Hayek–Mises Theory as a Demand-Side One

ABCT ADAS

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

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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).

9 thoughts on “Hayek–Mises Theory as a Demand-Side One

  1. JosephFetz

    ” … people gradually began to overlook that they are actually two sides to the same coin”

    That there is the key, and it is how I have always viewed it. One does not exist without, nor is it any more important than, the other.

    Reply
    1. JosephFetz

      I would also like to further say that in the discussion of supply and demand, that one cannot escape a mention of Say’s Law. I have thought about his writings for some time, and have reviewed them more than a few times, and I just don’t believe that many economists put it into the correct perspective.

      The standard supply-side argument is that “supply creates its own demand” (sic). But this cannot be true, because otherwise any good produced would be demanded (which certainly is not the case due to subjective value). I used to be a neoclassical, so this supply-side argument was part of my playbook for some time.

      Keynesian theory is demand-side theory, and Keynes himself had supposedly refuted Say’s Law (essentially turning it on its head). In fact, the standard supply-side argument essentially adopts the same explanation of Say’s Law that Keynes set out to refute– that “supply creates its own demand”.

      I don’t believe that Say’s Law states that supply creates its own demand, rather I believe that what Say was pointing out is that supply and demand are coordinated through the market by way of exchange, that they are essentially two sides of the same coin. Thus, any intervention on one side or the other will create a dis-coordination between the two.

      If a produced good has no demand, that is an entrepreneurial failure, not a general failure. This is due to the fact that the market is constantly changing and progressing to meet the demands of the consumer, but in addition that the consumer wishes to have the products in the same changing and progressing fashion. Money is just a means to this end, it is not the end in itself. It is the aid of transaction, calculation, and exchange; nothing more.

      * * *

      My own takeaway from this is that intervention is often the cause of such dis-coordination, that the manipulation of interest and the arbitrary change in the supply of money (as well as other lesser interventions) distorts the mechanism that allows supply and demand to intersect at a real price, and that this in turn disallows coordination amongst all stages of production. The problem that I see in modern economics is that it is entirely too focused upon having supply and demand intersect at an arbitrary point, that it gives too much emphasis on only one side of the coin.

      In sum, modern economics entirely ignores the basic insight that Say understood. I would like to say that all Austrians understand this insight, but too often I see many of them fall into the same trap of seeing only half of the picture. Too often I see them taking a supply-side stance due to the position of the opposition. Even worse, many of these people who are known as “Austrians” happen to be some of the most popular in terms of presenting the Austrian view to the public. Peter Schiff is probably the best example that I can give of somebody that is described to be an “Austrian”, yet he completely misunderstands Say’s Law (time and time again). Sure, some of his policy opinions are heading in the right direction, but more often than not for very wrongheaded reasons.

      Reply
      1. JCatalan

        The way I look at coordination is as follows. The market is an institution with a number of rules that evolve and change over time (e.g. profit and loss). These rules help constrain the spectrum of discoordination, so that while we may not have a perfectly coordinated market we have an institutional framework that at least limits discoordination, and a framework that improves over time. Interventionism distorts this framework and so the relevant limits to discoordination are changed. ABCT is a perfect example: the profit and loss mechanism is distorted, because phantom profits give the semblance of sustainability. In part, what drives these changes in the market are the interests of those exchanging with others, who want to get the most out of their exchanges.

        Regarding “supply creates its own demand,” I still think this is the right way to say it. When we talk about demand we usually talk about those who are “willing and able.” To be “able” you need to have a source of income, which is your own production. When Keynes critiqued Say’s Law, I think he didn’t put his ideas in the right context. Supply creates demand, but sometimes events can occur that temporarily disallow suppliers to sell their products (the volume of trade falls). That is, supply of real goods makes one able to demand real goods, but there’s an intermediate good called “money” that is also important to consider.

        Reply
        1. Anonymous

          To understand Say’s law, think of money as just another good. There is not really such thing as a buy or a sell, just exchanges. Supply is the exact same as demand, because when you are part of the supply in one exchange, you necessarily are part of the demand for the other side of the trade. We just call “supply” or “offer” the party of the exchange who demands money.

          The law does not mean that you will necessarily find someone with a matching offer/demand to cover the other side of your desired trade.

          The supply of a good does not produce a demand for that particular good, but that action is in itself also a demand (just for something else).

          Reply
          1. JCatalan

            The relevance of the introduction of money is to posit instances where some feature of the medium of exchange restricts the volume of exchange from where it would be if markets were equilibrated.

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