2 ACRITIQUE OF MONETARISM THE MYTHICAL CONCEPT OF CAPITAL

In general the Neoclassical School has followed a tradition which predated the subjectivist revolution and which deals with a productive system in which the different factors of production give rise, in a homogenous and horizontal manner, to consumer goods and services, without at all allowing for the immersion of these factors in time and space throughout a temporal structure of productive stages. This was more or less the basic framework for the research of classical economists from Adam Smith, Ricardo, Malthus, and John Stuart Mill to Marshall.⁴ It also ultimately provided the structure for the work of John Bates Clark (1847–1938). Clark was Professor of Economics at Columbia University in New York, and his strong anti-subjectivist reaction in the area of capital and interest theory continues even today to serve as the foundation for the entire neoclassical-monetarist edifice.⁵ Indeed Clark considers production and consumption to be simultaneous. In his view production processes are not comprised of stages, nor is there a need to wait any length of time before obtaining the results of production processes. Clark regards capital as a permanent fund which “automatically” generates a productivity in the form of interest. According to Clark, the larger this social fund of capital, the lower the interest. The phenomenon of time preference in no way influences interest in his model.

It is evident that Clark's concept of the production process consists merely of a transposition of Walras's notion of general equilibrium to the field of capital theory. Walras developed an economic model of general equilibrium which he expressed in terms of a system of simultaneous equations intended to explain how the market prices of different goods and services are determined. The main flaw in Walras's model is that it involves the interaction, within a system of simultaneous equations, of magnitudes (variables and parameters) which are not simultaneous, but which occur sequentially in time as the actions of the agents participating in the economic system drive the production process. In short, Walras's model of general equilibrium is a strictly static model which fails to account for the passage of time and which describes the interaction of supposedly concurrent variables and parameters which never arise simultaneously in real life.

Logically, it is impossible to explain real economic processes using an economic model which ignores the issue of time and in which the study of the sequential generation of processes is painfully absent.⁶ It is surprising that a theory such as the one Clark defends has nevertheless become the most widely accepted in economics up to the present day and appears in most introductory textbooks. Indeed nearly all of these books begin with an explanation of the “circular flow of income,”⁷ which describes the interdependence of production, consumption and exchanges between the different economic agents (households, firms, etc.). Such explanations completely overlook the role of time in the development of economic events. In other words, this model relies on the assumption that all actions occur at once, a false and totally groundless supposition which not only avoids solving important, real economic issues, but also constitutes an almost insurmountable obstacle to the discovery and analysis of them by economics students. This idea has also led Clark and his followers to believe interest is determined by the “marginal productivity” of that mysterious, homogenous fund they consider capital to be, which explains their conclusion that as this fund of capital increases, the interest rate will tend to fall.⁸

After John Bates Clark, another American economist, Irving Fisher, the most visible exponent of the mechanistic version of the quantity theory of money, also defended the thesis that capital is a “fund,” in the same way income is a “flow.” He did so in his book, The Nature of Capital and Income, and his defense of this thesis lent support to Clark's markedly “macroeconomic” view involving general equilibrium.⁹

In addition Clark's objectivist, static concept of capital was also advocated by Frank H. Knight (1885–1962), the founder of the present-day Chicago School. In fact Knight, following in Clark's footsteps, viewed capital as a permanent fund which automatically and synchronously produces income, and he considered the production “process” to be instantaneous and not comprised of different temporal stages.¹⁰

AUSTRIAN CRITICISM OF CLARK AND KNIGHT

Austrian economists reacted energetically to Clark and Knight's erroneous, objectivist conception of the production process. Böhm-Bawerk, for instance, describes Clark's concept of capital as mystical and mythological, pointing out that production processes never depend upon a mysterious, homogeneous fund, but instead invariably rely on the joint operation of specific capital goods which entrepreneurs must always first conceive, produce, select, and combine within the economic process. According to Böhm-Bawerk, Clark views capital as a sort of “value jelly,” or fictitious notion. With remarkable foresight, Böhm-Bawerk warned that acceptance of such an idea was bound to lead to grave errors in the future development of economic theory.¹¹

