Three Views of the Market Economy:

1. Three Views of the Market Economy: Capital-based macroeconomics is distinguished by its propitious disaggregation, which brings into view both the problem of inter-temporal resource allocation and the potential for a market solution. F. A. Hayek showed that a coordination of saving and investment decisions could be achieved by market-governed movements in interest rates. He also recognized that this aspect of the market economy is especially vulnerable to the manipulation of interest rates by the central bank. Milton Friedman’s monetarism was based on a still higher level of aggregation. The equation of exchange MV=PQ made use of an all-inclusive output variable (Q), putting into eclipse the issue of the allocation of resources between current consumption and investment for the future. Seeing no problems emerging from the market itself, Friedman focused on the relationship between the government-controlled money supply and the overall price level. Theorizing at a high level of aggregation, John Maynard Keynes argued that market economies perform perversely—especially the market mechanisms that are supposed to bring saving and investment into balance with one another. Seeing unemployment and resource idleness as the norm, Keynes called for countercyclical fiscal and monetary policies and ultimately for a “comprehensive socialization of investment.”

2. KEYNESIANISM LABOR-BASED MACROECONOMICS AUSTRIANISM CAPITAL-BASED MACROECONOMICS MONETARISM MONEY-BASED MACROECONOMICS Which schools advocate market solutions to economic problems? Which schools distinguish between consumption and investment? Which schools see the 1920s as an economically healthy period?

3. KEYNESIANISM (John Maynard Keynes): Markets don’t work --especially the loanable-funds market. MONETARISM (Milton Friedman): Markets do work. Never mind the loanable-funds market. AUSTRIANISM (Friedrich A. Hayek): Markets work --even the loanable-funds market.

4. KEYNESIANISM (John Maynard Keynes): Markets don’t work --especially the loanable-funds market. Saving is based upon habit (and income). Investment is based upon “animal spirits.” Income-expenditure analysis, which takes a depressed economy to be the “general case,” shows how a bad situation gets worse or how a good situation gets better.

5. MONETARISM (Milton Friedman): Markets do work. Never mind the loanable-funds market. Just add Investment (I) to Consumption ( C) to get Output (Q). Now write: MV = PQ. Both output (Q) and prices (P) began falling in 1929 because the Federal Reserve, behaving ineptly, allowed the money supply to collapse.

6. AUSTRIANISM (Friedrich A. Hayek): Markets work --even the loanable-funds market. Saving (S) and Investment (I) are brought into equality (and, more broadly, intertemporal equilibrium is maintained) by adjustments in the rate of interest. Pumping new money through credit markets drives a wedge between saving and investment, triggers and artificial boom, and sets the stage for an inevitable downturn.

7. KEYNESIANISM (John Maynard Keynes): Markets don’t work --especially the loanable-funds market. MONETARISM (Milton Friedman): Markets do work. Never mind the loanable-funds market. AUSTRIANISM (Friedrich A. Hayek): Markets work --even the loanable-funds market.

8. A Brief and Selective Survey on the Issue of Macroeconomic Aggregation Monetarism: Output reckoned as Q. The all inclusive Q puts the issue of the allocation between C and I into eclipse. The interest rate is out of play---but is affected when the Fed changes M. Keynesianism: Output reckoned as I and C. The distinction flags a basic problem, but fails even to hint at a market solution. The interest rate is out of play---or plays a role that is distinctly perverse. Austrianism: Output reckoned as I LONG, I SHORT and C. The disaggregation identifies a basic problem and a market solution. The interest rate is fully in play---affecting I LONG and I SHORT differently.

9. A STOCKTAKING: THREE SCHOOLS On Relative Movements of C and I KEYNESIANISM: Named for its founder, John Maynard Keynes. Builds into its theoretical framework a key perversity, namely that C and I move up and down together — such that there can be no trade-off between these two magnitudes. The PPF serves only to mark the boundary between unemployment and inflation.

10. A STOCKTAKING: THREE SCHOOLS On Relative Movements of C and I MONETARISM: Named for its focus on money. Combines C and I into the larger, all-inclusive Q. Assumes that markets somehow work to give us the right combination of C and I. Shifts attention to the relationship between M and P. Friedman’s money-growth rule (2-3%) is intended to minimize the harm done by the Federal Reserve.

11. A STOCKTAKING: THREE SCHOOLS On Relative Movements of C and I AUSTRIANISM: Named for its country of origin. Identifies a market process that adjusts C and I to match actual saving propensities. Shows how that process can be distorted by economically unsound—but politically expedient—monetary policy. Fed-led booms are inevitably followed by busts.

12. A STOCKTAKING: THREE SCHOOLS KEYNESIANISM Founder: John Maynard Keynes (1883-1946) School of Origin: Cambridge University (England) Focus: Employment of labor Dates: 1936 to present, variously reformulated. John Maynard Keynes’s General Theory of Employment, Interest, and Money (1936) presents the basic principles of “labor-based macroeconomics.”

13. A STOCKTAKING: THREE SCHOOLS MONETARISM Founder: Milton Friedman (1912- ) School of Origin: University of Chicago Focus: Money and Inflation Dates: 1956 to present, variously reformulated. Milton Friedman’s Optimum Quantity of Money and Other Essays (1969), which includes his “Quantity Theory of Money: A Restatement” (1956), presents the principles of “money-based macroeconomics.”

14. A STOCKTAKING: THREE SCHOOLS AUSTRIANISM Founder: Carl Menger (1840-1926) Premiere Macrotheorist: F. A. Hayek (1899-1992) School of Origin: University of Vienna (Austria) Focus: Capital and interest Dates: 1931 to present, variously reformulated. Friedrich A. Hayek’s Prices and Production (1931) presents the principles of “capital-based macroeconomics.”

15. A STOCKTAKING: THREE SCHOOLS On the Cause of Cyclical Downturns KEYNESIANISM: A waning of “animal spirits” causes investment to decline, bringing all else (Y, C, and S) down with it. The market economy is depression prone and requires pro-active fiscal and monetary policies for achieving prosperity and stability.

16. A STOCKTAKING: THREE SCHOOLS On the Cause of Cyclical Downturns MONETARISM: Central-bank bungling causes a collapse of the money supply, which puts downward pressure on prices. Since prices cannot adjust instantly, output falls. Policy formulation should focus on avoidance rather than on remediation. Monetarists often argue that the bungling occurred as the economy was experiencing an “ordinary recession.”

17. A STOCKTAKING: THREE SCHOOLS On the Cause of Cyclical Downturns AUSTRIANISM: Ill-conceived pro-growth policies of the central bank set the economy off on an unsustainable growth path. Eventual market corrections precipitate a downturn. An artificial boom inevitably ends in a bust.

18. CAPITAL-BASED MACROECONOMICS Q: What determines the economy’s growth rate? A: Your willingness to save. Q: What happens when people save more? A: The economy grows faster. Q: How can you get higher growth without saving? A: You can’t.

19. CAPITAL-BASED MACROECONOMICS Q: Is the verb “to grow,” as applied to the economy a transitive verb or an intransitive verb? Consider alternative usages: Save and the economy will grow. Elect a president who will grow the economy. Consider alternative propositions: Save more and the economy will grow faster. Be confident of the economy and consume. Let the Federal Reserve grow the economy.