New Perspectives on
Political Economy
A bilingual interdisciplinary journal
Vol. 10, No. 1, 2014
A bilingual interdisciplinary journal 3
New Perspectives on Political Economy
A bilingual interdisciplinary journal / Vol. 10, No. 1, 2014
New Perspectives on Political Economy is a peer-reviewed semi-annual bilingual interdisciplinary
journal, published since 2005 in Prague. The journal aims at contributing to scholarship
at the intersection of political science, political philosophy, political economy and
law. The main objective of the journal is to enhance our understanding of private property-,
market- and individual liberty-based perspectives in the respected sciences. We also belive
that only via exchange among social scientists from different fields and cross-disciplinary
research can we critically analyze and fully understand forces that drive policy-making and
be able to spell out policy implications and consequences. The journal welcomes submissions
of unpublished research papers, book reviews, and educational notes.
Published by CEVRO Institute Academic Press
Editorial Address:
New Perspectives on Political Economy
CEVRO Institute, Jungmannova 17, 110 00 Praha 1, Czech Republic
Manuscripts should be submitted electronically. All manuscripts and correspondence
should be addressed to nppe@vsci.cz.
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Authors submitting manuscripts should include abstracts of not more than 250 words and
JEL classification codes. New Perspectives on Political Economy edits for clarity, brevity,
and in accordance with the Chicago Manual of Style. Authors should use footnotes rather
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Authors should include information on their titles and professional affiliations, along with
e-mail address.
ISSN 1801-0938 (on-line)
ISSN 1804-6290 (print)
New Perspectives on Political Economy4
Editor-in-chief:
Josef Šíma, President, CEVRO Institute, Prague
Managing editor:
Pavol Minárik, CEVRO Institute, Prague
Advisory editor:
Ladislav Mrklas, CEVRO Institute, Prague
Associate editors:
Pavel Pšeja (political science), Masaryk University, Brno
Michal Kořán (international relations), Institute of International Relations, Prague
Alena Zemplinerová (political economy), Institute of Economics, Academy of Science,
Prague
Roman Cardal (political philosophy), CEVRO Institute, Prague
Jakub Kříž (law), CEVRO Institute, Prague
Book review editors:
Jan Jireš CEVRO Institute, Prague
Language editor:
Shelly Gussis
Editorial Board:
Terry Anderson, Hoover Institution,
Stanford University
Peter Boettke, George Mason University
Hardy Bouillon, Trier University
Enrico Colombatto, University of Turin
Christie Davies, University of Reading
Frank van Dun, Ghent University, Faculty
of Law
Richard Ebeling, Northwood University
Richard Epstein, New York University
School of Law
Robert Higgs, The Independet Review
Jesus Huerta de Soto, Universidad Rey
Juan Carlos
Jorg Guido, Hulsmann Université Anger
Zdeněk Kühn, Charles University, Faculty
of Law
Miroslav Novák, CEVRO Institute
Svetozar Pejovich, Texas A&M University
David Schmidtz, University of Arizona
Gerald Steele, Lancaster University
A bilingual interdisciplinary journal 5
Lessons From Developmental Strategies
Over The Last Hundred Years1
Jan Winiecki2
This is a brief story of the most popular developmental strategies applied over the last century
(to be more precise, since 1917), of their economic outcomes, as well as of the “conspiring
circumstances” that led to adjustment or complete abandonment of these strategies. I chose
two such popular strategies and, then, the third, much closer to classical economic prescriptions.
In other words, a return to economic foundations.
What was the nature of these two popular strategies? Chronologically:
•	 In the (communist) East it was a so-called “steep ascent” strategy envisaging the fastest
possible increase in the share of industry, and more specifically heavy industry.
The choice of strategy took place under the circumstances of a complete economic
system change. A centrally planned and administered economy was imposed in place
of the – already highly constrained – market economy (the former system in the English
language literature had more often been called a command economy).
•	 In the much more varied South (called after World War II the “Third World”) it was
also a highly interventionist, dirigiste (to use a French term) developmental strategy
of managing the economic development from the center, while accepting, however
grudgingly, the existing, but strongly constrained, market economy as a system.
Both strategies aimed to catch up with the West’s level of economic development, but –
thanks to the dominance of the state over the operations of the economy and hopefully
over the future economic development – to do it in a shorter time span than did the West.
To put it differently, they were both “shortcut” strategies. The idea was that saving time
means also saving the cost of moving the economy from underdevelopment to development
and reaching the West’s level of GNP per capita (nowadays a standard measure of
development) faster than under the largely spontaneous, market order-determined development
path.
1	 This is a written version of a presentation offered at the 2014 Conference on Political Economy at CEVRO
Institute in Prague.
2	 Professor and Chair of International Trade and Finance at University of Information Technology and Management,
Rzeszow, Poland. This term he is also a member of the Monetary Policy Council at the Polish National
Bank.
New Perspectives on Political Economy6
The results werein the case of both strategies drastically different from expectations.
With the benefit of hindsight, we now know that the goal of catching up was not achieved
and strategies themselves were abandoned one way or another:
•	 Either in a complete change after communism’s collapse in the 1989–91 period; or
Over a longer period, and often through a series of partial reforms departing step-bystep
from development economics’ theorizing-based strategy.
Although the spirit of dirigisme, of tinkering with the economy is alive and well (even kicking
recently, since the Great Financial Crisis), almost no one seriously suggests nowadays
the return to central planning and administration, combined with the strategy of the rapid
build-up of heavy industry (and sacrificing everything else, including the improvement in
living standard of the population). No one suggests either the return of the “Permit raj”,
a symbol of the almighty bureaucracy and planning for development in “India of the slow
economic growth era” between 1947 and 1990. That is, India under the spell of the dirigiste
development economic ideas, the believers of which pointed often to India as a shining
example in the early post World War II period.
The idea that a “shortcut” strategy does not work has been revealed step-by-step, decade
after decade. The same happened with the dawning realization that classica economic prescriptions
did not lose their validity also with respect to poor countries. This realization
was strengthened by the emergence of the new strands of economic thinking, underpinning
classical economics, such as new economic history, property rights theory, public choice
and similar strands of theorizing. The post-WW II revival of Austrian economics, crowned
in 1974 with the Nobel Prize in economics for Friedrich Hayek, was also a part of the process
in question.
Conspiring circumstances
John Stuart Mill in the middle of the19th century wrote that new ideas need “conspiring circumstances”
to succeed. Mill’s concept fits the post-World War II story of new 20th century
orthodoxies, theorizing on economic development. The clash of theorizing and realities
produced – over a period of decades – solid, and accumulating, evidence of multiple failures
of these strategies. The evidence in question and its political cum economic consequences
created a fertile ground for Millsian conspiring circumstances that led to the successful
reemergence of classical market-based economic ideas.
Significantly, the accumulating evidence of interventionist failures became increasingly
visible in more or less the same period all over the world: in the mid-1960s.
•	 In the most strictly controlled world of communism a series of reforms in Eastern
Europe (as the Soviet Union and its dependencies were called at the time) failed to
produce positive changes in the level of efficiency. Lasting improvements were neither
visible in reforms in Hungary and Poland in the second part of 1950s, nor later
in the USSR, Czechoslovakia, and communist East Germany. Costly distortions of
A bilingual interdisciplinary journal 7
aberrantly high resource intensity, resistance to innovation and resultant increasingly
obsolete product range, dramatically low quality of output, etc., continued
unabated.
•	 Moreover, Czechoslovak reforms spilled over, under the people’s pressure, into politics
and resulted in the Soviet-led military invasion and the removal of the reformist
government. The message was clear for Eastern Europe: no serious reforms were to
be pursued, only tinkering. An ossification process of the already extremely rigid economic
system began.
•	 With respect to less developed countries of the South,asaying became popular at the
time: “They were first facing the problems of economic growth and now they face the
growth of economic problems”. And indeed they were. Costly distortions began to
spread and became more painful with the shift from the “easy” import substitution
phase to that of substituting imports with domestic production of heavy industries,
where countries of the South did not possess comparative advantages.
Unsurprisingly, these distortions were roughly similar in both communist countries and
the less developed South. After all, both “East” and “South” pursued the same type of a
“shortcut” strategy: forced economic development led by the strong hand of the government
(with a greater or smaller dose of central planning thrown in). With similar strategies,
distortions were of the same kind. Where they were not, it was due to the fact that
distortions in communist economies resulted not only from a “shortcut” strategy, but also
from the economic system, prone to generate heavy distortions on its own, regardless of
the strategy.
The West had faced, of course, a largely different range of economic problems, those of
developed market economies. However, the post-WW II expansion of the role of the state,
the interventionist macroeconomic governance and overregulation, also began to show
with the passage of time increasingly adverse consequences. “One way” Keynesian demand
management, that is expansionist fiscal policies at growth decelerations and almost no
restrictive fiscal policies at excessive growth accelerations, created a pattern of ever higher
inflation from one business cycle to another, beginning in the late 1950s. Simultaneously,
economic growth tended to decrease from cycle to cycle.
And in 1970s, with the explosion in commodity prices, Western economies revealed
another weakness, this time created by overregulation. The rigidity was so serious that a
new term was coined: eurosclerosis. Let me add that although the term applied to Western
Europe, the US was not that far behind.
To sum up, the foregoing developments from World War II to the mid-1960s and beyond
to 1970s, when a variety of difficulties were revealed nearly everywhere, should have
brought into attention the J.S. Mill’s dictum that ideas need conspiring circumstances to
succeed. The dictum applies to both theoretical domination and policy practice. It signaled
that new orthodoxies did not work as expected and laid factual foundations for the future
return of classical economics, strengthened by new, or facing the renewal similar strands of
free market-based thinking.
New Perspectives on Political Economy8
The lesson from little dragons
The return of the capitalist market with the corollary of free prices and private economic
agents operating in a competitive environment had taken place step by step since the second
half of the 1960s. The first step in that direction took place even beforethe start of the
intellectual expansion of free market ideas in the post-WW II period. That step was made
by a small group of East Asian countries called alternatively “little dragons” or “little tigers”
to differentiate them from thebig dragon, Japan.
Contrary to common perception, their choices in favor of the capitalist market were
taken in different ways and in different environments. Hong Kong, under the energetic classical
liberal economic administrator, pursued its famous policy of “active non-intervention”
already since the mid-1950s. Taiwan and South Korea were typical dirigiste economies after
their emergence as independent states, with all the failings of such a developmental strategy.
They changed in late 1950s and early 1960s by allowing a much greater role of markets
and greater openness vis-à-vis the world market. The change took place under pressure from
the US, its defender in the military realm and the supplier of a very substantial amounts
of foreign aid. And Singapore threw its lot with more markets and more openness in mid-
1960s, when it decided to become an independent city-state.
Although their paths toward more markets and more openness were different, the economic
outcomes of the institutional changes were the same. Economic growth rates increased
sharply, while manufacturing export growth rates tripled or quadrupled in comparison
with the dirigiste past.
Interestingly, they for a long time were not seen as examples for other less developed
economies of the South. The strength of beliefs in development economics-based ideas of
managing from the center, planning investment and controlling foreign trade had been very
strong in that period. Ideological preferences were, moreover, reinforced by interests of the
ruling elites, which enjoyed both power and the ability to benefit materially, stemming from
the management of the national economy from the center.
Thus, “little dragons” were first called “special cases”, with their critics stressing the alleged
short-term adverse effects of “dangerous” market reforms. They needed
15 or more years of high growth and even higher exports to find a few – mostly timid –
followers in the South.
Although a strong version of interventionism, associated with managing the economy
from the center, began to lose gradually some of its attraction, the slowness of the process
was not a natural process, but a process obstructed by an innovative rearguard action of
intellectual supporters of dirigisme.