Years after Böhm-Bawerk, fellow Austrian Fritz Machlup voiced his strong criticism of the Clark-Knight theory of capital, concluding that

[t]here was and is always the choice between maintaining, increasing, or consuming capital. And past and “present” experience tells us that the decision in favour of consumption of capital is far from being impossible or improbable. Capital is not necessarily perpetual.¹²

Realizing the debate between the two sides is not pointless, as it involves the clash of two radically incompatible conceptions of economics (namely subjectivism versus objectivism based on general equilibrium), Hayek also attacked Clark and Knight's position, which he felt rested on the following essential error:

This basic mistake—if the substitution of a meaningless statement for the solution of a problem can be called a mistake–is the idea of capital as a fund which maintains itself automatically, and that, in consequence, once an amount of capital has been brought into existence the necessity of reproducing it presents no economic problem.¹³

Hayek insists that the debate on the nature of capital is not merely terminological. On the contrary, he emphasizes that the mythical conception of capital as a self-sustaining fund in a production “process” which involves no time prevents its own proponents from identifying, on the whole, the important economic issues in real life. In particular it blinds them to variations in the productive structure which result from changes in the level of voluntary saving, and to the ways credit expansion affects the structure of production. In other words the mythical concept of capital keeps its supporters from understanding the close relationship between the micro and macro aspects of economics, since the connection between the two is composed precisely of the temporal plans of creative entrepreneurs who, by definition, are excluded from the Walrasian model of the economic system, the model Clark and Knight incorporate into their theory of capital.¹⁴

Ludwig von Mises later joined the debate, showing his disapproval of the “new chimerical notions such as the ‘selfperpetuating character’ of useful things.”¹⁵ Mises echoes Böhm-Bawerk's¹⁶ views when he points out that such notions are eventually put forward to justify doctrines based on the myth of “underconsumption” and on the supposed “paradox of thrift,” and to thus provide a theoretical basis for economic policies which foster increased consumption to the detriment of saving. Mises explains that the entire current structure of capital goods is the result of concrete entrepreneurial decisions made in the past by real people who on specific occasions opted to invest in certain capital goods, and on others, to replace them or group them differently, and on yet others to even relinquish or consume capital goods already produced. Hence “we are better off than earlier generations because we are equipped with the capital goods they have accumulated for us.”¹⁷ Incredibly, it appears this theoretical principle and others equally obvious have yet to sink in.

In his more recent book, An Essay on Capital, Israel M. Kirzner emphasizes that Clark and Knight's concept of capital rules out human, entrepreneurial decision-making in the production process. Individuals’ different plans regarding the specific capital goods they may decide to create and employ in their production processes are not even considered. In short Clark and Knight assume that the course of events flows “by itself” and that the future is an objective given which follows a set pattern and is not influenced by individual agents’ microeconomic decisions, which they deem fully predetermined. Kirzner concludes that the view of Clark and Knight ignores “the planned character of capital goods maintenance,” adding that their model requires acceptance of the notion that

the future will take care of itself so long as the present “sources” of future output flows are appropriately maintained.... The Knightian approach reflects perfectly the way in which this misleading and unhelpful notion of “automaticity” has been developed into a fully articulated and self-contained theory of capital.¹⁸

A CRITIQUE OF THE MECHANISTIC MONETARIST VERSION OF THE QUANTITY THEORY OF MONEY

Monetarists not only overlook the role time and stages play in the economy's productive structure. They also accept a mechanistic version of the quantity theory of money, a version they base on an equation which supposedly demonstrates the existence of a direct causal link between the total quantity of money in circulation, the “general level” of prices and total production. The equation is as follows:

MV = PT

where M is the stock of money, V the “velocity of circulation” (the number of times the monetary unit changes hands on average in a certain time period), P the general price level, and T the “aggregate” of all quantities of goods and services exchanged in a year.¹⁹

Supposing the “velocity of circulation” of money remains relatively constant over time, and the gross national product approximates that of “full employment,” monetarists believe money is neutral in the long run, and that therefore an expansion of the money supply (M) tends to proportionally raise the corresponding general price level. In other words, though in nominal terms the different factor incomes and production and consumption prices may increase by the same percentage as the money supply, in real terms they remain the same over time. Hence monetarists believe inflation is a monetary phenomenon that affects all economic sectors uniformly and proportionally, and that therefore it does not disrupt or discoordinate the structure of productive stages. It is clear that the monetarist viewpoint is purely “macroeconomic” and ignores the microeconomic effects of monetary growth on the productive structure. As we saw in the last section, this approach stems from the lack of a capital theory which takes the time factor into account.

