The Foremost Austrian Contribution to Economic Science

In the midst of the chaotic resurgence of various heterodox explanations of the business cycle, the principal Austrian contribution to the discussion has been all but completely lost. Take for instance P. Nicholas Rowe's recent criticism of Arnold Kling's "recalculation problem" theory,1 and Bradford DeLong's mistaken claim that Kling's more controversial beliefs somehow represent Austrian business-cycle theory.2

The point is that given the ever-expanding branches of alternative economic thought, many of which find their origins in the same roots, it is difficult to discern what theory constitutes part of what school.3 For the Austrian School this has meant a complete loss of their single most important contribution to economic science, made between 1871 and 1949.

This contribution, which is in present day almost always ignored in all forms, is the explanation of a working price mechanism. Not only is it ignored but when the Austrians are brought into the discussion, the critics usually focus on what they consider to be the theory's general conclusions. These are, unsurprisingly, usually discarded as retrogressive and unnecessarily pain inflicting.4 It is a case of not being able to see the forest for the trees — the forest, in this case, being the price mechanism, by which the market operates, uniting economic theory.5

Not only is the price mechanism ignored or considered unimportant but it is also often assaulted for being a false characterization or even the source of our problems. Joseph Stiglitz, a Nobel Memorial Prize winning economist,6 writes that "the reason that the invisible hand seems invisible is that it is not there."7 In their criticism of markets, economists abstract the price mechanism into the "mystical" concept of the "invisible hand," which guides individuals' self-interest toward some universally beneficial end.8 Even defenders of the market often forget the obsolescence of the term "invisible hand," relying on it as a metaphor to illustrate the cooperative nature of the division of labor.9

Peter Minowitz inadvertently strikes at the root of the mistake: "Centuries after Smith's death, we are still struggling to fathom a two-word phrase that stands out in a thousand-page book."10 Indeed, the problem is that very few economists have come to fully realize that the mystical, intangible "invisible hand" has been long replaced by the very real theory of the price mechanism — prices are the way that the wants of consumers are transmitted to the entrepreneurs and the method by which the individuals that make up a division of labor coordinate.

Thus, when critics direct their efforts against the Austrian School they frequently do so within their own analytical framework, which is completely inadequate to accurately interpret the Austrian contributions to the science. They attack part of the theory without realizing that the various parts that make up the Austrian understanding of the market process are all interconnected within the "whole."11 The artery, so to speak, of the economic system (the whole) is the price mechanism, and so one can see how ignorance of the concept has led critics of the Austrian School far astray from the actual point.

Market Coordination

How do independent market agents compete and coordinate in the catallactic market?12 This question had long eluded the economics profession, and to the degree argued above it still does. The notion of the "invisible hand" was adequate only as a marker, to indicate that there was a broad understanding that some type of coordination mechanism existed, until something better arose to replace it. This "something" — the price system — was developed, as aforementioned, between 1871 and 1949, or between the publication of Carl Menger's Principles of Economics13 (Auburn, Alabama: Ludwig von Mises Institute, 2007 [1871]). Menger's main contributions are his development of the subjective theory of value and his "causal-realist" theory of prices based on subjective value. See pp. 114–74, 191–225. (Auburn, Alabama: Ludwig von Mises Institute, 2007 [1871]). Menger's main contributions are his development of the subjective theory of value and his "causal-realist" theory of prices based on subjective value. See pp. 114–74, 191–225. and Ludwig von Mises's Human Action.14 Unfortunately, while Human Action set off a rich tradition of research in the area of entrepreneurship within Austrian circles, it had much less of an impact on the mainstream.

In a division-of-labor society, which is one in which the individual depends chiefly on others to satiate his desires, the consumer reigns supreme. The task of investing and risking the capital15 to produce the goods to meet these desires is that of the entrepreneur, and as such he is the driver of the market.16 The theory of market coordination deals precisely with how entrepreneurs dissect and predict consumer preference, invest, produce, and distribute to meet demand. This is all encompassed within the umbrella of the price mechanism. Changes in preference are reflected in prices, thus changing the investment patterns carried out by entrepreneurs.