They first ignored economic successes of the little dragons, then called them special
cases (not applicable to the wide and diverse group of Southern countries) and finally
“adopted” the dragons as fellow interventionists. They announced triumphantly that “little
dragons” also intervened, the only difference being that they intervened “wisely”.
However, the major difference was not that they intervened wisely (adoptionists never
explained the secret of wise intervention), but that they intervened less. Besides, it is worth
A bilingual interdisciplinary journal 9
keeping in mind that the world was a different place from the 1950s to the 1970s. Nobody,
including the West, was then a paragon of excellence as far as freedom of markets was concerned.
In fact, “little dragons” succeeded primarily by sticking to market fundamentals,
like – for example – following the Heckscher-Ohlin version of classical trade prescriptions
in their export choices.
The period from the mid-1960s to the late 1980s was a slow uphill march of a greater role
of markets and greater openness in the South, a march with detours and returns at various
times and in various places. Moreover, the intellectual discontent and the discontent with
economic outcomes were less directly felt in the realm of politics, given the undemocratic
governance regimes in a majority of countries in question.
Nonetheless, the number of those governments that both were bona fide reformers and
felt brave enough to face the massive criticism from the still large numbers of believers in
the tenets of development economics increased over time. Rather small in the 1970s, it
grew in the 1980s, and multiplied in the later period.
The West and the post-communist transition
The story of the West, although beset by different problems from those typical for economic
development, was more straightforward politically. Being the only democratic area at the
time helped. Intellectual discontent and economic outcome discontent converged in the
second half of the 1970s and resulted in political changes through the ballot box.
The rest is history too well known to be repeated here. It is enough to state that Thatcher
and Reagan free market “counterrevolutions” not only liberalized the respective economies.
They also had an impact on the West as a whole. The 1980s and 1990s were for
the Western world the age of deregulation and macroeconomic moderation (and the age
of – less successful – attempts to put public expenditures in order). The United States and
the United Kingdom benefited most in terms of economic growth. The former grew over
the 1980–2005 period faster by almost one percentage point annually than the major West
European economies, while the latter grew faster than Germany, France, and Italy. And it
is worth keeping in mind that in the first 25 years after World War II, the growth pattern
was just the opposite.
The communist system turned out to be the most resistant to both new ideas (suppressed
in the public sphere) and discontent with economic outcomes (lied about but palpably
visible in long queues and other manifestations of excess demand). The tight totalitarian
control over the subjects was the cause. But once the rot started to spread, it spread more
quickly due to the lack of bona fide defenders of the regimes. As economic historian David
Landes so perceptibly remarked in his monumental book The Wealth and Poverty of Nations,
“The weakness of autocracy is in the human raw material. Fortunately.” So, with the collapse
of communism in Europe in the 1989–1991 period, the triumph of Millsian “conspiring
circumstances” was complete.
New Perspectives on Political Economy10
Two cases of transition – or transitions, economic but also or even in the first place po-
litical – should be considered in this story in somewhat greater detail: the post-communist
transition in Europe and the transitions in the two most populous countries of the world:
China and India. They will be dealt with in that order.
Post-communist transition in East-Central and Eastern Europe was certainly the most
difficult shift toward the greater role of markets and greater openness. Clearly, it was more
difficult to build the capitalist market system from scratch, where none had existed after the
imposition of communism, than to remove (numerous) distortions imposed upon the still
existing, even if severely constrained, market system in countries of the South. Apart from
institution-building, both stabilization and liberalization were more difficult. Moreover, the
extent of privatization was infinitely greater as well.
What helped in the eight countries stretching from Estonia in the North-East to Slovenia
in the South-West were common civilizational, that is Western, roots. Elites and societies in
these countries regarded themselves as a part of the West from which they had been forcibly
detached by the Soviets. Thus, political system change went there very smoothly. Nowhere
else, in the former East or in the South were informal institutions so conducive to such
change (maybe in Croatia for the same reasons).
So, the foregoing eight countries (Estonia, Latvia, Lithuania, Poland, Slovakia, Czech
Republic, Hungary and Slovenia) became the transition leaders and at some point anchored
inWestern organizations like NATO and the European Union. The remaining, more
numerous post-communist countries fared worse – at times much worse. The reasons, in
my opinion, expressed inter alia in my 2004 Routledge book Private Sector after Communism
(written jointly with Vladimir Benacek and Mihaly Laky), are not only in the less
consistently pursued transition strategy with respect to stabilization, liberalization, and privatization,
but also a much less conducive civilizational environment. The area of Eastern
Christendom, for example, never enjoyed the similar extent of civic and economic freedoms
over the last millennium. Seen from a historical perspective, informal institutions cast a
very long shadow.
The classification of the eight above-mentioned countries as examples of success is sometimes
contested. Critics point to the fact that these countries never achieved – after systemic
change – very high economic growth rates like,for example, the four “little dragons” in
the past or reformed communist China at present. The answer is, however, that they could
not for the following reasons:
•	 They had to shed the deadwood communist system’s production for production’s
sake, that is to cut production unneeded under the normal market circumstances. It
was primarily, but not exclusively, production of heavy industry.
•	 Next, gravitational model of foreign trade explains well the rapid expansion of these
countries’ exports to Western Europe. What it cannot explain, and predict, is the fact
that Western Europe is a slowly – and increasingly slowly – growing part of the world.
In spite of an undoubtedly high rate of export expansion to the West and successful
incoming foreign direct investment therefrom, the slow growth of the major trade
partner matters (and will matter even more).
A bilingual interdisciplinary journal 11
•	 Finally, shedding the deadwood of unneeded output resulted in sharp GDP declines
in the early transition affecting the average economic growth rate in the longer run.
Besides, it is an intellectual error, often committed by those who point to China as
a country that succeeded in economic transition without GDP decline, to expect
that the East-Central European economies could do the same, but failed in that task.
These are middle-developed economies, while the Chinese pattern is possible only
at a low level of economic development. Only at that low level there is still a labor
force available in agriculture that is willing to work in new, efficient labor-intensive
industries emerging in transition to the market. It is increases in their output that may
balance the decreases in output in the distorted heavy, capital-intensive industries,
dominant at the middle level of economic development. There was no such labor in
existence in any significant quantities in the middle developed economies of EastCentral
Europe.
China and India
Another set of confusing ideas surrounds China and India. In their case, however, it is
more an ideological than purely economic theorizing-based confusion. Some West-haters
(capitalism-haters, multinational business-haters, you name it) advertise the thesis on the
emerging “Beijing consensus” model allegedly better than a classical Western economic
thinking-based “Washington consensus” model.
The reality is – as it often happens – different. Just like with East Asian “little dragons”
whose successes were first ignored, then ascribed to luck and special circumstances, and
later adopted as another version of interventionism, the Chinese institutional shift to the
greater role of markets internally and greater economic openness externally, has also been
adopted as another version of interventionism. Although the old Marxian slogan “Proletarians
of all countries, unite!” has long been dead, another leftist slogan “Tinkerers of all
strands of economic thinking, unite (in negating the success of markets)” is still alive. And
increasingly kicking in recent years.
To summarize, the China-India story, whatever economic successes they achieved so far
in terms of economic growth and in lifting hundreds of millions from poverty to near-middle
class level, has been achieved thanks to the (still far from complete) capitalist market.
By contrast, whatever problems they continue to be beset with are largely due to the impact
either of the recent past (communist or bureaucratic planning past), or the impact of the
more distant past of despotic, stagnant respective empires.
New Perspectives on Political Economy12
Austrian Business Cycle Theory
Without Unrealistic Constructs
Daniil Gorbatenko1
Abstract
Austrian Business Cycle Theory (ABCT) purports to explain recurrent clusters of unsustainably
lengthy investment projects following episodes of credit expansion by central
banks. In this paper, we show that doing justice to the insights behind ABCT requires a
disequilibrium-based restatement of the theory and abandonment of unrealistic equilibrium
and equilibrium-related constructs. We also sketch the contours of the explanation of the
genuine errors that need to be made to set the stage for the unsustainable boom described
by ABCT.
Keywords
Austrian Business Cycle Theory, equilibrium, disequilibrium
1	 PhD candidate at the Department of Economics and Management (Economie et Gestion) at the Aix-Marseille
University; email: daniilgor2004@gmail.com. The author would like to thank P. Garello, Y. Maouchi,
and an anonymous reviewer for helpful comments. The usual caveat applies.
A bilingual interdisciplinary journal 13
1. Introduction: The Intuitions behind the Austrian Business
Cycle Theory And Its Current State of Development
Austrian Business Cycle Theory (ABCT) was developed in an attempt to account for a
recurrent pattern of events (normally referred to as the business cycle) under which the
boom stage during which the economic activity was high was followed by a period of economic
decline. The economists of the British Currency School who were in many ways
precursors of the economists of the Austrian School also noticed that this cyclical pattern
was preceded by attempts of the institutions controlling the money supply (in the British
Currency School’s case, the Bank of England) to expand the money supply. In this view,
the expansion of the money supply proceeded to create excess credit beyond the supply of
voluntary savings available in the economy. The Currency School’s economists referred to
this phenomenon as “forced saving”.2
The economists of the Austrian School have deepened these intuitions. The understanding
of the heterogeneity of capital and the explicit treatment of production as happening in
time allowed them to conjecture that the boom phase of the cycle consisted in the deviation
of the time structure of production from the time structure of consumer demands. The
deviation consisted in a cluster of investment projects being undertaken that later turned
out to be unsustainable.
The theory which emerged from these intuitions was, however, rather aggregative. Instead
of focusing on the cluster of particular investment projects and the loans by which
they are financed, Ludwig von Mises (2008 (1949)), F.A. Hayek (2008 (1931)) and those
who followed in their steps tried to use several problematic constructs.3
In general terms, the classical version of ABCT can be summarized as follows. In the
normal circumstances in which voluntary savings are the only source of credit, the equilibrium
loan market interest rate (gross market interest rate) stays equal to the natural (originary)
rate of interest. The latter is defined as the equilibrium interest rate which would have
been established if the lenders lent investors not money but intermediate goods directly.
In case of a credit expansion by the central bank, since the loan market interest rate falls
below the natural interest rate, it becomes illusorily profitable for the producers to make
the production structure of the economy more roundabout or to increase the number of
stages of production.4
2	 For a detailed discussion of the British Currency School’s view see Mises (2008 (1949), 568–73).
3	 For notable more recent versions of ABCT, which in our view employ reasoning similar to that of the early
accounts of Hayek and Mises, see Rothbard (1996 (1978)), Garrison (2000), Murphy (2011), Salerno (2012).
4	 Some economists of the Austrian School believe that credit expansion may also be caused by a concerted
action of private fractional-reserve banks in an economy without a central bank. For the reasons provided by
Selgin (1988, 80–82), we are sceptical of such a possibility. Nevertheless, even if decentralized credit expansion
is possible, it does not impinge on the arguments made in this paper. They would apply equally well to
such a case.
New Perspectives on Political Economy14
However, since consumers have not, in fact, changed their preferences in favor of abstaining
from some consumption, the lengthening of the production structure turns out to
be unsustainable when they attempt to readjust the production structure back in line with
their demands. Because the stock of scarce intermediate goods5
has not increased to enable
the coexistence of the non-decreased consumption and elongated production structure,
something has to give.
The banking system can keep the troubled investment projects afloat for some time by
accelerating the credit expansion and lending to them at even lower rates. But at some
point, the central bank becomes concerned with the inflation, which tends to increase
because of the leakage of the additionally created money into the markets for consumer
goods. It tightens the monetary policy stance, and banks cannot continue to accelerate
lending to the unsustainably long production processes. As a result, those processes have
to be frozen or abandoned.