The English economist R.G. Hawtrey, a main exponent of the Monetarist School in the early twentieth century, is one whose position illustrates the theoretical difficulties of monetarism. In his review of Hayek's book, Prices and Production, which appeared in 1931, Hawtrey expressed his inability to understand the book. To comprehend this assertion, one must take into account that Hayek's approach presupposes a capital theory; but monetarists lack such a theory and therefore fail to grasp how credit expansion affects the productive structure.²⁰ Furthermore against all empirical evidence, Hawtrey declares that the first symptom of all depressions is a decline in sales in the sector of final consumer goods, thus overlooking the fact that a much sharper drop in the price of capital goods always comes first. Thus the prices of consumer goods fluctuate relatively little throughout the cycle when compared to those of capital goods produced in the stages furthest from consumption. Moreover, in keeping with his monetarist position, Hawtrey believes credit expansion gives rise to excess monetary demand which is uniformly distributed among all goods and services in society.²¹

More recently other monetarists have also revealed their lack of an adequate capital theory and have thus expressed the same bewilderment as Hawtrey with respect to studies on the effects of monetary expansion on the productive structure. Milton Friedman and Anna J. Schwartz, in reference to the possible effects of money on the productive structure, state:

We have little confidence in our knowledge of the transmission mechanism, except in such broad and vague terms as to constitute little more than an impressionistic representation rather than an engineering blueprint.²²

Furthermore, surprisingly, these authors maintain that no empirical evidence exists to support the thesis that credit expansion exerts an irregular effect on the productive structure. Therefore they disregard not only the theoretical analysis presented in detail here, but also the different empirical studies reviewed in the last chapter. Such studies identify typical, empirical features which largely coincide with those observed in all cycles from the time they began.

Friedrich A. Hayek stated that his

chief objection against [monetarist] theory is that, as what is called a “macrotheory,” it pays attention only to the effects of changes in the quantity of money on the general price level and not to the effects on the structure of relative prices. In consequence, it tends to disregard what seems to me the most harmful effects of inflation: the misdirection of resources it causes and the unemployment which ultimately results from it.²³

It is easy to understand why a theory such as the one monetarists hold, which is constructed in strictly macroeconomic terms with no analysis of underlying microeconomic factors, must ignore not only the effects of credit expansion on the productive structure, but also, in general, the ways in which “general price level” fluctuations influence the structure of relative prices.²⁴ Rather than simply raise or lower the general price level, fluctuations in credit constitute a “revolution” which affects all relative prices and eventually provokes a crisis of malinvestment and an economic recession. The inability to perceive this fact led the American economist Benjamin M. Anderson to assert that the fundamental flaw in the quantity theory of money is merely that it conceals from the researcher the underlying microeconomic phenomena influenced by variations in the general price level. Indeed monetarists content themselves with the quantity theory's equation of exchange, deeming all important issues to be adequately addressed by it and subsequent microeconomic analyses to be unnecessary.²⁵

The above sheds light on monetarists’ lack of a satisfactory theory of economic cycles and on their belief that crises and depressions are caused merely by a “monetary contraction.” This is a naive and superficial diagnosis which confuses the cause with the effect. As we know, economic crises arise because credit expansion and inflation first distort the productive structure through a complex process which later manifests itself in a crisis, monetary squeeze, and recession. Attributing crises to a monetary contraction is like attributing measles to the fever and rash which accompany it. This explanation of cycles can only be upheld by the scientistic, ultraempirical methodology of monetarist macroeconomics, an approach which lacks a temporal theory of capital.²⁶

