To suppose that any increased issues of the Bank can have the effect of permanently lowering the rate of interest, and satisfying the demands of all borrowers, so that there will be none to apply for new loans, or that a productive gold or silver mine can have such an effect, is to attribute a power to the circulating medium which it can never possess. . . . To what absurdities would not such a theory lead us! . . . I am well aware that the total failure of paper credit would be attended with the most disastrous consequences to the trade and commerce of the country, and even its sudden limitation would occasion so much ruin and distress. . . (The High Price of Bullion, The Works of David Ricardo by J. R, McCulloch, Pub. John Murray, Albeimarle Street, 1871 pp. 286-87).

Ricardo later returned to this topic in his Principles of Political and Taxation. (Penguin Books, 1971, chapter xxvii On Currency and Banks). But the idea that forcing the interest rate below its market is what generated the business cycle and caused so much social and economic distress did not end with Ricardo. James Pennington, William Huskisson, Robert Mushet, Sir Henry Brooke Parnell, John Benjamin Smith, Colonel Robert Torrens and others carried on the analysis showing that the root cause of the business cycle lay in credit expansion.

The above clearly refutes Quiggin's assertion that the principles of the Austrian theory of the business cycle only made their appearance in the early twentieth century. That was bad enough, he then went on to compound his ignorance by asserting that Schumpeter had contributed to the Austrians' theory. He did nothing of the kind. In fact, Schumpeter, as Quiggin ought to know, was a Walrasian. His view that the business cycle is generated by the emergence of a cluster of inventions and innovations is not only outside of the Austrian explanation it is also untenable.

All of this is bad enough — and par for the course with Quiggin — but his omission of Knut Wicksell and Eugen von Bohm-Bawerk is truly unforgivable. The flaw in the currency school explanation is that while its purely macro-approach could explain the business cycle it could not explain the changes in the pattern of production that it entailed. It was Wicksell's opinion that it was not possible to permanently keep the money-rate of interest below the natural rate because the continual monetary expansion this policy requires would lead to a disproportional rise in commodity prices that would force the banks to adjust the money rate to the "natural rate".

Wicksell made it clear that artificially forcing down the rate of interest will influence commodity prices which in turn will change the structure of relative prices. (Knut Wicksell, Interest and Prices, Sentry Press, New York, N.Y., 1936, p. 7). Unfortunately his analysis was incomplete. Enter von Mises who openly drew on Knut Wicksell's concept of the "natural rate of interest"² and who carried his insights to their logical conclusion. This brings us to Böhm-Bawerk, one of the greats of Austrian economics, a student of Carl Menger and von Mises' teacher. Böhm-Bawerk's theory of capital and interest played a seminal role in Mises' thinking and his formulation of his theory of the business cycle. (Böhm-Bawerk, Capital and Interest [three volumes], Libertarian Press, 1959). That Quiggin is ignorant of this fact is enough in itself to disqualify from attempting even a potted history of the Austrian theory of the business cycle.

Quiggin states that "the Austrians balked at the interventionist implications of their own position..." This is sheer nonsense. He thinks he struck a goal with the observation that the business cycle predated central banking, thereby proving he knows nothing about Austrian economics. The Austrians explain that the root of the problem is fractional reserve banking. (The currency school's tragic error was to deny — unlike their American cousins — that bank deposits are part of the money supply). They only focus on central banks because they are the ones responsible for the money supply. This should put to rest his absurd statement that Murray N. Rothbard "blames central banking for the existence of the business cycle". (Anyone who has read Rothbard's The Panic of 1819 or his The History of Money and Banking in the United States will immediately realise how at variance with the truth Quiggin's assertion is).

It obviously follows that any system of fractional reserve banking — whether under the control of a central bank or not — is subject to Austrian analysis. The range of banking systems that Quiggin refers to all operated on a fractional reserve, including the gold standard. However, a pure gold standard is incompatible with a fractional reserve system. Therefore the old gold standard was in reality a quasi-standard.

This fact was made clear by Sir George Paish who stated that the gold reserve of the Bank if England rarely exceeded $50,000,000 [about £10,000,000 at the time]. (George Paish, The Trade Balance of the United States, Washington: Government Printing Office, 1910, p. 210). Jacob Viner noted that the British banking system rested on an extremely low ratio of gold to liabilities. He estimated that the ratio "fell at times to as low as 2 per cent and never between 1850 and 1890 exceeded 4 per cent" (Jacob Viner Studies in the Theory of International Trade, Harper & Brothers, 1937, p. 264). It should now be obviously the Austrians have never had any trouble explaining pre-industrial booms and busts. (Medieval booms and historical and economic amnesia).

Quiggin suggests that Austrian theory means that "consumption should be negatively correlated with investment over the business cycle". If by this he means that consumption should fall with respect to investment then he is wrong. The Austrian theory is a lot more sophisticated than that. Such a view assumes forced savings occurring in the absence of a current account deficit. However, imports could compensate for an artificially-induced expansion in the higher stages of production. This would be reflected in a persistent trade deficit.