Finally, because of the relative specificity of certain capital goods used in the troubled
projects, it may be difficult or even impossible to reallocate them to the uses which better
serve consumers. Thus, part of the capital of the economy becomes trapped or wasted,
necessitating temporary economic decline.
There are some intuitions reflected in the classical version of ABCT which are promising.
The first of them is the idea that during the boom stage, there is a deviation in some
sense of the time structure (or pattern) of production from the time structure (or pattern)
of the consumer demands. Another intuition that is worth mentioning explicitly is that
there is a real physical scarcity of certain intermediate goods that is exacerbated during the
boom and ultimately renders certain production processes unsustainable.
At the same time, the particular way in which those intuitions are formulated is highly
problematic. The first major problem which we will deal with in this section is that certain
mental constructs on which they are based are highly problematic.
The notion of aggregate roundaboutness measured by the number of stages of production
implies that there must be an uncontroversial way of assigning a particular capital good
to a particular stage of production at which it is produced. However, a simple observation
shows that it is impossible. It has usually been conceived that extraction of the raw materials
represents the earliest, or highest, stage of production. However, the extraction of most
raw materials requires the use of certain capital goods that need to be produced before it
takes place. It is not difficult to see a regress to an unclear end which is, however, obviously
not very relevant to the issues of the modern business cycle.6
5	 In this paper, by “intermediate goods” we will mean all goods which are used in the production of final consumer
goods. Intermediate goods are traditionally classified into capital goods and original factors of production
(raw materials). While this classification is not without problems (for instance, it is difficult to classify
electricity under it), in our view they are immaterial for the arguments put forward here.  
6	 This point was first raised in Young (2011, 27).
A bilingual interdisciplinary journal 15
Thus, in practice, in order to speak of aggregate roundaboutness, one has to try to define
the measure in terms of which a more roundabout production structure differs in the aggregate
from a less roundabout one. This measure must in some sense be physical because,
as we mentioned in section 1, one of the key intuitions behind ABCT is that a real physical
scarcity of intermediate goods is involved in the business cycle.
Hayek tried to solve this problem by invoking the ratio between the physical volumes
of the output of intermediate and consumer goods. That he was talking about physical
amounts is obvious from the following passage:
Probably the simplest method of transforming the picture of the continuous process
into a picture of what happens in a given period is to make cross sections
through our first figure at intervals corresponding to the periods chosen, and to
imagine observes beings posted at each of these cross cuts who watch and note
down the amount of goods7
flowing by.8
The figure referred to in the quote is the famous Hayekian triangle. For Hayek the changes
in the structure in production involved inter alia the changes in the proportion between the
physical volumes of intermediate goods vs consumer goods for a given period which tend to
mirror the changes in the proportion of money streams flowing into their purchases.
In such a case, the proportion of money spent for consumers’ goods and money
spent for intermediate products is equal to the proportion between the total demand
for consumers’ goods and the total demand for the intermediate products
necessary for their continuous production; and this, in turn, must correspond, in
a state of equilibrium, to the proportion between the output of consumers’ goods
during a period of time and the output of intermediate products of all earlier stages
during the same period.9
The boom phase of the business cycle, in this view, consists in the change of such proportion
during the boom period which is not compatible with consumers’ preferences. At the
turning point of the cycle, consumers act to reverse that proportion making certain investment
projects unsustainable.
The main problem with this reasoning is that it essentially implies that it is possible to
strictly separate all the original factors of production in a given period into those that are
embodied in consumer goods and those that are embodied in intermediate goods. The lat-
7	 Emphasis mine – D. G.
8	 Hayek (2008 (1931), 232).
9	 Ibid. P. 234.
New Perspectives on Political Economy16
ter must not be used to produce consumer goods within the period.10
Only in this case it
would make sense to talk about the changed physical proportions between producer and
consumer goods for a period which are equal to the changes in the proportion of the demands
for producer and consumer goods. The changes in the structure of production would
then mean merely redistribution of the physical quantity from consumer to producer goods
or vice versa.
However, certain original factors are, in fact, not fully incorporated into the consumer or
producer goods which they are used to manufacture. Consider the example of the production
of meat. Although estimates vary, a very large amount of water is needed to produce a
kilogram of meat. Yet, most of it will not be incorporated into the meat.
In addition to this, even if relative changes in demand for producer goods and consumer
goods only resulted in a changed identifiable physical proportion between the consumer
and producer goods produced, it would still not follow that the latter would be equal to the
new proportion between the money spent on producer and consumer goods. The value of
an intermediate good does not stem from its physical quantity but from the expected value
of the consumer goods which it is used to produce. There is, thus, nothing that would preclude
a scenario where a change in the structure of production would involve the production
of a highly massive stock of producer goods instead of certain consumer goods but a
relatively much smaller redistribution of monetary streams.
The notion of a single loan market interest rate is also of dubious utility. A bank demands
a certain rate of interest on the loan on the basis of other available alternatives for lending.
Since the alternatives are different and there probably are never enough alternatives of the
same attractiveness to accommodate the whole supply of credit, there will always be different
interest rates on loans which will never converge to a single rate.11
The construct of the natural (originary) interest rate at least in the business cycle context
is even more dubious. First, it is not clear what an interest rate could even mean if lending
happened directly in intermediate goods. Since those goods would be used in the production
of other goods, it would have been impossible to repay the loan in units of the originally
lent goods. Thus, the notion of an interest rate ceases to make sense. Another problem first
noted by P. Straffa (1932) and discussed in some detail by R. Murphy (2011) is that even if
10	 Otherwise, the distinction that Hayek was making would be meaningless because the essential idea is that
during a period certain physical quantity can be strictly classified into a part that contributes to the production
of final consumer goods and the one which does not. Thus, Hayek’s disctinction should have been not
between the produced physical volumes of consumer and intermediate goods but between, on one hand, the
physical volumes of consumer goods and the intermediate goods used in their production but not embodied
in them, and, on the other hand, all other intermediate goods.
11	 We did not even consider the risk premium as a component of actual interest rates which will vary in accordance
with the attitude to risk of particular lenders, as well as with the riskiness of particular projects to be
financed.
A bilingual interdisciplinary journal 17
the notion of the interest rate as applied to lending in the units of intermediate goods made
sense, each lent intermediate good would have its own natural rate of interest.12
At a more basic level, the use of problematic aggregative constructs which we have discussed
seems to arise from a more fundamental problem, i.e. the idea that the theory of
the business cycle must be formulated in terms of tendency toward a general equilibrium.
Hayek was especially explicit in his conviction that only equilibrium-based reasoning can
account for the phenomenon of the business cycle:
On the contrary, it is my conviction that if we want to explain economic phenomena
at all, we have no means available but to build on the foundations given by the
concept of a tendency toward an equilibrium. For it is this concept alone which
permits us to explain fundamental phenomena like the determination of prices and
incomes, an understanding of which is essential to any explanation of fluctuation
of production.13
Mises’s account of ABCT in Human Action is also dependent on an equilibrium construct,
although somewhat different from the Walrasian one employed by Hayek, i.e. the final
state of rest.14
However, the differences between those two equilibrium constructs are not
essential for the purposes of the argument made here because both of them imply that all
the factors operative at a certain moment in time will tend to be reflected in the prices
to which they are relevant. One type of factor that affects prices is the various plans. In
equilibrium-based analysis, all plans must be mutually adjusted to become compatible in
order for equilibrium to be achieved.
The connection between general equilibrium reasoning and aggregative constructs arises
because general equilibrium analysis, in order to be tractable, requires certain aggregative
factors that change (like the gross market interest rate) and certain aggregative outcomes
that result (like the total roundaboutness of the structure of production). If we can show
that equilibrium-based reasoning can and should be rejected from the account of the business
cycle, we can also show that the aforementioned aggregative constructs are unnecessary
for ABCT.
12	 Note, however, that Murphy is only able to provide an example which makes sense because he focused on the
case of a hypothetical economy with two consumer goods that can be exchanged inter alia for claims to future
amounts of those same consumer goods. It is possible to set the interest rate in terms of a units of a lent good
if one borrows apples and produces apples, but it is difficult to see how an interest rate can be set in units of,
for instance, oil if one is producing synthetic clothes.
13	 Hayek (2008 (1931), 225).
14	 See Mises’s (2008 (1949)) descriptions of price adjustments in chapter XX. They are given in terms of movement
towards the final state of rest.
New Perspectives on Political Economy18
2. A Disaggregated Description of the Business Cycle Pattern
The fundamental point behind the reasoning in this paper is that it is indeed possible to
achieve the goal mentioned in the end of the previous section if the theoretical description
centers on the primary phenomenon that requires explanation, namely, the clusters of
unsustainable long-term investment projects that are started in the beginning of the boom
stage but become unsustainable at the turning point of the cycle (further referred to as the
“excessively long projects”). The key feature of these projects is that they do not result (directly
or indirectly)15
in the production of consumer goods during the boom period. These
projects are not necessarily intertwined directly with the whole economy, thus an attempt
to explain them does not require making formal statements about the economy as a whole
and certain aggregate elements or properties of it.
A proper emphasis on such clusters of projects means that it must be immediately clear
from the resulting version of the theory how those projects are mistakenly undertaken and
then fail. If no bridge can be made from a version of ABCT to those projects, then such a
version is necessarily inadequate for explaining what it is called upon to explain.
Such an emphasis leads us to the crucial question of why the excessively long projects
may fail. In this regard, the essential observation is that the excessively long investment
projects fail before they start delivering final consumer goods to the market. This observation
suggests three possible types of economic causes of their failure:
1.	 Their originators realize that they were mistaken in their assessment of the future
demand for the relevant consumer goods.
2.	 Certain innovations make it more profitable to use the resources involved in the relevant
projects to be employed elsewhere.
3.	 There is an unexpected increase in costs of the projects.
The first possibility seems to be precluded by the fact that we are dealing with a cluster of
investment projects. If we take into the account the coordinative properties of the market
process, they seem to cast doubt on the possibility of systematic spontaneous entrepreneurial
mistakes of the kind that are necessary.16
The second possibility does not square well with the fact that the failure of the excessively
long investment projects marks the beginning of the bust stage of the business cycle.
Innovations should tend to result in economic growth, not in decline. Thus, we are left with
the third alternative, i.e. that the unsustainability of the excessively long projects results
from an unforeseen increase in the costs of their implementation.
15	 An investment project that does not itself lead to production of consumer goods in a given period may still
create such intermediate goods that are part of the chain resulting in the production of consumer goods in
such a period.
16	 For a more detailed discussion of why the idea of spontaneous concentrations of entrepreneurial forecasting
errors is problematic, see Rothbard (1996 (1978), 70–73).
A bilingual interdisciplinary journal 19
We will be assuming here that the costs of investment projects are well approximated
by the expenditures on labor and intermediate goods necessary to complete them. While
ABCT can in principle be extended to the analysis of the changes in the pattern of allocation
of labor, we will limit our analysis to the intermediate goods for the sake of keeping the
paper sufficiently tractable.
It is clear from the intuitions underlying ABCT that the unexpected growth of costs that
hits the excessively long projects is of an endogenous nature. Otherwise, the whole idea of
the business cycle would have been unfounded. In other words, there must be some process
internal to the market which aggravates the always existing scarcity of intermediate goods
which somehow arises from the mistaken decisions of the economic agents competing with
each other for those goods.