Furthermore not only are monetarists incapable of explaining economic recessions except by resorting to the effects of the monetary contraction;²⁷ they have also been unable to present any valid theoretical argument against the Austrian theory of economic cycles: they have simply ignored it or, as Friedman has done, have only mentioned it in passing, falsely indicating that it lacks an “empirical” basis. Thus David Laidler, in a recent critique of the Austrian theory of the cycle, had no choice but to turn to the old, worn-out Keynesian arguments which center on the supposedly healthy influence of effective demand on real income. The basic idea is this: that an increase in effective demand could ultimately give rise to an increase in income, and hence, supposedly, in savings, and that therefore the artificial lengthening based on credit expansion could be maintained indefinitely, and the process of poor allocation of resources would not necessarily reverse in the form of a recession.²⁸ The essential error in Laidler's argument was clearly exposed by Hayek in 1941, when he explained that the only possible way for production processes financed by credit expansion to be maintained without a recession would be for economic agents to voluntarily save all new monetary income created by banks and used to finance such processes. The Austrian theory of the cycle suggests that cycles occur when any portion of the new monetary income (which banks create in the form of loans and which reaches the productive structure) is spent on consumer goods and services by the owners of capital goods and the original means of production. Thus the spending of a share on consumption, which is surely always the case, is sufficient to trigger the familiar microeconomic processes which irrevocably lead to a crisis and recession. In the words of Hayek himself:

All that is required to make our analysis applicable is that, when incomes are increased by investment, the share of the additional income spent on consumers’ goods during any period of time should be larger than the proportion by which the new investment adds to the output of consumers’ goods during the same period of time. And there is of course no reason to expect that more than a fraction of the new income, and certainly not as much as has been newly invested, will be saved, because this would mean that practically all the income earned from the new investment would have to be saved.²⁹

It is interesting to note that one of today's most prominent monetarists, David Laidler, is forced to resort to Keynesian arguments in a fruitless attempt to criticize the Austrian theory of economic cycles. Nevertheless the author himself correctly recognizes that from the standpoint of the Austrian theory, the differences between monetarists and Keynesians are merely trivial and mostly apparent, since both groups apply very similar “macroeconomic” methodologies in their analyses.³⁰

The above reflections on monetarism (its lack of a capital theory and the adoption of a macroeconomic outlook which masks the issues of true importance) would not be complete without a criticism of the equation of exchange, MV=PT, on which monetarists have relied since Irving Fisher proposed it in his book, The Purchasing Power of Money.³¹ Clearly this “equation of exchange” is simply an ideogram which rather awkwardly represents the relationship between growth in the money supply and a decline in the purchasing power of money. The origin of this “formula” is a simple tautology which expresses that the total amount of money spent on transactions conducted in the economic system during a certain time period must be identical to the quantity of money received on the same transactions during the same period (MV=ΣSpt). However monetarists then take a leap in the dark when they assume the other side of the equation can be represented as PT, where T is an absurd “aggregate” which calls for adding up heterogeneousquantities of goods and services exchanged over a period of time. The lack of homogeneity makes this an impossible sum.³² Mises also points out the absurdity of the concept of “velocity of money,” which is defined simply as the variable which, dependent on the others, is necessary to maintain the balance of the equation of exchange. The concept makes no economic sense because individual economic agents cannot possibly act as the formula indicates.³³

Therefore the fact that monetarists’ equation of exchange makes no mathematical or economic sense reduces it to a mere ideogram at most, or, as the Shorter Oxford English Dictionary puts it, “a character or figure symbolizing the idea of a thing without expressing the name of it, as the Chinese characters, etc.”³⁴ This ideogram contains an undeniable element of truth inasmuch as it reflects the notion that variations in the money supply eventually influence the purchasing power of money (i.e., the price of the monetary unit in terms of every good and service). Nevertheless its use as a supposed aid to explaining economic processes has proven highly detrimental to the progress of economic thought, since it prevents analysis of underlying microeconomic factors, forces a mechanistic interpretation of the relationship between the money supply and the general price level, and in short, masks the true microeconomic effects monetary variations exert on the real productive structure. The harmful, false notion that money is neutral results. However, as early as 1912, Ludwig von Mises demonstrated that all increases in the money supply invariably modify the structure of relative prices of goods and services. Aside from the purely imaginary case in which the new money is evenly distributed among all economic agents, it is always injected into the economy in a sequential manner and at various specific points (via public expenditure, credit expansion, or the discovery of new gold reserves in particular places). To the extent this occurs, only certain people will be the first to receive the new monetary units and have the chance to purchase new goods and services at prices not yet affected by monetary growth. Thus begins a process of income redistribution in which the first to receive the monetary units benefit from the situation at the expense of all other economic agents, who find themselves purchasing goods and services at rising prices before any of the newly-created monetary units reach their pockets. This process of income redistribution not only inevitably alters the “structure” of economic agents’ value scales but also their weights in the market, which can only lead to changes in society's entire structure of relative prices. The specific characteristics of these changes in cases where monetary growth derives from credit expansion have been covered in detail in previous chapters.³⁵

