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9.11 A Keynesian Downturn in the Austrian Framework

The level of aggregation that characterizes the Keynesian framework precludes

any treatment of boom and bust as an instance of intertemporal

discoordination. Structural changes in the economy as might be depicted by a

change in the shape of the Hayekian triangle are no part of the analysis. The

triangle can change only in size, increasing with economic growth (but, in

light of the paradox of thrift, not with saving-induced growth) and decreasing

with occasional lapses from full employment.

The interest rate plays no role in allocating resources among the stages of

production and only a minor role in determining the overall level of investment.

Hence investment is treated as a simple aggregate, with the demand for

investment funds taken to be unstable and highly interest-inelastic. Further, to

the extent that investment is self-financing, such that increased investment

leads to increased income, which in turn leads to increased saving, the two

curves (saving and investment) shift together and hence the particular interest

elasticity of investment is irrelevant.

Straightforwardly, the circular-flow equation (the equality of income and

expenditure as an equilibrium condition) together with a simple consumption

function imply a positively sloped, linear relationship between investment

and consumption. Consider a wholly private economy in which income and

expenditures are in balance:

Y = C + I (9.4)

Consumer behaviour is described by the conventional linear consumption


C = c0 + mpc Y (9.5)

where c0 is the autonomous component of consumption spending and mpc is

the marginal propensity to consume. Combining these two equations so as to

eliminate the income variable gives us the relationship between consumption

and investment for an economy in a circular-flow equilibrium.

C = c0/mps + (mpc/mps) I (9.6)

where mps, of course, is simply the marginal propensity to save: mps = 1–

mpc. This upward-sloping linear relationship was clearly recognized by Keynes

(1937, pp. 220–21) and can be called the Keynesian demand constraint. It has

an intuitive interpretation that follows straightforwardly from our understanding

of the investment multiplier and the marginal propensity to consume.

The slope of this line is simply the marginal propensity (mpc) times the

multiplier (1/mps). Suppose the mpc is 0.80, implying an mps of 0.20 and a

multiplier of 5. An increase in investment spending of $100, then, would

cause income to spiral up by $500, which would boost consumption spending

by $400. This same result follows directly from the slope of the demand

constraint (mpc/mps = 0.80/0.20 = 4): an increase in investment of $100

increases consumption by $400.

The Keynesian demand constraint appears in Figure 9.11, sharing axes

with the production possibilities frontier. In Keynesian expositions, however,

the downward-sloping supply constraint plays a very limited role. When the

multiplier theory is put through its paces, the frontier serves only to mark the

boundary between real changes in the spending magnitudes (below the fronThe

Austrian school 511

Figure 9.11 An investment-led collapse into recession

S, I





Stages of production I

S(YS(Y 0) 1)


co mpc

C = m p s + mps I

S(Y1) = I

S(Y0) = I

tier) and nominal changes in the spending magnitudes (beyond the frontier).

Significantly, the economy is precluded by the demand constraint from moving

along the frontier.

The constraint itself is as stable as the consumption function – as is clear

from its sharing parameters with that function. Hence the point of intersection

of the constraint and the frontier is the only possible point of full

employment. (In the earlier Figure 9.9, which illustrates the paradox of thrift,

the demand constraint shifts downward, reflecting an increase in saving – and

hence a decrease in the consumption function’s intercept parameter c0. It was

precisely because of his belief that this parameter was not subject to change

that Keynes was not particularly concerned about the implications of increased

saving.) Finally, we can note that a more comprehensive rendering of

the Keynesian relationships – one that takes into account the demand for

money (that is, liquidity) as it relates to the interest rate – would alter the

demand constraint only in ways inessential to our current focus.

According to Keynes (1936, p. 315), economy-wide downturns characteristic

of a market economy are initiated by sudden collapses in investment

demand. The constitutional weakness on the demand side of the investmentgood

market reflects the fact that investments are always made with an eye to

the future, a future that is shrouded in uncertainty. Here, the notions of loss of

business confidence, faltering optimism and even waning ‘animal spirits’

(Keynes, 1936, pp. 161–2) come into play. In Figure 9.11, the demand for

investment funds collapses: it shifts leftward from D to D. Reduced investment

impinges on incomes and hence on consumption spending. Multiple

rounds of decreased earning and spending pull the economy below the frontier.

The reduced incomes also translate into reduced saving, as shown by a

supply of loanable funds that shifts from S(Y0) to S(Y1). If the shift in supply

just matches the shift in demand, the rate of interest is unaffected.

The solitary diagram that Keynes presented in his General Theory (p. 180) is

constructed to make this very point. Abstracting from considerations of liquidity

preference, Keynes tells us, the supply of loanable funds will shift to match

the shift in investment demand. Further, an inelastic demand for investment

ensures that even if the interest-sensitive demand for money allows for a

reduction in the interest rate, the consequences of the leftward shift in investment

demand will be little affected. More to the point of the present contrast

between Keynesian and Austrian views, the economy’s departure from the

production possibility frontier and the leftward shifting of the supply of loanable

funds are but two perspectives on the summary judgement made by Keynes.

The market economy in his view is incapable of trading off consumption

against investment in the face of a parametric change – in this case, an increased

aversion to the uncertainties associated with investment activities. The

economy cannot move along its production possibilities frontier.

The reduction in demands all around is depicted by a shrunken Hayekian

triangle. With an unchanged rate of interest, there can be no time-discount

effect. Hence an untempered derived-demand effect reduces the triangle’s

size without changing its shape. But even if, following Keynes, we were to

allow for a change in the rate of interest, the change would be in the wrong

direction, compounding the economic collapse. A scramble for liquidity would

increase the interest rate, with consequences (not shown in Figure 9.11) of

further reduced investment, further reduced incomes, further reduced consumption

and further reduced saving.

The Austrians would be on weak grounds if they were to deny even the

possibility of a self-aggravating downward spiral. Markets are at their best in

making marginal adjustments in the face of small or gradual parametric

changes. A dramatic loss of confidence by the business community may well

The Austrian school 513

send the economy into a downward spiral. Axel Leijonhufvud (1981) discusses

price and quantity movements relative to their equilibrium levels in

terms of a ‘corridor’. Price or quantity deviations from equilibrium that

remain within the corridor are self-correcting; more dramatic deviations that

take prices or quantities outside the corridor can be self-aggravating.

The Austrians are on firmer grounds in questioning the notion that such

widespread losses of confidence are inherent in market economies and are to

be attributed to psychological factors that rule the investment community.

Business people’s confidence may instead be shaken by economy-wide

intertemporal discoordination, which itself is attributable to a prior credit

expansion and its consequent falsification of interest rates. If this is the case,

then Keynes’s theory of the downturn is no more than an elaboration of the

secondary contraction that was already a part of the Austrian theory of boom

and bust.