The process internal to the market is competition. Thus, the excessively long projects
must compete with some other projects in an unsustainable way for certain resources (the
“contested goods”). Unlike the former, the latter projects (hereinafter, the “closer-to-production
projects”) must result (directly or indirectly)17
in the production of final consumer
goods at some point during the boom stage. This has to be the case because, otherwise,
there would be no role for consumer preferences in bringing about the reversion of the
wrong pattern of resource allocation.
The closer-to-production projects do not necessarily have to take less time to deliver final
consumer goods than the excessively long projects in absolute terms. Rather, at the moment
at which the latter projects are started, the former must be closer to the production of
the final consumer goods. This allows us to avoid the thorny issues of talking about stages
of production and the increase in their number.
The final building block that we need for our description derives from the character of
business planning undertaken in time. In any production, producers cannot just base their
planning on wild guesses about what goods the consumers will prefer to buy. They must
ground their plans in the relevant experience from the preceding period or periods (the
“reference period(s)”). Thus, the originators of the closer-to-production projects must relate
their plans to the reference period(s). For the sake of simplicity, we will assume in this
paper that no change in consumer preferences with regard to the consumer goods produced
by the closer-to-production projects happens in the boom stage compared to the reference
period(s) of the originators of the closer-to-production projects.18
We also assume that there
is no technological change with respect to the production of the relevant consumer goods,
17	 See footnote 15.
18	 It is beyond the scope of this paper to give a detailed descriptions of this process, but it is not necessary for its
purpose. However complex the use of past experience by entrepreneurs might be, what matters for the theory
contained here is that there is a certain picture of the particular market patterns on which the business planning
by the various agents discussed in this paper is based. Those agents might believe that the boom period
will be exactly the same as the previous period of the same calendar duration, or they might base their calculations
on a certain generalization of several such reference periods. What the monetary expansion must bring
about is a deviation of the relevant market process from the expected pattern in the relevant market.
New Perspectives on Political Economy20
and that no increase in their production or production of their substitutes happens in the
boom period.
The originators of investment projects must also look into the past to forecast the prices
for the intermediate goods which they will use, in this case the contested goods. Here we
assume that in the boom stage of the cycle nothing changes with regard to the demand and
supply of the contested goods, except for the unforeseen additional demand from the excessively
long projects.
There is also a third class of entrepreneurs which have been ignored in the previous
versions of ABCT whose decisions are, however, indispensable for producing the boom pattern.
These are the suppliers of the contested goods. They also must ground their planning
for the boom period on past reference periods. We will discuss their role in more detail in
the next section. Finally, the same kind of reasoning applies mutatis mutandis to the banks
that allocate the excess credit whose creation is enabled by the central bank.
The preparatory steps of the argument which we made above allow us to zoom in on the
crucial but vague intuition underlying ABCT in a straightforward way. The idea is that during
the boom stage of the business cycle the time structure of production deviates in some sense
from the time structure of consumer demands. This deviation may now be said to consist in
a cluster of excessively long investment projects temporarily diverting part of the contested
goods from the closer-to-production projects not in accordance with consumer preferences.
To clarify this general statement, at some point during the boom stage of the cycle, the
originators of the closer-to-production projects discover that they are unable to supply their
customers with as much of certain consumer goods as they were planning to. This happens
because part of the contested goods has (unexpectedly for the originators of the closer-toproduction
projects) been consumed by the excessively long projects.
At the same time, since the preferences of the relevant consumers with regard to the consumer
goods that are produced under the closer-to-production projects have not changed
compared to the reference period(s), more money is now chasing a lower quantity of goods
compared to the reference period(s).
The originators of the closer-to-production projects learn this by means of price signals.
They observe that they are able to demand higher prices for the consumer goods that they
produce than in the reference period(s), and they know that they are supplying fewer of
them in the current period. To the extent that it is still profitable for them to increase
production of the relevant consumer goods, despite the need to compete for the contested
goods with the excessively long projects, they will tend to grasp such a profit opportunity.
This increased competition for the contested goods will tend to drive up their prices.
But how could this turn of events be fatal for the excessively long investment projects?
The only possible answer is that they must be tailored to the prices of the contested goods
at which their originators are initially able to acquire them. They must not necessarily become
unsustainable with any increase in the prices of the contested goods which go into
their calculation. It is sufficient that the potential increase in their prices for which the
calculations of the projects provide is lower than the actual increase arising through the
process described above.
A bilingual interdisciplinary journal 21
This condition for the unsustainability of the excessively long investment projects is
quite plausible. After all, at the stage of planning the projects, the entrepreneurs who consider
undertaking them must make use of the then current prices of the contested goods.
Based on the reference period(s) they will likely make provisions for those prices fluctuating
within a certain range. However, this safety range may well turn out to be not sufficient
upward to absorb the aforementioned increase in the prices of the contested goods.
At the same time, the originators of the excessively long projects must initially be able
to purchase part of the contested goods at prices which are within the aforementioned safe
range. Otherwise, the excessively long projects would not be undertaken. We will address
the question of how the formation of this first set of prices of the contested goods may happen
in section 4.19
Finally, as in the classical versions of the theory, the banking system may try to help
the excessively long projects by lending to them at even lower interest rates than in the
beginning. However, this strategy will tend to be self-defeating because at this point it will
only tend to result in the increases in the prices of the contested goods, offsetting the effect
of the lowered interest rates. At some point, banks will realize that it is not profitable to
finance the excessively long projects.
3. The Compatibility with Equilibrium Constructs
At this point, we can return to the problem of compatibility of the equilibrium-based formulations
of ABCT with the properly focused general description of the boom stage of the
cycle which we have just made. We have mentioned in section 1 that the hitherto published
prominent versions of ABCT have all been based on equilibrium reasoning. However, we
argued in the preceding section that any version of ABCT must be compatible with the
primary phenomenon it purports to explain. We also sketched out a theoretical description
of the boom stage of the business cycle directly in terms of that phenomenon, namely in
terms of a cluster of excessively long investment projects.
The upshot of the above is that if equilibrium-based reasoning is incompatible with this
description, it would strongly suggest that it is incapable of accounting for the subject matter
of ABCT and should thus be rejected.
Clearly, the description that we made in the preceding section is incompatible with a single
act of equilibration. After all, under the pattern that we just described, at first, the originators
of the excessively long investment projects are able to acquire part of the contested goods
19	 It does not seem to matter for the validity of the argument of this paper whether the originators of the excessively
long projects are able to buy part of the contested goods at safe prices only once or several times. Thus,
we can, for the sake of simplicity refer to those safe prices as the first set of prices of contested goods and to
the prices which reveal the unsustainability of the excessively long projects as the second set of such prices.
New Perspectives on Political Economy22
that they require at one set of prices which are lower than the prices they will face when it is
discovered that they have diverted the contested goods from the closer-to-production projects
in an unsustainable way. Two sets of prices require two instances of equilibration.
In light of this, the question becomes whether the business cycle pattern can be accounted
for by means of an inter-temporal equilibrium construct. This question also needs
to be answered in the negative because of the logical structure of the pattern that needs to
be explained. We need to recall that in the most abstract terms, what we deal with are two
types of projects which are ultimately incompatible in the sense that not enough contested
goods are available to complete both of them at the prices to which the excessively long
investment projects are tailored. Meanwhile, both types of projects are for some time being
implemented simultaneously until their mutual incompatibility is discovered when it is
reflected in the prices of the contested goods.
In other words, the formation of the second set of prices20
of the contested goods, which
reveal the unsustainability of the excessively long projects, is not brought about by an exogenous
change in which case the pattern would be consistent with the inter-temporal equilibrium.
Rather, its emergence is an endogenous result of those projects’ being incompatible
from the start but being undertaken for some time simultaneously. In a pattern consistent
with inter-temporal equilibrium, the two incompatible types of projects would have to undergo
adjustment before starting to be implemented.
One possible objection remains to be answered here. It may be argued that inter-temporal
equilibrium is a benchmark with which the course of events during the business cycle
should be contrasted. In other words, one could say that in the case of an increase of voluntary
savings various investment plans tend to be equilibrated over time while in the case of
the artificial boom they become discoordinated. Here it must be noted that we do not object
to the use of the notion of equilibrium in this way. However, this usage is fundamentally different
from that which we have discussed above. It leaves space for genuine errors, and does
not attempt to impose a certain straitjacket on reality. Perhaps, for the purpose of avoiding
confusion it is better to speak not about equilibrium but the degree of coordination among
plans which is and can never be perfect.
4. How Errors Are Made More Probable by Credit Expansion
In the preceding sections we dealt with the way the business cycle needs to be described.
Now that we have established that the business cycle pattern can only be consistently described
in disequilibrium terms, we need to explain how the genuine entrepreneurial errors
which are possible in a disequilibrium context may plausibly come about. We use the words
“may plausibly come about” deliberately because abandonment of the equilibrium frame-
20	 See footnote 19.
A bilingual interdisciplinary journal 23
work necessarily leads to abandonment of an apodictically certain link between the credit
expansion and the cluster of unsustainable investment projects. This may sound like an
unacceptable theoretical price to pay but we will try to demonstrate further in this section
that there is a silver lining to this sacrifice.
However, before we start explaining how the malinvestment pattern may plausibly happen
because of credit expansion, we must ask another question. How do markets achieve
the relative coordination between the inter-temporal structure of production and the intertemporal
structure of consumer preferences in the case of a somewhat similar situation not
involving credit expansion? We are talking here about a scenario with an increase in the
supply of voluntary savings that are made available to the banking system. Echoing the famous
comment by Hayek on Keynes’s theory of macroeconomic instability, it is essential to
explain how the coordination mechanism works in the normal case in order to understand
how it might fail in the case of credit expansion.
In other words, the question is why monetary savings made by consumers will tend to
be channeled into the right projects and why credit expansion will tend to cause an intertemporal
disconnection between investment projects and consumer preferences. To answer
these questions, we need to consider the elementary mechanics of a bank investment loan.
In order to draw down an investment loan, the entrepreneur must believe that the project
that will be financed with this loan will provide a return which will exceed the amount of the
money she will owe to the bank by at least a certain amount. This implies that the decision
to draw down a loan will only be made if the entrepreneur expects a certain minimum level
of profitability of the relevant project.
The availability of the additional money to lend for the banks as a result of an increase of
savings does not in itself change the expected profitability of any investment project. What
changes the expected profitability of some projects is the fact that the corollary decrease in
the demand for consumer goods lowers the prices of some intermediate goods that can be
used in those projects. To the extent that entrepreneurs recognize the increased expected
profitability of some projects, this circumstance tends to cause the demand for investment
credit on their part to rise and to allow the banks to loan out the additional money they
received from the savers.
But why will the additional amount of money arising from the savers’ making savings
through the banks tend to be allocated to the projects which have become more profitable
in the way described above? The answer has to do with our description of business planning
in time in section 2. Banks also have to ground their lending plans in the reference
period(s). If there is no significant change in the boom period in the other projects that
they would finance compared to the reference periods, banks will not tend to allocate the
additional money to them if there are investment projects which are now more profitable
even without any decrease in the interest rates. Thus, the additional money will tend to be
allocated to the projects which have become more profitable as a result of the increase in
voluntary saving without any connection to interest rates.
It is important to note here that the average interest rate in the loan market may not even
fall as a result, contrary to what is usually claimed. This is not a violation of the basic sup-
New Perspectives on Political Economy24
ply and demand reasoning because the fact that some projects became profitable compared
to the reference period(s) results in an increased supply of loanable funds being met by an
increased demand.
Thus, the crucial inter-temporal coordinative role is played by the prices of the relevant
intermediate goods. In the classical accounts of ABCT, their role was not sufficiently recognized
and excessive attention was paid to the aggregates of interest rates.
Now that we have looked into the way the coordination works in the case of the additional
credit arising from an increase in savings, we can start addressing the crucial question
of why a credit expansion may plausibly result in the discoordination described by ABCT.