What policy do monetarists advocate to prevent and counter crises and economic recessions? They generally confine themselves to recommending policies that merely treat the symptoms, not the ultimate causes, of crises. In other words they suggest increasing the quantity of money in circulation, and thus reinflating the economy to fight the monetary contraction which, to a greater or lesser degree, always takes place following the crisis. They fail to realize that this macroeconomic policy hinders the liquidation of projects launched in error, prolongs the recession and may eventually lead to stagflation, a phase we have already analyzed.³⁶ In the long run, as we know, the expansion of new loans during a crisis can, at most, only postpone the inevitable arrival of the recession, making the subsequent readjustment even more severe. As Hayek quite clearly states:

Any attempt to combat the crisis by credit expansion will, therefore, not only be merely the treatment of symptoms as causes, but may also prolong the depression by delaying the inevitable real adjustments.³⁷

Finally, some monetarists propose the establishment of a constitutional rule which would predetermine the growth of the money supply and “guarantee” monetary stability and economic growth. However this plan would also be ineffective in averting economic crises if new doses of money continued, to any degree, to be injected into the system through credit expansion. In addition whenever a rise in general productivity “required” increased credit expansion to stabilize the purchasing power of money, this action would trigger and intensify all of the processes which inexorably lead to investment errors and crisis, and which monetarists are incapable of understanding, due to the obvious deficiencies in the macro-economic analytical tools they use.³⁸

A BRIEF NOTE ON THE THEORY OF RATIONAL EXPECTATIONS

The analysis carried out here can also be applied to make some comments on both the hypothesis of rational expectations and other contributions of new classical economics. According to the hypothesis of rational expectations, economic agents tend to make correct predictions based on an appropriate use of all relevant information and on scientific knowledge made available by economic theory. Those who accept this hypothesis argue that government attempts to influence production and employment through monetary and fiscal policy are fruitless. Supporters therefore hold that, to the extent that economic agents foresee the consequences of traditional policies, these policies are ineffective in influencing real production or employment.³⁹

Nevertheless there are serious flaws in the economic logic of these analytical developments in new classical economics. On the one hand, we must take into account that economic agents cannot possibly obtain all of the relevant information, both with respect to the particular circumstances of the current cycle (practical knowledge), and with respect to which economic theory best explains the course of events (scientific knowledge). This is due, among other factors, to a lack of unanimity as to which theory of cycles is the most valid: though the arguments presented here indicate that the correct explanation is the one provided by the Austrian theory of the business cycle, as long as the scientific community as a whole fails to accept it, we cannot expect all other economic agents to recognize it as an acceptable explanation.⁴⁰ Furthermore for exactly the same reasons the economic theory of socialism has proven it is impossible for a hypothetical benevolent dictatorscientist to obtain all practical information concerning his subjects, it is equally impossible for each economic agent to obtain all practical information concerning his fellow citizens, and all scientific knowledge available at any one time.⁴¹

