lack of demand” for their products.
However, once we introduce money into the system, it is possible for every merchant to want to sell more units of their good (at a certain money-price) than customers want to buy. For example, if the market price for (a dozen) eggs is $3, it’s possible that the farmer wants to sell a dozen eggs to the cobbler but the cobbler prefers to hang on to his $3, and chooses to buy no eggs. At the same time, if the market price for a pair of shoes is $40, it’s possible the cobbler wants to sell one pair to the farmer, but the farmer prefers to keep his $40. Once we introduce the complication of money, it’s at least mathematically possible that both men, in their capacity as a seller, will experience an “insufficient demand” for their wares. This was literally impossible in a barter world.
I will stop my discussion here. Even with money, Say’s analysis (in his book) gave the insight into seeing how such a “general glut” could be solved, by an adjustment of market prices. But for our purposes in this article (and in my podcast episode), I’m just pointing out that much of the classical wisdom gave an intuitive hint as to what the answer looks like, but that the reality of money prices makes an actual answer messier and more nuanced.
Keynesian Demand Management
For the purposes of this article, I’m going to be very high-level, highlighting only on a few features of each school of thought. When it comes to the Keynesians, the central element is a focus on “Aggregate Demand.” Specifically, in his 1936 book, Keynes argued that left to their own devices, markets could become mired in a rut where total private spending (on both investment and consumption) was inadequate to provide full employment. The classical economists were simply wrong (Keynes argued) when they claimed that in such a situation, wage rates and other prices would fall, quickly restoring equilibrium. (We don’t need to go into Keynes’ theories as to why the market couldn’t fix itself.)
Since Keynes thought that the classical approach—summed up by Say’s Law—was only true in the special case of full employment, Keynes offered a more general theory (hence the title of his book). Specifically, he said that if the central bank lowered interest rates down to 0% and private spending were still insufficient to provide full employment, then to escape such a “liquidity trap” it would be necessary for the government to run a budget deficit and boost Aggregate Demand directly.
One of the problems with mechanical (or what was called hydraulic) Keynesianism as it was implemented in the 1950s and 1960s was that it ignored the role of expectations among market participants. If we were in an initial recession where unemployment was (say) 8% and consumer price inflation was (say) 1%, then yes maybe the government could inject more money and knock unemployment down to 5% while inflation only rose to 4%--meaning we could have a point-for-point tradeoff in unemployment and inflation (since each moved three percentage points). But once labor unions got wise to this game, they would increase their wage demands and/or insist on automatic COLA clauses in their contracts, so that in the next recession, maybe the central bank would have to tolerate a two percentage point hike in the inflation rate, to achieve a one percentage point drop in unemployment. The “stagflation” of the 1970s confirmed the limited success of the old school Keynesian approach.
The Real Business Cycle (RBC) Theorists
In reaction to the Keynesian demand-side approach, some laissez-faire economists in the late 1970s and early 1980s developed an entirely “real” (rather than monetary) explanation of the business cycle, which viewed recessions as the “rational” response to various productivity shocks in a world of uncertainty. These elegant models had sophisticated math and were internally consistent, and moreover didn’t rely on illusion to trick workers into accepting wage cuts when prices were rising faster than wages (which the old Keynesian models needed).
However, the problem was simply that these RBC models didn’t seem to explain real-world business cycles. The Keynesian critics mocked the RBC approach as saying it would reclassify the Great Depression as the Great Vacation, because in the RBC model the reason for large-scale unemployment is that workers “rationally” decide to withhold their labor from the market in periods of relatively low productivity. Since the 1930s were characterized by men holding up signs begging for work, this just didn’t feel like the theory fit the facts.
Post-Keynesians
Some heterodox thinkers, especially Hyman Minsky, developed business cycle explanations relying on bubbles in private credit markets that would eventually pop. I won’t say more here, except to note that their framework (in my view) was not rigorously developed, and their recommended solutions (such as more extensive government regulation of financial markets) seems naïve to me, and ignorant of the information / incentive problems plaguing government regulators.
Austrians
Finally, we come to the Austrians. I won’t dwell on their theory of the business cycle here, as I have recently interviewed Paul Cwik who wrote a new book on the subject. In the context of my above discussion, allow me simply to say that the Austrian theory combines the best of all of the rival schools. It retains the classical and RBC foundation of keeping in mind the “real” structure of an economy, but it also incorporates the realism and volatility of a society using money and banking.
Specifically, Mises’ theory supposes that “credit expansion” by the banks pumps in new money (created via loans) that isn’t backed up by genuine saving. This leads to an unsustainable boom, which eventually must result in a bust. To repeat, I think the Austrian theory is the best so far, because it unites both “real” and “monetary” factors into a single explanation.
I will wrap up this essay at this point. I hope my quick sketch has been helpful in showing the strengths and weaknesses of the rivals to the Austrian approach, and why I think Mises—who first published his theory in 1912—is still the master in this arena.
Dr. Robert P. Murphy is the Chief Economist at infineo, bridging together Whole Life insurance policies and digital blockchain-based issuance.
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