Without a dynamic price mechanism — trademark of a money-based, capitalist society — there can be no calculation, and without calculation there can be no advanced division of labor. What we enjoy today in the form of production and wealth is the direct consequence of monetary calculation by means of prices. Without money and monetary calculation our society would be no more advanced than it was during the age of barter.

We know that in a market society consumer preference is sovereign, and because of this entrepreneurs aim at investing into lines of production that best fulfill consumer desires. A further consideration is that monetary calculation allows entrepreneurs to determine profit and loss, which in turn reflects how well they satisfy consumer desire. Strictly monetarily speaking, we can assume that because the entrepreneur himself is interested in maximizing the satisfaction of his own desires, he will therefore strive to garner the greatest possible profit from whatever quantity of capital he may decide to invest into a particular line of production.

He does this by appraising his expected gains from a particular venture against the estimated cost of the factors of production he must put to use toward that venture. If the entrepreneur expects to profit from the endeavor and believes that no other use of his capital will reap greater profit (opportunity cost), he will make the investment. Thus, we see how in order to maximize his ability to satisfy his own desires the entrepreneur must invariably act to indulge the self-interest of the consumer.

The entrepreneur is not omniscient. He cannot perfectly forecast the future, as he is always planning amidst uncertainty. There are times when the entrepreneur makes a poor appraisement, expecting profit and instead incurring a loss. In this case, his investment did not adequately sate consumer preference. It follows that it is by this method — through profit and loss — that the market rewards those entrepreneurs who best satisfy the consumer and punish those who do not, redistributing capital into the hands of those who use it most efficiently.17

Capital is distributed among the different avenues of production by means of the uniformity-of-profit principle.18 Simply put, entrepreneurs will invest along the most profitable lines of production until either profits no longer cover costs or investment along other lines becomes more profitable, resulting from a fall in the price of the final consumer good(s) that these lines produce. Thus, the profit motive, in conjunction with changing prices, guides the distribution of capital throughout the structure of production. There is a tendency toward the uniformity of profit and prices, both geographically and intertemporally. This tendency is interrupted by the dynamic nature of the market, due both to changing preferences and to technological progress, as well as any permanent cost inequalities, such as differences in the cost of transportation over varying distances.

"Thus, we see how in order to maximize his ability to satisfy his own desires the entrepreneur must invariably act to indulge the self-interest of the consumer." 

This dynamic distribution of capital along countless lines of production is made possible only by economic calculation, which in turn relies entirely on a working price mechanism. Only by means of money prices can coordination between entrepreneurs and consumers take place in society. Prices are established by the consumers, as they bid money toward the goods they demand and away from the goods no longer wanted. This in turn determines the prices of the relevant capital goods, as it guides entrepreneurs in deciding how much capital to invest along the different stages of production.19

The importance of the consumer cannot be overstated. That the prices of consumer goods decide the price of all relevant factors of production does not mean that efficient calculation can be achieved simply by attaching arbitrary prices to these consumer goods.20 If the efficient production and distribution of goods is a question of whether or not the consumer's demands were satisfied, then it follows that the arbitrary setting of prices runs contrary to this objective. The decentralized assignment of prices of consumer goods is imperative in accomplishing coordination between supply and demand, because only the individual consumer himself knows his own preferences.21 Artificial coordination, or that which takes place independent of the consumer, is therefore destined to failure.22

It is equally important to stress the interdependence of prices. If we study the relationship between the prices of consumer goods, we can derive the impact of changing prices on the entire structure of production. If prices are derived from value, then it follows that a change in the price of one good means an average revaluation of utility scales on the part of consumers, and therefore the value of other goods changes as well. In other words, the change in the price of one good will cause a change in the price of others. Since the price of capital goods is imputed from the price of the final product, it follows that the prices of the factors of production will be altered as well.