On the other hand, even if, for the sake of argument, we allow that economic agents can obtain the relevant information and hit the mark with respect to the theoretical explanation of the cycle (unanimously understanding the essential elements of our circulation credit theory), “rational expectations” theorists are still incorrect when they conclude that government fiscal and monetary policies can produce no real consequences. This is the strongest argument against the theory of rational expectations. Even if entrepreneurs have “perfect” knowledge of events to come, they cannot shy away from the effects of an expansion of credit, since their very profit motive will inevitably lead them to take advantage of the newly-created money. In fact even if they understand the dangers of lengthening the productive structure without the backing of real savings, they can easily derive large profits by accepting the newly-created loans and investing the funds in new projects, provided they are capable of withdrawing from the process in time and of selling the new capital goods at high prices before their market value drops, an event which heralds the arrival of the crisis.⁴² Indeed entrepreneurial profits arise from knowledge of specific conditions with respect to time and place, and entrepreneurs may well discover significant opportunities for profit in each historical process of credit expansion, despite their theoretical knowledge of the processes which inexorably lead to a depression, a stage they may quite legitimately expect to escape from, due to their superior knowledge as to when the first symptoms of the recession will appear. Gerald P. O'Driscoll and Mario J. Rizzo make a similar observation:

Though entrepreneurs understand this [theory] at an abstract (or macro-) level, they cannot predict the exact features of the next cyclical expansion and contraction. That is, they do not know how the unique aspects of one cyclical episode will differ from the last such episode or from the “average” cycle. They lack the ability to make micro-predictions,... even though they can predict the general sequence of events that will occur. These entrepreneurs have no reason to foreswear the temporary profits to be garnered in an inflationary episode. In the end, of course, all profits are purely temporary. And each individual investment opportunity carries with it a risk. For one thing, other entrepreneurs may be quicker. Or so many may have perceived an opportunity that there is a temporary excess supply at some point in the future.⁴³

In addition rational expectations theorists still do not comprehend the Austrian theory of the cycle, and, like monetarists, they lack an adequate capital theory. In particular they fail to see how credit expansion affects the productive structure and why a recession inevitably results, even when expectations regarding the general course of events are flawless. After all, if entrepreneurs think they possess more (subjective) information than all other economic agents and believe themselves capable of withdrawing from an expansionary process before they sustain any losses, it would go against the grain for them to dismiss the possibility of making short-term gains in a market where such a process had been initiated. In other words, no one is going to turn his nose up at created money just because it will ultimately usher in a recession. One does not look a gift horse in the mouth, especially if one plans to get rid of the horse before the catastrophe hits.

The role of expectations in the cycle is much more subtle than new classical economists assert, as Mises and Hayek reveal in their treatment of the Austrian theory of the cycle, covered in chapter 6. Indeed Mises explains that there is often a certain time lag between the beginning of credit expansion and the appearance of expectations regarding its consequences. In any case the formation of realistic expectations merely speeds up the processes that trigger the crisis and makes it necessary for new loans to be granted at a progressively increasing speed, if the policy of loan creation is to continue producing its expansionary effect. Therefore, other things being equal, the more accustomed economic agents become to a stable institutional environment, the more damaging credit expansion will be, and the more maladjustments it will cause in the stages of the production process. (This particularly applies to the expansion of the 1920s, which led to the Great Depression). Moreover, ceteris paribus, as economic agents become more and more accustomed to credit expansion, larger and larger doses of it will have to be injected into the economic system to induce a boom and avoid the reversion effects we are familiar with. This constitutes the only element of truth in the hypothesis of rational expectations. (In the well-chosen words of Roger W. Garrison, it is “the kernel of truth in the rational expectations hypothesis.”⁴⁴) Nevertheless the assumptions on which the theory rests are far from being proven right, and entrepreneurs will never be able to completely refrain from taking advantage of the immediate profit opportunities which arise from the newly-created money they receive. Thus even with “perfect” expectations, credit expansion will always distort the productive structure.⁴⁵

In short the underlying thesis behind the theory of rational expectations is that money is neutral, given that agents tend to precisely predict the course of events.⁴⁶ Defenders of this hypothesis fail to realize that, as Mises correctly explained, the concept of neutral money is a contradiction in terms:

The notion of a neutral money is no less contradictory than that of a money of a stable purchasing power. Money without a driving force of its own would not, as people assume, be a perfect money; it would not be money at all.⁴⁷

Under these circumstances it is not surprising that new classical economists lack a satisfactory theory of the cycle, as did their monetarist predecessors, that their only explanation for the cycle is based on mysterious, unpredictable, real shocks,⁴⁸ and that they are ultimately incapable of explaining why such shocks recur regularly and consistently exhibit the same typical features.⁴⁹