Intuitively, we need to demonstrate that something important changes vis-à-vis the normal
credit creation scenario.
This important change consists of there being no decrease in the prices of intermediary
goods because the consumers have not reduced their consumption. Thus, a crucial pillar of
the coordinative mechanism is missing from the start. The banks that want to create credit
out of thin air to allocate to investment projects do not face offers from entrepreneurs
whose projects have become profitable because of the decreases in costs. Thus, banks have
to induce the potential borrowers to borrow from them by lowering interest rates on the
loans involving the excess credit and making certain projects look more profitable.
Two questions remain to be answered here. First, why are such loans significantly more
likely to be allocated to the excessively long investment projects? The answer has to do with
the reasoning of the preceding section. If the investment projects which receive the excess
credit are not excessively long, their competition with the other projects for the relevant
intermediate goods will be apparent from the very start from the increases in prices of
such goods. Those price increases will tend to negatively compensate the increased profitability
due to the lowered interest rates. In practice, the loans of the excessive credit to
such projects will probably mostly not even be made because the suppliers of the relevant
intermediate goods will be in position to increase the quoted prices for them from the very
start. This will tend to reveal the unsustainability of the projects which are not excessively
long but have become profitable due to the lowered interest rates at the stage of negotiating
the terms of the loans. Thus, to the extent the excess credit created by the central bank is
actually loaned out, it will tend to be allocated to the excessively long projects.21
The second question is why banks, the entrepreneurs who borrow the excess credit for
the excessively long investment projects and, as we mentioned in section 1, the suppliers of
the contested goods will tend to fail to see that they are making errors in their commercial
decisions. In other words, we need to describe in what conditions credit expansion makes
likely the genuine errors that we mentioned in section 3.
21	 Since the market process (including in the banking sphere) works only imperfectly, it is theoretically possible
that the projects which banks are prepared to lend to when they are able to create excess credit have actually
been sufficiently profitable before, and that they did not receive loans by mistake. Thus, excess credit may theoretically
be allocated to good projects. However, the more excess credit is created, the more likely it is that it
will go into excessively long projects.
A bilingual interdisciplinary journal 25
The first problem that we face here is that, in principle, entrepreneurs might be aware
of ABCT and might thus avoid errors by not borrowing the money that arises from credit
expansion. The solution to the problem lies in realizing that an entrepreneur cannot be certain
of the fact that either her project is going to be financed by means of credit expansion
or that her particular project is going to be unsustainable. Here the abandonment of the
necessary connection in ABCT between credit expansion and the cluster of malinvestments
provides the very silver lining we mentioned in the beginning of this section. Since there is
no such necessary connection that could be understood by entrepreneurs, even if they knew
about ABCT, they would still face a choice between foregoing the potential profit from
the investment project financed by means of credit expansion and risking failure of such
a project due to the mechanism described by ABCT. Thus, we can say that even some entrepreneurs
knowledgeable about ABCT may be lured towards undertaking unsustainable
investment projects. It also seems to follow that the larger the scope of credit expansion, the
higher the risk becomes that some of the entrepreneurs will choose to try their luck because
with the increasing amount of credit, the interest rates will be set increasingly lower, thus
reducing the total amount of debt from the loans.
Of course, the vast majority of entrepreneurs never were, are and probably will be aware
of ABCT in any meaningful sense, but this counterargument needs to be addressed in light
of the popularity in modern economics of certain interpretations of the rational expectations
hypothesis.
The same reasoning applies to banks with the modification that the risks they bear in
this situation are even less significant because for them the alternative consists not in some
other use of their resources but in not using some credit at all.
The final question which remains to be answered is why the sellers of the contested
goods who must initially sell them to the entrepreneurs undertaking the excessively long
projects at prices that are too low, i.e. do not reflect the changed structure of demands
for these goods compared to the reference period(s), may make this error. Here, although
the sellers of the contested goods might be able to realize that the demand for them has
increased compared to the reference period(s), in certain plausible conditions it may be difficult
for them to do so. For example, if the lengthier investment projects are not very large,
and (or) if they are not concentrated in a narrow industry, and (or) if the sellers are not
very concentrated. Because of the considerations of brevity, we may not plunge ourselves
deeply into the discussion of various combinations of such and similar conditions, but it is
clear from this short analysis that a situation where the sellers of the contested goods fail to
timely notice the increase in demand is fairly plausible and does not require any unrealistic
assumptions. Moreover, the larger the scope and extent of the credit expansion, the more
likely are some sellers of the contested goods to commit price-setting errors.
In other words, the key feature of the additional investment demand for intermediate
goods that can be created by credit expansion, is that it ultimately arises arbitrarily from
the top without any connection to the underlying market process, and thus to the relevant
knowledge of the suppliers of intermediate goods. Thus, where such arbitrarily created
change is not momentous, it may not be noticed on time and may create discoordination.
New Perspectives on Political Economy26
On a final note, the original mistakes of the suppliers of the contested goods may trigger
further mistakes which are usually not thought to be the subject of ABCT. If the producers
of the contested goods, having realized that the demand for their products for the relevant
period is going to be higher than they had expected, attempt to accommodate it by investing
into increases in production, they will still have to charge higher prices for their products
because they bear additional costs. However, as we established, these increased prices are
unacceptable for the originators of the excessively long projects. Thus, at the end of the day,
it is not just the originators of the excessively lengthy investment projects who may make
malinvestments but also the producers of the contested goods. It is even possible that errors
can be made further down the chain by the suppliers of the producers of the contested
goods and even their suppliers, but a detailed discussion of these issues is beyond the scope
of this paper.
5. Concluding Remarks. Potential Applications
We have demonstrated in the preceding pages of this paper that the crucial insights of
ABCT neither need, nor can be formulated by means of an equilibrium construct. Attempting
to do this leads to the paradox under which the theory precludes the phenomena, which
it is supposed to explain, from happening. We also attempted to formulate in general terms
a genuinely disequilibrium-based account of ABCT.
This paper is only sketching the contours of the theory; thus, it only deals with an outline
of the necessary conditions for the Austrian business cycle pattern to take place. But even
such cursory analysis has, in our view, important implications that go beyond the issues
discussed here.
One of these important points is that even the economists of the Austrian School, who
are generally much more realistic in their treatment of economic phenomena than their
mainstream colleagues, do not have at this point a satisfactory theory of price formation
and changes. Perhaps, such theory cannot be formulated in a satisfactory manner at all
due to the inherent complexity of the issues involved, but it seems that these issues warrant
revisiting by the modern economists of the Austrian school in order to make the theories
more tractable and convincing.
The second major implication is that in some cases we need to abandon the apodictic
character of the theory in order to preserve its relevance to the reality under consideration.
This may be a hard pill to swallow for some Austrian economists but the idea is not new.
The ideas elaborated on in this paper are in line with the insightful criticisms of ABCT
by Hülsmann (1998) and Wagner (1999) who have both demonstrated that the insights
contained in ABCT are not congruent with a logically necessary connection between credit
expansion and entrepreneurial errors leading to the boom and bust.
Finally, the realistic approach to ABCT simplifies the job of those researchers who
would attempt to provide an empirical illustration of the theory on the basis of the histori-
A bilingual interdisciplinary journal 27
cal instances of the business cycle. It gives them real-world reference points that they might
try to locate and theoretically connect in the events of the relevant episodes, such as the
cluster of investment projects, the contested intermediary goods and their price dynamics,
etc., instead of merely looking at certain statistical aggregates.
In other words, the concepts of credit expansion, contested goods, excessively long
projects and closer-to-production projects allow for genuine historical, rather than merely
aggregative econometric analysis of the past business cycle episodes, quite in line with
Mises’s notion of applying theory to history.22
It is possible to try to find in the historical
episode in question the referents of the aforementioned straightforwardly applicable concepts.
If such referents are found, a conclusion can be made that a given historical episode
is an instance of the pattern described by ABCT. Otherwise, the economic historians studying
a particular episode will have to conclude that some other theory is needed to explain.
As a brief example of how such analysis may proceed, it can be noted that with regard
to the most recent episode of the business cycle in the US, which partly consisted of a
bubble in the market for new single-family houses, several Austrians have claimed that it is
well-explained by ABCT.23
However, the reasoning contained here casts a serious doubt on
this conclusion for the simple reason that investment projects for building the single-family
houses in question just do not take a sufficient amount of time.24
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Hülsmann, J. (1998) ‘Toward a General Theory of Error Cycles’, Quarterly Journal of Austrian
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Mises, L. v. (2008 (1949)) Human Action: A Treatise on Economics. Auburn, Alabama: Ludwig
von Mises Institute.
22	 See Mises (2007 (1957)) for a book-length treatment of these issues.
23	 See e. g. Boettke and Horwitz (2009), Salerno (2012).
24	 Saniavskaia (2013) estimates that it takes on average 5–6 months to build a single-family house in the US.
Clearly, the construction projects with respect to such housing do not qualify as the excessively long projects
that should have failed if the recession of 2008 was an instance of the boom and bust process discussed here.
New Perspectives on Political Economy28
Mises, L. v. (2007 (1957)) Theory and History: An Interpretation of Social and Economic
Evolution. Auburn, Alabama: Ludwig von Mises Institute.
Murphy, R. P. (2011) Multiple Interest Rates and the Austrian Business Cycle Theory.
Rothbard, M. N. (1996 (1978)) ‘Economic Depressions: Their Cause and Cure’, In The
Austrian Theory of the Trade Cycle and Other Essays, edited by Richard M. Ebeling. Auburn,
Alabama: Ludwig von Mises Institute .
Salerno, J. T. (2012) ‘A Reformulation of the Austrian Business Cycle Theory in Light of
the Financial Crisis’, The Quarterly Journal of Austrian Economics 15 (1): 3–44.
Selgin, G. (1988) The Theory of Free Banking. Boston Way, Lanham, MD: Rowman & Littlefield
Publishers, Inc.
Siniavskaia, N. (2013) How Long Does It Take to Build a House? Eye On Housing, October
21. Accessed September 4, 2014. http://eyeonhousing.org/2013/10/how-long-does-it-
take-to-build-a-house/.
Straffa, P. (1932) ‘Dr. Hayek on Money and Capital’, The Economic Journal 42 (165): 42 –53.
Wagner, R. (1999) ‘Austrian Cycle Theory: Saving the Wheat while Discarding the Chaff’,
Review of Austrian Economics 12: 65–80.
Young, A. (2011) ‘Illustrating the Importance of Austrian Business Cycle Theory: A Reply
to Murphy, Barnett, and Block: A Call for Quantitative Study’, Review of Austrian Economics
25 (2): 19–28.
A bilingual interdisciplinary journal 29
Heterogeneous Capital and the Coasean
Firm – A Critique of Some Recent
Developments in the Austrian Theory of
the Firm
Ivan Jankovic1
Abstract
In this paper some recent improvements and refinements of the mainstream Austrian
theory of the firm are analyzed (Foss and Klein, 2012; Foss et al, 2007). Those refinements
attempt to fuse the old Austrian-Coasean theory of the firm with a sophisticated analysis of
entrepreneurship and capital theory, in order to broaden the scope and the application of
the original intuition behind the Coasean theory that governance, planning and hierarchical
mode of relationship are necessary features of an efficient market system. I criticize
this strategy by combining the insights of the Austrian capital theory and the standard
neoclassical theory of the firm, to show how the Coasean firm, both in its original and Austrian
derivations misrepresents the real reasons and function of the firm in a market society.