Knowing the importance of the price mechanism, it should now be exceedingly clear why it is so dangerous to ignore it when studying economic phenomena. Consumer-driven prices harmonize market activity, and artificial disruption of these prices may in turn disrupt said harmonization.

Hayek's Contribution

Friedrich Hayek's role in developing price theory centers on his elucidation of intertemporal coordination, or that which takes place over a period of time, between consumers and producers — this area of price theory is oftentimes referred to as "capital theory." Hayek's involvement in capital theory began during the mid-1920s with the publication of a number of German-language papers on monetary theory, where he attributed the ongoing economic boom in the United States to the lowering price level.23 He was evidently influenced by Ludwig von Mises's 1912 treatise on money, where Mises had first ascribed this phenomenon as the cause of business cycles.24

Hayek managed to impress Professor Lionel Robbins, who in 1929 became head of the Economics Department at the London School of Economics (LSE), and was invited to give a series of lectures on capital theory in early 1931.25 These lectures were consolidated in written format in Prices and Production, published later that same year. While Hayek's theory was perhaps difficult to grasp, most economists of the LSE soon joined the Hayekian tradition.26

Hayek did not sit idle, and he soon developed a rivalry with John Maynard Keynes, beginning with a critique of Keynes's A Treatise on Money. Unfortunately, this would mark the beginning of the Hayekian demise in England. Hayek's approach received heavy criticism from important economists such as Joan Robinson, Piero Sraffa, and Keynes, the latter two in defense of Keynes's own framework.27 Soon, Frank Knight attacked Hayek's capital theory, and he was followed by Nicholas Kaldor, who had once been a follower of Hayek's.28

By the late 1930s Hayek had lost most of his support at the LSE. Nevertheless, Hayek reformulated and refined his theory, publishing The Pure Theory of Capital in 1941. By this time, however, the economics profession had moved beyond the topic of the causes of industrial fluctuations.29 In spite of this, Hayek's ideas should be considered invaluable in the study of cyclic fluctuations — in evaluating both cause and consequence.30

Production is derived from consumer preference. The explanation of the price mechanism above, however, simply assumes that the entrepreneur commands the necessary capital to invest and meet consumer desires. It is important to bear in mind that this capital, and the capital goods (producers' goods) that it represents, does not simply appear ex nihilo; rather, it is the product of prior accumulation (savings). Savings can only be described as consumption deferred to an unknown future point in time, allowing temporary use of said capital for investment. The investments, of course, are made for the purpose of satisfying that future consumption.31 In Prices and Production, Hayek set out to explain the workings of the price mechanism that coordinated present savings with present investment as a means of satisfying future consumption.32

"The decentralized assignment of prices of consumer goods is imperative in accomplishing coordination between supply and demand, because only the individual consumer himself knows his own preferences. Artificial coordination, or that which takes place independent of the consumer, is therefore destined to failure." 

The fundamental revision to monetary economics that Hayek wanted to see brought about was the replacement of the mechanistic approach to money and the general price level with one that recognized money's role in changing prices relative to each other. This revision suggested no less than revisiting the real effects of money on the structure of production.33

Hayek explained changes in the structure of production as results of changes in aggregate nominal demand34 toward consumption and investment. He presupposed that this could occur in one of two fashions: voluntary savings or monetary expansion. In both cases, like every other entrepreneurial action, changes in the structure of production are predominately profit oriented.

Two premises should be explained. The predominate price that coordinates savings and investment is the rate of interest, manifested on the market as the loan market rate of interest.35 As savings rise, the rate of interest falls; as savings fall, the rate of interest rises. Ceteris paribus, debtors prefer to borrow at a lower rate of interest.

Also important, though not directly related to the topic of interest, is the distinction between specific and nonspecific factors of production. The former are capital goods useful for only certain forms of employment, while the latter are more widely employable. It follows that nonspecific capital goods are more mobile in the structure of production, while specific factors are immobile. Of course, the degree of specificity depends entirely on the good itself — Austrian belief in the heterogeneity of capital should be stressed. The availability of nonspecific factors of production is what allows entrepreneurs to redistribute capital goods from one phase of production to another.

