Hayek and Mises vs. Keynes vs. Friedman

Since the financial crisis, there has been a renewed interest in the Austrian Business Cycle theory, as developed by Mises and Hayek. The theory states that a boom is created by the over expansion of credit, as facilitated by a central bank, which leads to mal-investment that can only be cured through a recession. The recession is the painful process where resources are re-allocated away from unwise projects and back toward more efficient uses. Keynesians argue that a recession is caused by a lack of demand in the private sector, and that government must pick up the slack with deficit spending and monetary stimulus. And finally, the Chicago school says that markets for the most part work, but a recession can be caused by an arbitrary reduction in the supply of money.

In explaining an early iteration of the Austrian Business Cycle theory, Mises uses an analogy of a "master builder". Below, I have modified his analogy slightly and adopted to the Keynesian and Monetarist theories. Yes, it is overly simplistic, and a professional economist might have some disagreements, but it's designed to give an idea of how these theories differ. For more, be sure to watch the Hayek/Keynes rap music video produced by Russ Roberts.

The Master Builder Analogy

Austrian Business Cycle: A builder has a collection of building materials at a local warehouse, but the builder is under the impression that he has 10% more materials then he really has, and he designs a house based on the inflated level of materials. Construction begins and at some point, he discovers that the materials will not be available to complete the project. Since a half completed house is completely useless, the house must be knocked down so that a new house can be designed based on the materials that are actually available. The longer it takes for the builder to discover the mistake, the worse the problem gets. The builder looks into what went wrong, and it turns out that the warehouse owner was intentionally manipulating warehouse records to increase his storage fee revenue, which was based on the inflated level of inventory. When the builder goes to the authorities to report the fraud, it turns out the local government planners were actually in on the scheme. They had been certifying these inflated records because they thought it would be a great way to promote more building.

Keynesian: Keynes would argue that the builder designs and starts construction on the giant house because he is overconfident. He knows that the materials are not available right now, but he is betting on the fact that the good times will continue and that he will ultimately be able to get the materials he needs, or at worst, sell the unfinished house to someone else. But once it becomes clear that he will not be able to complete the house, he becomes overly fearful, and immediately shuts down not only this project, but all of his other projects – even the ones that are almost complete and for which he has enough materials. The unfinished projects are abandoned, the workers are sent home without a job, and they stop consuming, which creates even more unemployment, and the downward spiral ensues. The only way to stop the downward spiral is for the government planners to borrow money or even print money to keep the project going, regardless of how unwise the project is. Even though the workers are working on a house that will never be completed, the government planners must do whatever it takes to make sure the workers continue to receive wages, so that they can in turn continue to spend. Eventually, confidence will return, and projects will resume and new projects will begin.

Monetarism (Chicago school): The Chicago school economists would say that the master builder designs and begins construction on a home based on what he expects to receive in regularly scheduled deliveries over the course of the project. As long as the materials are delivered at their regularly scheduled times, the project will be successfully completed. But for some reason, when he gets near completion, the deliveries stop and the builder can't finish the project. It turns out that the materials were available but the local government planners had abruptly ordered that all deliveries be suspended because they were concerned that too many houses were being built. The builder has no choice but to suspend the project, send all of the workers home unemployed and make plans to knock down the unfinished home. The planners then realize the problem they have caused, and order that deliveries resume. However, the builder is suspicious that the deliveries will stop again, so he refuses to continue the project. The planners then deliver materials at twice the normal rate, until finally the builder has accumulated more than enough materials and is finally convinced to resume the project. Once the house is complete or near completion, the planners order that the excess building materials be collected from the work site and put back in the warehouse. If they wait too long to take back the excess materials, the builder will use those materials to build more houses, which was what the planners were trying to avoid in the first place. Of course, none of this would have happened had the government planners not intervened and stopped the normal scheduled deliveries of building materials in the first place.