The main problem of this new synthesis is that it just broadens the old error committed by
Mises and Rothbard, treating Coasean theory of the firm as central planning hierarchy to
be consistent with Austrian argument against planning, and for economic calculation and
entrepreneurship. In my analysis, the ingenious inclusion of the Austrian capital theory into
the Coasean framework by Foss and Klein only adds another layer of errors to the original,
untenable conception of the firm as a hierarchical and organizational entity by arguing that
the firm is needed to handle the problem of heterogeneity of capital goods.
Keywords
Capital theory, firm, Coase, Austrian School.
1	 Doctoral candidate in political science , Simon Fraser University, Vancouver; email: ijankovi@sfu.ca.
New Perspectives on Political Economy30
1. Introduction
The conventional treatment of the theory of the firm in the modern literature of the Austrian
school combines Mises’, Hayek’s and Rothbard’s emphasis on entrepreneurship and
economic calculation with the concept of the firm proposed by Ronald Coase and is widely
accepted among the students of economic organization (Foos and Klein, 2012; Foss et al,
2007; Ionadies, 1999). This theory depicts the firm as a central planning and hierarchical
entity, supplementing or rather supplanting the market as a coordinating mechanism. Principally,
it combines Coase and Mises, i.e develops a theory of the firm as a commanding
authority serving the purpose of “organizing the entrepreneurial judgement” as Foss and
Klein like to say. This dominant tradition of organizational thinking within the Austrian
school will be called “Austrian Coaseanism” or simply the “mainstream Austrian theory of
the firm”. A minority of authors writing in the Austrian tradition question this amalgamation
of Misesian and Coasean traditions and argue that the firm should be understood as a
specific market mechanism (Salin, 2002; Mathews, 1998; Jankovic, 2010).
There are many other aspects related to the Austrian theory of the firm treated in other
works, but they are only tangentially related to the main problem of the theory of firm. For
example, Dulbeco and Garrouste (1999) propose a unification between the capital theory
and theory of entrepreneurship, but here the firm is conceptualized just as a kind of black
box with the tools necessary to explain the main problems such as individual knowledge
and asset specificity. The theory is a functional one in the same sense the neoclassical
theory of the firm is functional, striving to explain the exchange on an open market. Salin
(2002), ties the discussion of the firm to the problem of division of labor; Walsh (2009)
offers an ingenious Mengerian invisible-hand explanation of the origins of the business firm
trying to strike a balance between the notions of spontaneous order and conventional treatments
of the firm; Cowen and Parker (1997) explore the problems of reconciling the theory
of the firm and the process-character of the market exchange. Garrouste (2002) analyzes
the implication of the Hayekian problem of knowledge in conjunction with the institutional
theory of the firm: how the knowledge within the firm grows and how it is distributed
among the participants in the enterprise. An entire array of other Austrian works of the
firm explores various aspects of this relationship between knowledge and organizational
structures (Foss, 1999; Tsoukas 1996; Minkler, 1993).
The problem that I want to analyze in this paper is much narrower: it concerns some limited
(in scope) refinements of the orthodox Austrian theory of the firm – the one combining
Coase’s concept of the firm with the Austrian arguments about entrepreneurship and
prices. This new approach most notably pursued by Nikolai Foss and Peter Klein (Foss et
al, 2007; Foss and Klein, 2012) strives to include into the analysis the theory of capital and
to show that initial synthesis of Coase and Mises was justified by arguing that the Coasean
notion of the firm is the best environment to accommodate the Austrian theory of heterogeneous
capital, developed by Menger and Bohm-Bawerk. This is a broadening and strengthening
of the theory insofar as it implies that there is a deeper structural affinity between
Coaseanism and Misesianism, which concerns the very heart of the Austrian theory – the
A bilingual interdisciplinary journal 31
theory of capital. As we know, the main dividing line between Bohm-Bawerkian and neoclassical
theories of capital was over the issue whether capital should be conceptualized as
a homogenous fund of value, consisting of identical and perfectly substitutable elements or
rather as a collection of heterogeneous, imperfectly substitutable goods that incur significant
costs of changing the employment of different parts of the capital stock over time. The
latter position is accepted by Foss and Klein, and it is argued that the firm understood as
a Coasean planning-hierarchical organization is needed in order to manage the costs of reutilizing
the heterogeneous capital goods. To further broaden their theory, Foss and Klein
argue that the capital owner’s managing of capital goods is necessary in order to discover
the new attributes of those goods amenable to different prospective entrepreneurial utilizations
(Fos et al, 2007 ). In a sense, Klein and Foss theory attempts to combine Misesian
and Hayekian-Kirznerian concepts of entrepreneurship and to merge that composite with
the Coase’s theory of the firm.
	 I criticize this project in two steps. First, I offer an analysis of the reasons why the
general attempts to synthesize Coase’s firm and Mises’ entrepreneur are untenable. In the
second part, I follow up with an analysis of why and how Foss-Klein refinement actually
adds just another layer of mistakes to the originally mistaken idea that Misesian entrepreneur
needs the firm understood as a planning hierarchy.
2. Coase’s theory of the firm and Misesian entrepreneurship
One of the most critical facts about the Coase’s theory of the firm, which is very seldom
emphasized, is that it represents just a special application of the general market socialist
and market failure theories (Bylund, 2014). Coase writes his famous paper in 1937 in the
middle of the controversy over the possibility of rational economic planning in socialism.2
And he sides squarely with socialists and against Mises and Hayek in this debate by accepting
the perfect competitive theory as the standard for judging the efficiency of the market.
Coase tries to rehabilitate central planning as a mechanism of coordinating economic activity,
badly damaged by the Austrian critique in the 1920s and 1930s.
This is quite obvious at the very beginning of the article when Coase contrasts price
mechanism and planning, and ponders their relative usefulness:
It is easy to see when the State takes over the direction of an industry that, in planning
it, it is doing something which was previously done by the price mechanism.
2	 Useful reviews of the debate are given in Rothbard (1991), “The End of Socialism and the Calculation Debate
Revisited”, The Review of Austrian Economics, Volume 5, Issue 2, pp 51–76; and Kirzner (1988), “The Economic
Calculation Debate: Lessons for Austrians”, The Review of Austrian Economics. 1988, Volume 2, Issue
1, pp 1–18.
New Perspectives on Political Economy32
What is usually not realised is that any business man in organising the relations between
his departments is also doing something which could be organised through
the price mechanism. There is therefore point in Mr. Durbin’s answer to those who
emphasise the problems involved in economic planning that the same problems
have to be solved by business men in the competitive system…The important difference
between these two cases is that economic planning is imposed on industry
while firms arise voluntarily because they represent a more efficient method of
organising production, In a competitive system, there is an “optimum” amount of
planning!” (Coase, 1937: 3)
Thus, Coase argues that an efficient economic system represents some kind of market socialist
combination of planning and price mechanism; what the entrepreneurs do is the
same thing that the central planners in Russia are doing. The only difference is that socialists
may have pushed things too far, whereas firms in capitalism provide for an ‘optimal’
amount of planning.
To what extent is Coase reiterating the position of market socialists, primarily Lange
and Lerner in the debate about the rational planning in socialism, is best seen by the fact
that he identifies the model of perfect competition as a relevant description of the process
of market exchange, any departure from which is seen as a market failure. He then identifies
a problem with one of the conditions of perfect competition, namely the absence of
free prices on the real market (as opposed to the model) and then argues that this requires
a limited central planning through the firms to remedy this market failure. This is the essence
of the famous Coasean formula about the firm as a tool of “minimizing transaction
costs”: “The main reason why it is profitable to establish a firm would seem to be that there
is a cost of using the price mechanism. The most obvious cost of “organising” production
through the price mechanism is that of discovering what the relevant prices are. This cost
may be reduced but it will not be eliminated by the emergence of specialists who will sell
this information.” (Coase, 1937: 4).
Coase clearly believes that the only imaginable situation in which the price mechanism
would operate efficiently is the one conforming to the preconditions of perfect competitive
equilibrium, including free information. Since this condition is not met in reality, the price
mechanism ‘fails’, and the firm represents a correction of this ‘failure’; planning has to
come to the rescue by its intervention in the form of the entrepreneurial firm, which performs
exactly the same kinds of function all other government interventions are designed to
perform in all market failure theories: bringing about the conditions of perfect competitive
markets. The real markets are deficient, because of the transaction costs of using the price
mechanism and “planning” corrects this deficiency.
Coase sees the price mechanism and “planning” as two competing coordinating mechanisms
that peacefully coexist. Depending on the specific circumstances of a given society,
one of them could have been dominant or ‘supersede’ the other in a certain area or certain
branch of industry, but from his point of view there is no necessary contradiction between
the two. As he emphasizes, in an economy there is always equilibrium between the marginal
A bilingual interdisciplinary journal 33
utility of an additional transaction carried out within a firm and marginal utility of an additional
market transaction (Coase, ibid. p. 405). Moreover, which one of them would relatively
prevail primarily depends on the technical characteristics of the industrial structure
in question. Some technological innovations could drastically increase the marginal gains
of using entrepreneurial, ‘non-market’ solution, while the costs of using the market are stagnating:
“Inventions which tend to bring factors of production nearer together, by lessening
spatial distribution, tend to increase the size of the firm. Changes like the telephone and
the telegraph which tend to reduce the cost of organising spatially will tend to increase the
size of the firm. All changes which improve managerial technique will tend to increase the
size of the firm.” (Coase, ibid. p.397).
It follows from here that market is understood almost like a nuisance or a necessary
evil, which characterizes the less technologically advanced industrial stages: the more the
technological and organizational capabilities of a society increase, the more the firm becomes
able to ‘supersede’ the market and the price mechanism. Coase even offers a telling
example of Russian emancipation from serfdom and the zigzag movement from “central
organization” to “market” and all the way back again, all depending on the technical and
technological characteristics of the production process: “It seems important to realise that
the passage from the domestic system to the factory system is not a mere historical accident,
but is conditioned by economic forces. This is shown by the fact that it is possible to
move from the factory system to the domestic system, as in the Russian example, as well as
vice versa. It is the essence of serfdom that the price mechanism is not allowed to operate.
Therefore, there has to be direction from some organiser. When, however, serfdom passed,
the price mechanism was allowed to operate. It was not until machinery drew workers into
one locality that it paid to supersede the price mechanism and the firm again emerged”
(Coase, ibid. 397).
Therefore, the capitalist firm is just a new form of the same model of organizing production
known from slavery or serfdom, the form which re-emerged as soon as the favorable
economic and technological conditions allowed for the formation of the factory system. An
untrammelled “market” dominated by the price mechanism was just a short and relatively
insignificant intermezzo.
Having all this in mind, it is very peculiar that the mainstream of the Austrian school
accepted wholeheartedly Coasean theory of the firm and moreover attempted to integrate
it with the Austrian models of monetary calculation, capital heterogeneity, and economic
entrepreneurship. This starts with Mises and Rothbard who were first to appropriate the
Coasean notion of the firm as a hierarchy and a planning instrument, and then the same
error was echoed and further amplified by the whole host of their followers (Klein, 1992;
Foss, 1996; Ioanniddes, 2002; Langlois, 1995; Klein and Foss, 2012). The basic and obvious
problem with all the attempts to reconcile the Austrian theory of monetary calculation
with Coase’s theory of the firm is that the latter had been devised as one of the arguments
against the former. And the same thing that Coase explains as beneficial and remedial
features of the commanding authority within the firm is described by the Austrians as a
form of economic inefficiency and chaos; after all, what else “superseding the price mecha-
New Perspectives on Political Economy34
nism” by planning could be within the Austrian framework? For example, Coase this way
describes the operation of the firm:
As D. H. Robertson points out, we find islands of conscious power in this ocean of
unconscious co-operation like lumps of butter coagulating in a pail of buttermilk.”