In the case of a rise in voluntary savings, the rate of interest falls and the proportion of total capital in the hands of investors rises. This increases the price of capital goods relative to consumer goods, as the former rise and the latter fall. This process does not occur instantaneously or proportionally amongst all goods, however. The lengthening of the structure of production, as a result in the increase in available capital, will occur gradually, guided by the price mechanism. Investors may first focus new capital on the stages of production immediately earlier than the final stage, raising the prices of the factors of production necessary during this stage itself. Ultimately, as the fall in consumer nominal demand begins to affect the prices of goods in the final stage of production by causing them to fall, and given the rise in prices of the factors of production of the immediately preceding stages, investors begin to redistribute their capital to more roundabout methods of production.36

The lengthening of the structure of production goes on in this fashion, with a rise in the price of factors of one stage causing an increase in investment in the previous stage, which in turn instigates a fall in the prices of the factors of production in the later stages. This will occur until the profit margins between the stages of production narrow to the degree at which there is no longer an incentive to invest in an earlier stage. 37

Figure 1:Graphical exposition of the effects of a lengthening structure of production without a corresponding rise in real savings.

Hayek's pivotal insight is that the effects of an increase in loanable funds causes the loan market rate of interest to depress below the natural rate of interest for a significant amount of time, leading to considerable discoordination within the structure of production. To put it in more understandable terms, it is the theoretical exposition of the effects of a price ceiling on the rate of interest. Like any other price ceiling, the effect is a shortage of the affected good and related chaos.38

Figure 1 illustrates the effects of a lengthening of the structure of production without a corresponding rise in savings.39 The real supply of available capital goods is shown by the curvilinear triangle represented by AB1C1. Contours between the axes represent the structure of production, rightward movements representing a deepening of the capital structure. Solid lines represent the degree to which the lengthened structure of production is supported by real savings, while doted lines mark the portion of the processes of production that are left incomplete as a result of the creation of a scarcity of capital goods.

What triggers the revelation of this incomplete investment, oftentimes described as "malinvestment,"40 is a consequent rise in the price of consumer goods relative to capital goods. That capital deepening did not come at the expense of consumer demand but instead was made possible by an artificial increase in loanable funds, suggesting that the initial fall in the price of consumer goods that should have otherwise taken place did not actually occur. Consumer-goods prices will also rise as a factor of an increase in the price of labor, a product of an increase in the demand for labor as a factor of production, and as a result of a possible diminishing in the stock of capital goods, as some nonspecific goods are used in earlier stages of production. The rise in the price of consumer goods catalyzes the abrupt shortening of the structure of production, revealing a mass of malinvestment.

Hayek's contribution, building on what Mises had written, is invaluable. It is the only theory that builds on an accurate explanation of a working price system in a market economy. It does not just assume discoordination, but explains why this discoordination occurs.41

Mainstream Deficiency

The ultimate rejection of Hayek's capital theory by his peers is without a doubt the principal reason that it is not more widely accepted among mainstream economists today. Several possibilities for Hayek's eventual downfall have been suggested. Perhaps his theoretical exposition was not as watertight as one would have hoped. Furthermore, by the time Hayek published his defense (The Pure Theory of Capital), the profession was no longer interested. There is also no doubt that the difficulty of Hayek's presentation, illustrated by the fact that several reviews of his Prices and Production fell short of showing full understanding of it, may have contributed to his work falling to the wayside.42

After his review of Keynes's A Treatise on Money, Hayek did not critique the former's General Theory, which took the profession by storm during the late 1930s and early 1940s.43 The Keynesian revolution was left virtually unopposed, and Hayek persisted in studying capital theory at a time in which it was no longer considered at all relevant. At the time the world was still suffering the Great Depression, and Keynes's book, which dealt much more with the methods of ending the depression, simply made more sense.

