Economics on Trial

Does Austrian Business Cycle Theory Have Merit?


Friedman Challenges Hayek


“The Hayek-Mises explanation of the business cycle is contradicted by the evidence. It is, I believe, false.”
—Milton Friedman

Last month, I wrote about the long-standing debate between the Monetarists and the Austrians, which surfaces at practically every Mont Pelerin Society meeting. Both schools are ardent defenders of the free market, yet they fight incessantly over methodology and economic modeling.

The issue is not so much politics as economics. In fact, Milton Friedman, chief spokesman for the Monetarist school, recently wrote a flattering introduction to the 50th anniversary edition of Friedrich Hayek’s The Road to Serfdom. But his attitude (and Allan Meltzer’s) toward Hayek’s Prices and Production and the Austrian theory of the business cycle is less charitable.

Friedman first raised the issue of Austrian business-cycle theory in a 1964 article on monetary studies at the NBER[1] and updated it in a 1993 article in Economic Inquiry.[2] In both articles, Friedman questions the Mises-Hayek thesis that recessions are caused by prior inflations. He examined cyclical activity in the United States (as measured by GDP and other data) between 1879-1988, excluding war cycles and 1945-49. He concludes that there is no significant correlation between the length and severity of an expansion and the succeeding contraction. However, there was a fairly high correlation between the length and severity of a contraction and the succeeding expansion.

The Basics of Mises-Hayek Cycle Theory

Friedman has discovered a most interesting statistical phenomenon, and his interpretation deserves a careful response from those of us sympathetic to the Austrian school. But in order to respond properly, it is critical that we understand exactly what the Austrian theory of the business cycle is and what it implies.

Mises and Hayek argue that the business cycle is caused primarily by cheap credit issued by the government via expansion of the money supply or lowering the discount rate. According to the Austrians, easy money creates an imbalance in the time structure of the economy. It artificially lowers interest rates below the natural rate and creates an economic boom, particularly in the higher-order capital goods industries (mining, manufacturing, commercial real estate, etc.). However, this boom cannot last. As the economy heats up, interest rates rise above the natural rate and the investment boom turns into a bust. The inevitable recession re-establishes the proper balance between consumption and investment.

The Mises-Hayek model is often termed an “overinvestment” or “malinvestment” theory of the cycle because it focuses on the expansion and contraction of the capital investment sector during the business cycle.[3]

Essentially, I see the Mises-Hayek model as confirming Friedman’s dictum, “There is no such thing as a free lunch.” The state cannot create irredeemable paper money out of thin air without paying the price. Monetary inflation doesn’t simply raise prices, it distorts the economy. The first effect of easy money is a boom, but eventually a bust must follow.

The Issue Over Data

Friedman seems to have a basic understanding of the Mises-Hayek model, which is that the cause of a recession is the prior inflation, and the greater the fiat inflation, the greater the subsequent crash, other things being equal. (The higher they climb, the greater they fall.)

Friedman rejects Austrian business cycle theory because the evidence seems to counter any relationship between a recession and a prior inflation. However, I believe Friedman uses the wrong data. In order to properly judge Mises-Hayek, one should correlate “easy credit” with economic activity, not past economic activity (expansion) with subsequent economic activity (contraction). An economic recovery or recession might change dramatically with a shift in monetary policy. For example, the Federal Reserve may not allow a deep recession to run its course, e.g., in 1982, when it injected massive new reserves into the banking system. Also, GDP is not a good indicator of investment activity, the main focus of the Mises-Hayek theory. GDP measures only final output, not the production of higher-order capital goods.

Clearly, there is a strong link between monetary policy and economic activity. Much of Friedman’s lifetime work deals with this close relationship. Mises-Hayek simply goes further, demonstrating how the monetary transmission mechanism works through the capital investment sector.

I offer two examples to elucidate the Mises-Hayek model. First, take the U.S. in the 1950s and early 1960s. Monetary inflation was relatively modest back then, and so was the business cycle. But monetary inflation grew much more rapidly in the late 1960s and 1970s, and so did the volatility of the economy. The expansions were greater and the contractions were more severe, just as Mises-Hayek would predict.

Look at Japan in the 1980s. If the Bank of Japan had adopted the Friedman monetarist rule (increasing the money supply at only 2-3 percent each year), the Austrians would predict only a mild inflationary build-up and subsequent recession. Unfortunately, the Bank of Japan engaged in an extremely liberal money policy, expanding the monetary base by 11 percent for four straight years and keeping interest rates artificially low. The result was (1) dramatic economic growth in the late 1980s, followed by (2) a crash and depression in the early 1990s. I fail to see how the data here contradicts Mises-Hayek. In fact, Japanese economist Yoshio Suzuki confirmed the Austrian thesis recently: “As Hayek teaches us, easy money does not always raise the price of goods and services, but always creates an imbalance in the structure of the economy, particularly in the capital markets. . . . This is exactly what happened in Japan [in the 1980s].”[4] He pointed out that Japanese consumer and wholesale prices were relatively stable during the late 1980s, but an unsustainable “bubble” in asset prices (stocks, real estate, art work, etc.) occurred.

Milton Friedman and I continue to exchange letters debating the merits of Austrian business cycle theory. I agree with him that more research and testing need to be done on this critical issue. Stay tuned. []

1.   Milton Friedman, “The Monetary Studies of the National Bureau,” 44th Annual Report, National Bureau of Economic Research (1964), reprinted in The Optimal Quantity of Money and Other Essays (Chicago: Aldine, 1969), pp. 261-84.

2.   Milton Friedman, “The `Plucking Model’ of Business Fluctuations Revisited,” Economic Inquiry (April, 1993), pp. 171-77.

3.   A detailed explanation of Austrian business cycle theory can be found in Murray Rothbard, America’s Great Depression, 4th ed. (New York: Richardson & Snyder, 1983 [1964]). Hayek’s Prices and Production, 2nd ed. (New York: Augustus M. Kelley, 1935 [1931]), is still in print.

4.   Dr. Yoshio Suzuki, “Comment on Papers by Benegas Lynch and Skousen,” Mont Pelerin Society Meetings, September 27, 1994, Cannes, France. Suzuki also stated, “In my 40 years’ experience as a monetary economist, I have never felt as strongly as I do today the need to bring back to life the essence of Hayek’s trade cycle theory.”


January 1995

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