But in view of the fact that it is usually argued that co-ordination will be done by
the price mechanism, why is such organisation necessary? Why are there these “islands
of conscious power”? Outside the firm, price movements direct production,
which is co-ordinated through a series of exchange transactions on the market.
Within a firm, these market transactions are eliminated and in place of the complicated
market structure with exchange transactions is substituted the entrepreneurco-ordinator,
who directs production. (Coase, 1937: 388).
Compare this now with how Murray Rothbard explains economic irrationality of socialism,
with price controls and government ownership:
...islands of non-calculable chaos swell to the proportions of masses and continents.
As the area of incalculability increases, the degrees of irrationality, misallocation,
loss, impoverishment, etc., become greater. For each governmental firm
introduces its own island of chaos into the economy: there is no need to wait for
full socialism for chaos to begin to work. (Rothbard, 2009: 953)
We here clearly see that Rothbard and Coase describe essentially the same phenomenon,
the spread of the non-market, planning coordination within a free market environment,
using the same imagery of “islands” and seas. But, the differences in assessment of this phenomenon
could not be more striking: Coase sees the ‘islands of planning’ as a welcome corrective
to the inefficiencies of the market system reflected in high transaction costs, whereas
Rothbard, on the contrary, sees in the same islands of planning the areas of ‘incalculability’
and economic irrationality, which, if allowed to spread over a sufficiently large part of the
economy, could wreak havoc on it, even before we get to the point of full socialism (which is
just a state in which there is nothing but irrationality of planning, encompassing continents
now, instead of mere ‘islands’).
It is nothing short of astonishing that irrespective of this, Rothbard accepts Coase’s
theory of the firm! And, moreover, he offers the Austrian arguments on price calculation
as a supplement to Coase’s theory in determining the optimal size of the firm.3
Namely,
according to Rothbard, the firm as a central planning island in the sea of price coordination
could exist only insofar as the independent, outside markets for capital goods are preserved
that would protect the integrity of the internal pricing mechanism within the firm (Rothbard,
2009).
3	 See Rothbard, 2009, pp. 609–617, and further development by Klein 1996.
A bilingual interdisciplinary journal 35
The most peculiar contradiction here is that Rothbard in the same breath accepts Mises’
argument about the impossibility of rational economic planning absent the market prices,
and Coase’s theory about central planning as a way to correct the failures of market prices!
But, he cannot have it both ways: non-market “planning” is either a problem, or a solution;
it cannot be both: either it is an ‘island of incalculability’ which, if it grows enough,
destroys the economic system (but even at lower levels of intensity, it impairs the economic
efficiency) or it is a transaction cost-minimizing tool that helps overcome the imperfections
of the market mechanism. There’s no way of squaring the circle here.4
One could say that Rothbard diverges from Coase insofar as he identifies the calculational
chaos with an increase in government control and ownership over the resources,
whereas Coase did not make such a distinction. Not the firms in general, but governmentowned
firms are the ones that increase the calculational chaos according to Rothbard. But,
this is irrelevant. From the Coasean point of view, it does not matter at all whether we are
talking about the government-owned or private firms; both are equally the instruments of
organizational planning that equally replace and supersede the market. Rothbard never
tried to refute this; so, he is caught in a vice: if he wants to draw a sharp distinction between
the government-owned firm and the private firm in the context of economic calculation,
then he has to abandon the notion of the private firm as a planning entity (which he does
not want to do); or if he wants to retain the Coasean notion of any firm as an organizational
entity ‘superseding’ the price mechanism, then he has to concede that calculational
chaos equally increases with the emergence and growth of both the private and governmentowned
firms. Then the only consistent solution is to look at every single firm, private or not,
as an impediment to market efficiency.5
He cannot constantly equivocate by defining “the
firm” as a “private firm” when trying to demonstrate the supposed advantages of this form
of organization, and as “government firm” when trying to demonstrate the ‘calculational
chaos’ to which any central planning inexorably leads.
4	 The only attempt to do this, as far I can tell, is Lewin (1998). But, although the paper promises to answer the
following questions: “On the one hand, if socialism is indeed irrational, in the sense of precluding the ability
to perform the necessary calculations, how is it that the firm is not similarly encumbered? After all, is not a
state socialist system simply one large firm? And are firms not islands of socialism in a market sea?” (Levin,
1998: 500–501). The ensuing analysis does not tell us anything about this set of issues. Instead, Levin argues
that the entity called the “firm” is necessary to provide an environment for entrepreneurial calculations of cost
and profit. But, this is perfectly consistent with the nexus-of-contracts view of the firm and does not explain
at all why we would have to understand the firm as a commanding entity, rather than as a legal fiction for voluntary
contracts. Moreover, he equivocates about the very meaning of the key term “planning”. At the beginning,
this term means the relationship between the owner and employees. Later on, he switches to the notion
of planning as entrepreneurial anticipative calculation of costs and benefits. This is close to what Mises would
call the ‘praxeological’ meaning of planning: simply, every market agent plans, i.e. anticipates his own costs
and benefits. If this is so, it’s not clear why then the employees would not be “planning” as well. And if everybody
is “planning”, what is then the point of making an analytical distinction between the “planning” and the
“market” in the first place?
5	 This is the criticism that Demsetz (1988; 2011) levels against Coase.
New Perspectives on Political Economy36
3. Heterogeneity of capital and the firm
We now turn to the refinements of this Rothbard’s mistaken acceptance of the Coasean
theory of the firm by the authors who tried to incorporate the Austrian discussion of the
capital heterogeneity into the system (Klein and Foss, 2012, Foss etl 2006; ). It is safe to say
that what they achieved was simply to generalize and amplify Rothbard’s initial mistake of
treating central planning as a cure for market failure by infecting even the Austrian capital
theory with Coaseanism.
Let’s start by discussing the differences between the Austrian and neoclassical capital
theories, and then explore what conclusions the Rothbardians derive from those differences
in the context of the theory of the firm. Heterogeneity of capital stems from the general
analysis of value, price, and the market process by Menger and Bohm Bawerk. Carl Menger
revolutionized economic theory by reinterpreting the origins of value and reversing the flow
of economic causation in his famous book ‘The ‘Principles of Economics’, as compared to
earlier theories. Unlike his classical predecessors, Menger argued that the source of value
is individual human valuation of consumer goods’ utility for the satisfaction of his needs,
and that the standard of evaluation is marginal utility which is decreasing (Menger, 2007).
This helped solve the paradox of value that plagued classical economics, mired in the cost
of production and labour theories of value, which were unable to explain the market value
of non-reproducible goods, or natural goods.
However, the critical corollary of this revolution in the theory of value was Menger’s
theory of imputation that shifted the causal arrow from the classical cost theories, by claiming
that the cause of all material production and the source of their value are human needs
and human evaluations of the material goods, and that all other goods that are used at
some point to produce those final consumption articles derive their utility and their price
from the value of the final goods. Marginal utility determines the price of the final goods,
whereas the marginal productivity in producing those final goods determines the price of intermediate
capital goods. The value is, so to speak, imputed backwards to the capital goods
and land from the consumer goods, rather than prices of final goods being determined by
the objective, ex ante given costs of their production (Menger, 2007: 51–74).
A further consequence of this shift is that production is not seen any more through the
lenses of an input-output analysis, depicting the process of production as a transformation
of a given set of inputs (factors) into the set of final goods, but rather a complex intertemporal
process that starts with the higher order goods, as Menger names them, and then
proceeds through a series of intermediate steps to the final stage of consumption goods
(Menger,ibid. ).
Bohm-Bawerk describes this as a “roundabout” process of capitalist production, and
at each level of production a large-scale process of selection and specialization of capital
goods is taking place; the further we go from the stage of final goods along the chain of
production structure, the less specialized goods become: land, raw materials or products of
nature could be put in very many uses; some intermediate goods such as the refined metals
and some machines are less specialized than some others such as more narrowly special-
A bilingual interdisciplinary journal 37
ized capital equipment or half-products (Bohm-Bawerk, 1959: 3–15). And this is the source
of heterogeneity of capital in the Austrian theory.
The most obvious feature of this theory puts it at odds with the now conventional neoclassical
understanding of capital. All those theories, in various forms depict capital as a
homogenous fund of value which serves the purpose of automatically converting the inputs
into the output. The production process is understood as instantaneous and capital goods
as perfectly substitutable. The factors of time and heterogeneity of inputs are done away
with.6
4. Klein and Foss reinterpretation
One aspect of the Austrian capital theory we are here most interested in is how it interacts
with the conventional and nonconventional theories of entrepreneurship and the firm. In
the Austrian literature, this issue is pursued with vigilance in the last couple of decades,
and we are going now to explore some of the results that are achieved and their limitations.
As already suggested, the Austrian literature pursuing those kinds of complications
is mostly Misesian-Rothbardian in its direction, and the exposition and critique here would
be directed to the entire tradition, although I would single out a couple of the most prominent
and canonical authors of this tradition. Primarily, I have in mind the refinements and
broadening of the paradigm brought about by Nicolai Foss and Peter Klein, and some other
authors following their lead.
The basic thrust of their argument is an attempt to broaden the application of the Rothbardian
dubious reconciliation of the Coasean “organizational” theory and Austrian price
theory by including the theory of capital into the synthesis. And although impressive in its
learning and comprehensiveness, this attempt is untenable for the same reasons Rothbardian
initial argument for Coaseanism is wanting. Klein and Foss (2012) as well as Foss et al
(2007) start from the fact of heterogeneity of capital in the Austrian tradition and contrast
it with the treatment of capital in the mainstream neoclassical tradition. This is, in a sense,
an already explored possibility; for example Dubleco and Garrouste (1999) are trying to
bridge the gap between the Hayekian-Kirznerian entrepreneurial knowledge and the BohmBawerkian
asset specificity. However, they use the firm just as a functional black box to perform
the feat, avoiding any explicit Coasean themes for analysis of the inter-firm structure.
They are not interested in the structure of the firm.
6	 For a good summary of the debates on capital theory between Austrians and neoclassicals see Hayek (1935)
and Cohen (2008). The debate was waged over the period of more than 30 years. For the Austrian expositions
see, Bohm Bawerk (1895), Hayek (1935) and Machlup (1935). For the neoclassical “fund of value” position
see Clark (1895) and Knight (1934).
New Perspectives on Political Economy38
Klein and Foss, on the contrary, make the Coasean structural theory, appropriated by
Mises and Rothbard, the center piece of their synthesis, and then build further from there
by enriching the synthesis with the Kirznerian and Bohm-Bawerkian themes. Their approach
is to correct the neoclassical theory not only in one point (the structure of capital)
but in two: the structure of capital and the structure of the firm. First, the functional theory
of the firm which serves to transform the given set of inputs into outputs is simplistic and
actually wrong since it depicts the process of production as a one-stage enterprise; capital
is instantaneously transformed into a set of final, consumer goods. Foss et al argue, in
line with Bohm Bawerk that production process unfolds in the numerous stages, and is
diachronical rather than instantaneous. Also, in order to understand the entire process
of production, it is not sufficient to postulate the firm as the production function, but one
needs to explain its internal structure and working: when does firm emerge, how and why it
grows, when it ceases growing, why certain transactions are carried out within the firm and
certain others outside of it, and so on.