"The point is not to cast these theories as erroneous — even if many of them are — rather, the objective is to highlight the inherent deficiencies of an analysis that fails to take into consideration the most important dimension of the problem: the price mechanism." 

Any strands of Hayekian thought left in the mainstream were promptly routed by the conclusions drawn during the Cambridge capital controversy — especially the notion of "reswitching," which was used to question the precision of Hayek's and Böhm-Bawerk's notion of capital intensiveness.44 Yet the relevance of technique reswitching to capital theory has yet to be established.

The controversy proved that lower rates of interest did not necessarily cause entrepreneurs to change the capital intensiveness of specific processes of production45 but failed to address the general increase in capital intensiveness of economic activity. Hayek's time structure of production was unfairly discarded, and the loss can be most felt in the deficiencies of current mainstream doctrines.

Worst of all, the abandonment of intertemporal coordination — and thus discussion on that particular strand of the price mechanism — caused economic science to deviate away from all discussion and explanation of all coordination processes.

Thus, modern mainstream prescriptions for economic depressions are oftentimes woefully inadequate because they fail to take into consideration the necessity of reestablishing proper coordination between different market agents over an undefined period of time. What is the use of monetary stimulus if the effect is further discoordination? Why perform fiscal stimulus if the consequence is capital consumption without furthering the reestablishment of market coordination? These are important questions that are left ignored when academics pursue the topics at hand. The point is not to cast these theories as erroneous — even if many of them are — rather, the objective is to highlight the inherent deficiencies of an analysis that fails to take into consideration the most important dimension of the problem: the price mechanism.

In the first chapter of his Prices and Production, Hayek argues that the main deficiency of modern macroeconomics is overreliance on the quantity theory of money and too sharp a focus on changes in the general price level.46 Hayek failed to realize the full scope of the profession's failures. The foremost failure was — and it remains — a complete lack of understanding of how the price mechanism guides economic activity and harmonizes the economic system. Their treatment of the topic is highly superficial and found entirely wanting.

Worst of all, a sophisticated explanation of the price mechanism is already available, in the words of the various scholars that made and make up the Austrian tradition. It is, without a doubt, the central thesis of the Austrian theory.

It is unfortunate for the profession — as much as it is for the individual academics themselves — that they have decided to disregard these insights in favor of their own flawed framework. How much decadence has befallen the economics profession is all too manifest in Bradford DeLong's sad confusion between Austrian theory and the far more primitive theory of the "recalculation problem."

