I was originally trying to figure out how to illustrate the Mises–Hayek theory of the business cycle for another post, but as I was thinking through the logic it became clearer to me that the causes of the Austrian business cycle are strictly demand-side. The subsequent correction is mostly a supply-side phenomenon, although there may be some shifting of the demand curve due to concurrent forces. In the graphical exposition above, I cite an increase in the money supply as a response to an increase in the demand for money as one proximate cause for a rightward shift in the demand curve, but I’m sure there are various other reasons one could think. Also, I’m not so sure an increase in the demand for money would necessarily lead to a shift in the demand curve as much as it would soften the original leftward shift (M ≡ money supply, md ≡ individual demand for money; if M = Σmd, then ↑Σmd = ↑M → if the initial phase of the bust brings about a contraction of excess fiduciary media, then an increase in desired cash balances will lessen the quantity of excess fiduciary media).1 In any case, demand-side shifts are more contingent on certain probabilities attached to simultaneous phenomena, such as an increase in the demand for money.
The Mises–Hayek theory is oftentimes mistaken as a supply-side phenomenon, but I think this is because of an undue emphasis on the consequent structural readjustment. But, the structural readjustment is made necessary precisely because of demand-side adjustments. And the latter takes place because the collapse in demand (overall and for specific products) causes a collapse in the price of inputs, shifting the supply curve down and to the right. Admittedly, this isn’t a demand-side theory in the same vein as the textbook characterization of the Keynesian theory, since in this case the recovery to the the original level of output is brought about by an increase in demand (rather than by an increase in quantity demanded). But, I think textbook Keynesian theory suffers from what Gene Callahan calls “bad metaphysics”:2 supply and demand were separated for analytical purposes, but then people gradually began to overlook that they are actually two sides to the same coin. Although I don’t think real business cycle theory is incompatible with simultaneous, but related, changes on the demand side, any theory that emphasizes strictly supply-side changes is also bound to be unduly shortsighted.3
What brought me to think about this was Mark Thoma’s recent post commenting on an article by John Taylor. The title provides the gist: “the unemployment problem is cyclical.” I’m not defending Taylor or even considering his position, but there is something fundamentally wrong with not being able to picture a situation where unemployment is both cyclical and structural.4 It would be like saying that business cycles don’t bring about both demand- and supply-side changes. This is one of the things that makes the Mises–Hayek theory so appealing: it doesn’t confuse the supply and demand dichotomy for what it’s not, and it explains the business cycle by considering both supply- and demand-side factors. It’s actually surprising that so many people confuse it as a strictly supply-side theory since Hayek was clear in arguing that its causes are monetary.5
1. I’ve written on this before; see my post: “Recessionary Free Banking.”
2. The post I’m referencing is discussing something else entirely, but I’m just borrowing the concept. But, Gene Callahan makes a similar point to mine in his very next post, albeit in a different context.
3. Writing this post reminded me of some comments on real business cycle theory made in a class I took on international monetary theory. One student asked professor Gerber why some economist still hold onto supply-side explanations of cyclical fluctuations if these predict a rise in the price level (the supply curve shifts up and to the left). But, if a real business cycle theorist claims that the supply shock can cause subsequent changes on the demand-side, then the price level conundrum is solved. But, I’m not real business cycle theorist, and thinking about this actually helped me realize that Austrian business cycle theory is caused by a shock in demand.
4. It matters how you define the term “structural unemployent.” Wikipedia defines it as a skills mismatch. This isn’t my position (see my piece on Mises Daily, “Affording the Unemployed“). Further, I don’t think this is what other economists have in mind when they talk about structural unemployment within the context of the business cycle. Rather, we’re referring to changes in the allocation of the means of production. In this sense, “structural” unemployment is both structural (where re-training might be necessary) and frictional. The term “cyclical” also suggests that there are other issues which aren’t there when we’re talking about “natural unemployment” (UN = US + UF). But, again, we’re writing in a context that takes the business cycle for granted. “Cyclical” and “structural” are really being used to distinguish between demand- and supply-side causes, respectively.
5. The bust is easier to illustrate with the AD–AS model, but I don’t think AD–AS is well suited to illustrate the boom (which, in turn, suggests that the above modeling is missing important nuances — but not nuances that detract from my general point). The boom is not about a rightward shift in the demand curve that causes a temporary, unsustainable increase in output. Rather, it’s about how credit expansion can influence the pattern of demand in such a way that it brings about the misallocation of resources. In other words, output remains the same, but the composition of output is unsustainable. But note, changes on the supply-side still follow changes on the demand-side. Why does the revealing of malinvestment cause a shock to output, as opposed to a mere change in composition again? It has to do with the sudden disintegration of order — see Andreas Hoffmann and Björn Urbansky, “Order, Displacements and Recurring Financial Crises” (I had my reservations about this paper, but I can’t remember exactly what they were right now).