Moreover, for the Austrian trade cycle to kick in consumption does not have to fall even where investment is being funded out of forced savings. All that is needed is for the rate of consumption to drop to a rate lower than it would otherwise be. Now if the Austrians are wrong, something Quiggin clearly believes, then the statistical evidence would be against them. Well, it ain't, something that the Great Depression indisputably proves. Credit expansion funded an enormous amount of investment during the 1920s that greatly exceeded real savings.

According to Austrian thinking the higher stages of production must eventually begin to contract, which they did about 1924 and 1927. On each occasion the Fed expanded the money supply. When the monetary brakes were finally applied the inevitable slowdown emerged. If this view is correct then several things follow: the contraction must hit the higher stages first where the physical production of capital goods must fall at a faster rate than the contraction in consumer goods production, and the prices of producer goods must also fall faster and further than consumer goods prices. All of these things happened. The following table provides the proof.

Comparative Producion of Producers' and Consumers' Goods in the United States (1925-1929 average=100)
	1925	1926	1927	1928	1929	1930	1931	1932
Producers' Goods	93	99	92	104	113	83	54	29
Consumers' Goods	97	97	102	100	104	88	89	82
Source: C. A. Phillips, T. F. McManus and R. W. Nelson, Banking and the Business Cycle, Macmillan and Company 1937, p. 127.

The consumer goods production index in 1929 stood at 100. By 1932 it had fallen to 70, rising to 77 in 1933 after which it continued to rise. Bad as these figures are they are dwarfed by what happened to the capital goods industries where production dived from 100 in 1929 to 32 in 1932, rising to 38 in 1933. (Frederick C. Mills, Prices in Recession and Recovery, The National Bureau of Economic Research, Inc., New York, 1936, p. 418). I should add that during this catastrophic contraction real hourly wage rates continued to rise even as prices fell.

Quiggin finishes with the statement that Austrian business cycle theory "has been a recipe for intellectual and policy disaster and theoretical stagnation". What self-serving garbage. Keynesianism creates a global financial crisis and he attacks Austrianism. Name me a single disaster brought on by Austrian economic theory, Quiggin? Name a single central bank that even subscribes to Austrian business cycle theory? As for "theoretical stagnation", that comes from the neo-classical school and intellectually desiccated leftists.

So what's Quiggin's most likely solution? The "post-Keynesian followers of Hyman Minsky". Post-Keynesians would be better called anti-economists. At least that would be honest. And with respect to Minsky, spare me. The man has nothing to offer. He has no real understanding of the business cycle. All he can do is give a description of what he thinks happens. Minsky and his disciples are — like all leftists — intellectual dead enders.

Austrian business cycle theory is a very involved subject. I realise that my response to Quiggin will probably raise a number of questions in the minds of readers. But I need to stress that no article, no matter how long, can do real justice to the Austrian theory.

One thing, however, is glaring obvious, business cycle theory is in itself a vitally important subject that needs to be publically debated, especially considering the current economic circumstances. Unfortunately Australia's rightwing — those self-appointed gatekeepers of free market thinking — have taken it upon themselves to determine who shall defend the market. The result has been a bloody disaster.

The Great Depression, unemployment, government spending and production: America-hating leftists lie to protect Obama's dangerous economic program

1. The currency school's understanding of the business cycle would have been complete had they a capital theory and had recognised chequing accounts (sometimes called "bank money") as part of the money supply. Ironically, a Scotsman by the name of John Rae published a remarkable work in 1834 containing a highly advanced capital theory that included time preference and the heterogenous nature of capital, stages of production and the role of time. (John Rae, New Principles of Political Economy, Augustus M. Kelley, 1964). When writing of capital and classical economists Hayek commented:

It may perhaps be mentioned . . . that the classical English economists since Ricardo, and particularly J. S. Mill (the latter probably partly under the influence of J. Rae), were in this sense much more "Austrian" than their successors. (Friedrich von Hayek, The Pure Theory of Capital, The University of Chicago Press, 2007, p. 68).

2. It is generally believed that Wicksell's natural rate is based on the marginal productivity of capital as it would be in a barter economy. Marget argued that Wicksell's "natural rate" was wrongly translated with "deplorable results". (Arthur W. Marget, The Theory of Prices, Vol. I, Prentice-Hall, Inc., 1938, pp. 201-204). Wicksell stated:

It is, however, sufficiently certain that sooner or later the money rate will move into coincidence with the natural rate of interest on capital. In other words, the magnitude of the money rate is ultimately determined only by the relative excess or scarcity of real capital goods*. (Ibid. p. xxvi).

*This is clearly a productivity theory of interest..

Gerard Jackson is Brookesnews' economics editor

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