• 1Nick Rowe, "Money, Barter, and Recalculation. A Response to Arnold Kling" (December 2010); Arnold Kling, "A Rant Against Monetarism" (December 2010) and "The Recalculation Story: A Summary" (July 2010).
• 2Bradford DeLong, "Nick Rowe on Why the Austrian Theory of the Business Cycle is Arrant Nonesense" (December 2010). DeLong would probably find it more fruitful to read a dedicated Austrian book on the business cycle, but this has most likely already been suggested to him countless times.
• 3This is not only true of the Austrian School but of most schools of thought, including the Keynesians. There is a great deal of heterogeneity in the economic profession, and it calls into question the present state and direction of economic science in terms of accuracy.
• 4For example, see Paul Krugman, "Antipathy to Low Rates" (June 2010). Unfortunately, while these criticisms are by and large unserious, the current (unfair) status of the Austrian School as heterodox forces us to take these criticisms seriously. When approaching the task of responding to criticism from the "mainstream" (from whoever it may originate), the objective should not be to necessarily "defeat" the opponent — an overly aggressive method may in fact be counterproductive — but to persuade those readers who have not yet taken sides (or are willing to change their minds). Within that context, while the Austrian School has not really been able to topple economists like Krugman or DeLong, it is worthwhile to realize that we have been "winning" in the sense that our ranks have recently begun to swell.
• 5The development of price theory owes its advances almost exclusively to Ludwig von Mises, who in The Theory of Money and Credit (1912) united price theory with Menger's subjective theory of value. See Joseph T Salerno,Money: Sound and Unsound (Auburn, Alabama: Ludwig von Mises Institute, 2010), pp. 61–114. Mises later expanded upon this earlier effort in Human Action (1949), where he elucidated the role of the price mechanism in society as a whole. This fact alone makes Mises the most important economist of the 20th century. It is worth mentioning that Hayek's role in developing the theory of the price mechanism was highly influenced by Mises's 1912 work; see Friedrich Hayek, Prices and Production and Other Works (Auburn, Alabama: Ludwig von Mises Institute, 2008), p. 253.
• 6 Nobelprize.org; Stiglitz and two others won the prize in 2001 "for their analyses of markets with asymmetric information," which is a topic that should have everything to do with the price mechanism. Yet, in his prize lecture Stiglitz discusses only to a very limited degree the price mechanism as a whole, instead focusing on specific prices and arguing that these do not provide market agents information reflective of the health of the economy as a whole. This approach is inadequate because it fails to consider the relationship between different prices and the role of multiple sources of information, as well as the natural tendencies for there to be asymmetric information on the market.
• 7Joseph E. Stiglitz, Making Globalization Work (New York City: W.W. Norton & Company, Inc., 2006), p. xiv.
• 8Paul A. Samuelson, Economics: An Introductory Analysis (New York City: McGraw-Hill Book Company, 1948), p. 36. The "invisible hand" is oftentimes attributed to Adam Smith's Wealth of Nations , but Smith only mentions "invisible hand" once throughout the volume. See Gavin Kennedy, "Adam Smith and the Invisible Hand: From Metaphor to Myth," Econ Journal Watch 6, no. 2 (2009), pp. 239–63.
• 9Norman P. Barry, "In Defense of the Invisible Hand," Cato Journal 5, no. 1 (1985), pp. 133–48.
• 10Peter Minowitz, "Adam Smith's Invisible Hands," Econ Journal Watch 1, no. 3 (2004), p. 411.
• 11This is not only true of the method by which the mainstream criticizes the Austrians but it also characterizes their own approach to economics. See Hayek, Prices and Production and Other Works, p. 199. Hayek criticizes the approach to monetary theory that virtually disengages it from the "main body of economic theory."
• 12Catallactics, as defined by Mises, is the study of all market relationships and actions preformed on the basis of monetary calculation — it follows that the price mechanism, or the system that makes possible monetary calculation, is the central tenet of the study of the market. Ludwig von Mises, Human Action (Auburn, Alabama: Ludwig von Mises Institute, 1998 [1949]), pp. 233–35.
• 13Menger, Principles of Economics (Auburn, Alabama: Ludwig von Mises Institute, 2007 [1871]). Menger's main contributions are his development of the subjective theory of value and his "causal-realist" theory of prices based on subjective value. See pp. 114–74, 191–225.Menger,
• 14Joseph T. Salerno, "The Place of Mises's Human Action in the Development of Modern Economic Thought," The Quarterly Journal of Austrian Economics 2, no. 1 (1999), p. 35. Writes Salerno, "Mises's outstanding contribution in Human Action was to singlehandedly revive [the Mengerian approach] and elaborate it into a coherent and systematic theory of price determination."
• 15It is crucial for later discussion to acknowledge that capital is a monetary term. Mises wrote, "The whole complex of goods destined for acquisition is evaluated in money terms, this sum — capital — is the starting point of economic calculation" (Mises, Human Action, pp. 260–61).
• 16Mises likens the consumer to a captain, while the entrepreneur is the one who steers the ship. See Mises, Human Action, p. 270.
• 17Mises makes an exception in Human Action regarding the notion that the market rewards the entrepreneur who best meets consumer demand. He suggests that this is only true in a market where there is either sufficiently elastic demand or there is competition between suppliers, arguing that if both factors are false, then the firm can exact a monopoly price that acts against the best interest of the consumer. See Human Action, pp. 354–76. Mises qualifies his discussion on monopoly price, however, by warning of the role of government in the creation of monopoly prices: "The great monopoly problem mankind has to face today is not an outgrowth of the operation of the market economy. It is a product of purposive action on the part of governments" (p. 363). It stands to reason that to Mises all but only a small fraction of market activity, save for that distorted by interventionism, is to the benefit of the consumer. However, it is also worth mentioning that Mises's monopoly theory has been convincingly criticized by both Murray Rothbard and George Reisman. See Murray N. Rothbard, Man, Economy, and Statewith Power and Market (Auburn, Alabama: Ludwig von Mises Institute, 2009 [1962]), pp. 629–754; George Reisman, Capitalism (Laguna Hills, California: TSJ Books, 1990), pp. 414–17.
• 18This term is borrowed directly from Reisman's Capitalism, pp. 172–94, but the principle predates Capitalism. For example, it is restated throughout Human Action. See Mises p. 358.
• 19This is Carl Menger's theory of value by imputation, transformed by Mises into a theory of cost by imputation (prices are not measurements of value but derivations of value). See Menger, Principles of Economics, p. 152; Mises, Human Action, pp. 330–35.
• 20This argument is briefly considered in David Gordon's ”A Truly Austrian Treatise" (2009), when comparing George Reisman's theory of cost to those of Carl Menger and Ludwig von Mises.
• 21This is the nature of Friedrich Hayek's knowledge problem. See Friedrich Hayek, "The Use of Knowledge in Society," in Individualism & Economic Order (Auburn, Alabama: Ludwig von Mises Institute, 2009 [1948]).
• 22Otherwise, the central planner must not only consider prices of the immediate past (sometimes considered present prices) but must also predict prices of the future (themselves independent of past prices and relevant only to changing consumer preference) on an economy-wide scale. Salerno, Money: Sound & Unsound, pp. 183–85.
• 23Fritz Machlup, "Von Hayek's Contributions to Economics," The Swedish Journal of Economics 76, no. 4 (1974), pp. 499–500.
• 24Hayek, in Prices and Production and Other Works, p. 253, references a translated excerpt from Mises's The Theory of Money and Credit >. A more modern translation reads, "The increased productive activity that sets in when the banks start the policy of granting loans at less than the natural rate of interest at first causes the prices of production goods to rise while the prices of consumption goods, although they rise also, do so only in a moderate degree … but soon a countermovement sets in: the prices of consumption goods rise, those of production goods fall" (The Theory of Money and Credit, p. 401).
• 25Bruce J. Caldwell, "Hayek's Transformation," History of Political Economy 20, no. 4 (1988), p. 516.
• 26Regarding the difficulty of Hayek's theory it is important to consider two things. First, the lectures themselves were conducted in nearly unintelligible English. Second, the way the theory was presented and written made it difficult to comprehend. See Caldwell "Hayek's Transformation," p. 517; Friedrich A. Hayek, Contra Keynes and Cambridge (Indianapolis, Indiana: Liberty Fund, 1995), p. 21.
• 27Hayek, Contra Keynes and Cambridge, pp. 21–31, 37–40.
• 28 Caldwell, "Hayek's Transformation," pp. 517–18. Both Knight and Kaldor advanced their own theories of capital, both theories similarly as obscure.
• 29Machlup, "Von Hayek's Contributions to Economics," p. 508–12.
• 30Interestingly, John Hicks — who was at the LSE during Hayek's time there — remained relatively loyal to Hayek's intertemporal approach to macroeconomic coordination. Although Hicks never came to fully accept Hayek's explanation of business cycles, he nevertheless maintained that the dismissal and abandonment of Hayek's capital theory was an unfortunate loss for mainstream economics. To this end, Hicks wrote Capital and Time in an attempt to synthesize mainstream economics with the Austrian time structure of production. See Mark Skousen, The Structure of Production (New York City: New York University Press, 1990), p. xi.
• 31Mises, Human Action, p. 487.
• 32Hayek, Prices and Production and Other Works, p. 253n54. Here Hayek references the quote provided in footnote 23 above and argues that the principal purpose of his lectures was to expand on just how intertemporal coordination occurs through the price mechanism. (Mises's 1912 work hardly expanded on the topic itself.)
• 33Machlup, "Von Hayek's Contributions to Economics," p. 502; Hayek, Prices and Production and Other Works, pp. 198–202.
• 34Nominal demand here refers to money demand.
• 35Roger W.Garrison, "Hayekian Trade Cycle Theory: A Reappraisal," Cato Journal 6, no. 2 (1986), p. 440. The loan market rate of interest is not necessarily the same as the natural rate of interest, but it is derived from it. There are certain factors, including the dynamic disequilibrium, which preclude the two from being exactly the same at any one time. Furthermore, there are various other derivative rates of interest — discount rate, short-term, medium-term, and long-term loan rates, et cetera — on, or that affect, the loan market. Mises, Human Action, pp. 542–45.
• 36What is meant here by "roundabout" is investment into the production of goods farther away from the final consumer product. It is not a comment on the actual means of production used for the production of that particular good but rather on the distance the relevant capital good is from the final good to be produced for the consumer at some point in the future.
• 37At this stage, there might be some confusion about what exactly is meant by "earlier" or "later," and "higher" and "lower" stages of production. The structure of production is composed of phases of production, some being farther away from the consumer than others. Stages farther away from the consumer are considered to be "earlier" in the process of production and "higher" in the structure of production, while stages nearer to the consumer are "later" and "lower."
• 38For an excellent discussion on the chaos caused by the imposition of artificial prices see Reisman, Capitalism, pp. 219–64. Reisman makes clear that not only do artificial prices disrupt coordination in the production of the specific good in question but of all other goods as well.
• 39Taken from Friedrich A. Hayek, "Capital and Industrial Fluctuations," Econometrica 2, no. 2 (1934), p. 154.
• 40The term "malinvestment" was stressed because it was used to distinguish the Austrian theory of the business cycle from other traditional — and erroneous — overinvestment theories.
• 41Those wary of the complexity of Hayek's exposition may instead prefer to read Ludwig M. Lachmann, Capital and Its Structure (Kansas City, Kansas: Sheed Andrews and McMeel, 1978); , Roger W. Garrison, Time and Money: The Macroeconomics of Capital Structure (New York City: Routledge, 2001); Murray N Rothbard, Man, Economy, and State with Power and Market (Auburn, Alabama: Ludwig von Mises Institute, 2001); Jesús Huerta de Soto, Money, Bank Credit, and Economic Cycles (Auburn, Alabama: Ludwig von Mises Institute, 2009).
• 42One has only to read Piero Sraffa's vicious review of Prices and Production. Indeed, Sraffa opens with, "For, however, peculiar, and probably unprecedented, their conclusions may be, there is one respect in which the lectures collected in this volume fully uphold the tradition which modern writers on money are rapidly establishing, that of unintelligibility." In his review, Sraffa attacks Hayek's conception of neutral money, the purpose of which was to build an artificial model of the structure of production in equilibrium. His criticism of the study of money as that of the value of money itself fails to properly consider Hayek's central thesis: the price of all goods relative to each other. Hayek, Contra Keynes and Cambridge, pp. 198–209.
• 43Hayek did critique Keynes's views held in The General Theory during his later life, but by this time Hayek and the Austrian School had become of secondary importance. Friedrich A. Hayek, Choice in Currency: A Way to Stop Inflation (Auburn, Alabama: Ludwig von Mises Institute, 2009 [1976]).
• 44For an overview, see Joseph E. Stiglitz, "The Cambridge-Cambridge Controversy in the Theory of Capital," The Journal of Political Economy 82, no. 4 (1974), pp. 893–903.
• 45Paul A. Samuelson, "A Summing Up," Quarterly Journal of Economics 80, no. 4 (1966), p. 569.
• 46Hayek Prices and Production and Other Works, pp. 197–200. Hayek also blames the profession's focus on specific parts of the system without considering the system as a whole. This can lead one to similar conclusions as those in the present essay.