Foss et al (2007) attempt to establish the rationale for Coasean firm as the only solution
for those problems by using the tools provided by Frank Knight. Namely, they emphasize
the importance of entrepreneurial judgement which is not based on any given criterion or
probability distribution among the given entrepreneurial choices. Judgement is a qualitatively
different kind of decision-making than ‘optimizing’ in the neoclassical framework;
starting from Knightian distinction between risk and uncertainty, they argue that entrepreneurial
decision-making includes the handling of the situations which are not subject
to ordinary risk, and hence uninsurable. An entrepreneur deals with what Knight calls
uncertainty and Mises the class probability (as opposed to case probability). This is a set of
circumstances in which the array of possibilities is not closed and a great deal of what the
entrepreneur does has to do with the anticipation of future gains from qualitatively different
possible entrepreneurial initiatives with unpredictable results: “Judgment primarily refers
to the process of businessmen forming estimates of future events in situations in which
the relevant probability distributions are themselves unknown. Entrepreneurship represents
judgment that cannot be assessed in terms of its marginal product and which cannot, accordingly,
be paid a wage.” (Foss et al, 2007: 1167).
The second great innovation that Foss and Klein offer is the claim that in the world of
homogenous capital goods of neoclassical theory, the identical and perfectly substitutable
“shmoos”, in the parlance of Paul Samuelson, there would be no need for corporate governance,
industrial organizations such as firms or any other non-market (in the Coasean sense)
forms of governance: “In a world of shmoo capital economic organization is relatively unimportant.
All capital assets possess the same attributes, and thus the costs of inspecting,
measuring, and monitoring the attributes of productive assets is trivial. Exchange markets
for capital assets would be virtually devoid of transaction costs” (Foss et al, 2007: 1168).
Hence, the very existence of the firm is dictated not only by standard Coasean transaction
costs but also by Bohm Bawerkian capital transaction costs.
However, Foss and Klein refine the theory further yet by making it more subjectivist and
less ‘Ricardian’. Heterogeneity of capital is not understood only in the standard Menger-
A bilingual interdisciplinary journal 39
Bohm Bawerkian way, as a reflection of the multitudes of purposes to which any physical
piece of equipment or factor could be put, but also includes the concept of heterogeneity
of a single and seemingly homogenous capital asset. Using Kirzner’s and Hayek’s conceptualizations
of the process of market competition, they argue that capital goods are not just
separate and purpose-specific physical things whose replacement or reutilization is costly,
and hence it does not make much sense to talk about capital as a homogeneous fund of
value; even more importantly, a single physical asset is a bundle of numerous attributes,
many of which are not always understood or utilized as economic goods (Foss and Klein,
2012: 116–131). So, heterogeneity of capital goods is also seen in the fact that different
entrepreneurs have different ideas of how a multitude of attributes that any physical item
has could be combined and exploited to make profit. Utilization of capital goods is a continuous
and never-ending process of discovery of the useful characteristics of every single
capital asset that is used in the production process. The same capital good could be radically
different to the two different entrepreneurs, depending upon which concrete attributes
any one of them perceives as important for the production processes at hand. A very large
number of entrepreneurial discoveries consist not in finding a new material or a new capital
good to serve the given purposes (or new purposes for the same attributes of a given good),
but in discovering some new feature of the already existing capital asset which had not been
perceived before as suitable for such purposes.
This way, Klein and Foss combine in a sense the best of both worlds; from the Misesian,
essentially Bohm Bawerkian, tradition they take the concept of entrepreneurship as economic
utilization of heterogeneous physical capital, as human action on the real markets
which is concentrated on production, exchange, investment using monetary calculation
and market prices to allocate physical resources to alternative uses. From the Hayekian
and Kiznerian theory of competition as a discovery procedure, and the entrepreneur as a
knowledge economizer, they take a radical subjectivist emphasis on specific tacit knowledge
and gradual discovery of unknown data to develop the notion of capital goods as being
subjectively structured by the information, knowledge, and perception of the entrepreneurs
themselves. That way, heterogeneity of capital is a pervasive fact of economic life; it is not
seen only in objectively different physical characteristics and purposes to which different
goods could be put, but also in subjective attributes that different entrepreneurs assign to
the physically same capital goods.
The function of the entrepreneur in this picture is to embark upon a process of production
with physical capital by using his own judgement in the conditions of radical uncertainty
in order to discover a set of attributes of the given assets, allowing him to provide
the marginal value to the consumer. Their emphasis on capital theory and their ingenious
reinterpretation of the concept of heterogeneity allows Klein and Foss to offer a brilliant
synthesis of the Misesian and Hayekian perspectives within the theory of entrepreneurship.
On the one hand, an entrepreneur is not just the discoverer and arbitrageur who passively
reacts to the changes in market data and by his prompt and skillful use of his specific and
tacit knowledge beats the competition in the race for profit. An entrepreneur is also someone
who directs and employs physical capital, the transformation of which takes time, cop-
New Perspectives on Political Economy40
ing with uncertainty and requires judgement and planning. Organizing physical production
is an even more important element of entrepreneurial activity than a mere epistemological
function of price and opportunity discovery. The conceptualization of the unity of those
two aspects of entrepreneurial activity is a signal contribution of Klein and Foss.
5. Critique
The gist of the Foss/Klein revision of the standard Austrian framework is best expressed
in their previously quoted statement “In a world of shmoo capital economic organization
is relatively unimportant. All capital assets possess the same attributes, and thus the costs
of inspecting, measuring and monitoring the attributes of productive assets is trivial. Exchange
markets for capital assets would be virtually devoid of transaction costs” (Foss et
al, 2007: 1168). This statement is essentially just a translation of the basic Coasean claim
about the absence of the firm in the neoclassical paradigm into the language of capital
theory. Coase imagines that the only reason why the firm could emerge is to minimize the
transaction costs,7
and since the transaction costs in the neoclassical model are zero, then
neoclassical theory ‘fails’ to explain the very existence of the firm. In the same manner,
Foss et al claim that the only reason why the “organizational forms” of governance could
emerge is to deal with the transaction costs of operating the capital assets, and since the
capital assets are identical in the neoclassical treatment, the transaction costs are minimal
and hence the firm is unnecessary.
But, both claims are equally dubious. As Harold Demsetz (2011a) demonstrates, the
firm in the neoclassical model is meant to perform a functional role as a part of the system
of exchange between the open market and households. Firms emerge not because the
market is characterized by high transaction costs but because it is characterized by a high
extent of division of labor; the reason for a firm’s existence is that it provides a large degree
of specialization which increases productive efficiency and represents an alternative to the
self-sufficient provision within a household. The firm is an instrument of production and
exchange which becomes more important as the extent of market specialization and division
of labour increases, not less. The opposition in the neoclassical theory is not the one
between the market driven by price signals and the firm driven by commands and planning,
but the one between the markets with the firms as the instruments of specialization and
exchange and households as self-sufficient and non-market environments of production and
distribution.
Contrary to what Coase claims, the firm could exist even in the zero transaction cost
world, and moreover it is likely that the extent and the reach of the firm production in such
a world would have increased rather than decreased, because it would have made the provi-
7	 For a critique of this assumption see Demsetz 1988.
A bilingual interdisciplinary journal 41
sion of goods within the household less appealing (since the cheaper firm-produced goods
are more widely available than otherwise), and would have, hence, allowed the firms to
serve a much wider circle of people (Demsetz, 2011a: 10). Coase completely neglects the
productive efficiency in studying the origins, boundaries and growth of the firm. The only
costs allowed in his model are transaction and managing costs, and the balance of those two
costs on the margin determines the extent of the firm’s growth and size. But, we can have
the enormously large firms in the world of zero transaction costs because of a higher degree
of specialization and productive efficiency which makes the production for the market more
profitable than self-sufficient production. A firm can continue growing if the transaction
costs are zero just as it can shrink if the transaction costs skyrocket.
Foss et al (2007) make the analogous mistake in their treatment of the ‘shmoo’ capital.
Just as Coase wrongly imagined a world of zero transaction costs in which all the market
agents would just trade and exchange goods using the price mechanism, Foss et al imagine
a world of perfectly substitutable capital assets in which the entrepreneurs would cease to
control and own any capital goods and would communicate simply through the spot contracts
on the market, making firms all but disappear: “The possibility of specifying all possible
uses of an asset significantly reduces the costs of writing complete, contingent contracts
between resource owners governing the uses of the relevant assets. Contracts would largely
substitute for ownership, leaving the boundary of the firm indeterminate” (ibid. 1168).
But, this also completely neglects the effects of specialization and productive efficiency: in
the world of perfectly identical and substitutable capital goods, the production within a firm
would become infinitely more rather than less appealing. If we accept that the firm allows
for greater specialization and a decrease in per unit costs, then the world of shmoo would be
an Eldorado for the firm as an organization. Heterogeneity of capital is a cost that the intrafirm
production faces, rather than an incentive to it. It makes the functioning of the market
system less smooth and more complicated than it would have otherwise been; if heterogeneity
is assumed away, i.e. the assets are assumed not to be specific and substitution easy and
quick; then the firm could exploit all the advantages of production that it already has, but on
a much grander scale. In the world of shmoo the firm would be much more important and
widespread than it is now. Transaction costs, however we define the term, represent just one
element of the environment in which the firms operate, whereas productive efficiency, the
extent of the market specialization, oftentimes represents more important factors influencing
the size and growth of the firm. In other words, in the world of shmoo capital, the transaction
costs of switching the uses of a given capital good would be negligible, which would
provide a tremendous incentive to the firms to widen the scope of their operation, instead
of shrinking it. Lower transaction costs of exchanging the capital assets across the stages
and branches of production would facilitate the cheap production within the firm, reducing
the unit costs and increasing the productive efficiency. Just as in the case of Coase’s theory,
households would minimize the extent of self-sufficient production and increase their reliance
on the outside markets, i.e. on buying the cheaper products from the firms.
It has already been observed (Demsetz, 1988; Hulsmann, 2004; Jankovic, 2010) that
the very concept of transaction cost lacks any serious explanatory and predictive power.
New Perspectives on Political Economy42
Limited knowledge, costs of monitoring, difficulty in discovering prices – all those diverse
forms of costs are arbitrarily subsumed under the generic rubric of ‘transaction costs’. But,
all these cognitive and behavioral limitations of human beings are with us with or without
the firms, and it is not clear why only those costs would be relevant and not some others
that Coase did not specify. Is lifting a pen to sign a contract transaction cost or not? Or
waiting for the elevator that would take us to the floor where the firm headquarters are?
(Hulsmann, 2004) Everything and anything could qualify as a transaction cost depending
on how far we are willing to go in calling every obstacle we encounter a transaction cost.
We essentially end up with a notion of ‘transaction costs’ which approximately means: ‘any
kind of reason or problem that we can think of why a particular transaction had not taken
place’. ‘Transaction costs’ become indistinguishable from the ‘costs of resolving problems’
(Demsetz, 1988:) As Demsetz bluntly puts it: “A cost is cost whether we name it transaction
cost or fertilizer cost. Consider a manufacturer who does not ship his product to
another firm because the other firm is unwilling to pay the costs of producing the product.
What difference does it make to efficiency if the high cost is due to the price of labor or to
the cost of shipping the product – and is not the cost of shipping the product a transaction
cost?” (Demsetz, 2011b: 13). In the final instance, this entire line of reasoning leads to the
claim that we need hierarchical planning and commands to replace market prices since we
live in an imperfect world.
Foss et al just add one more item to this unending list of poorly defined “transaction
costs” – the costs of shifting various specific, heterogeneous capital goods from one use to
another. They assume the same Coasean critique of the markets in which the precondition
of its efficient functioning is the absence of transaction costs. In this context, the requirement
is that capital be the homogenous blob, shmoo capital, seamlessly fluctuating between
the various stages of production and various branches of industry: management, entrepreneurship,
vertical integration of production, all those phenomena the Austrian Coaseans
see as the effect of capital being heterogeneous and specific. Somewhat crudely, but correctly
put, they see, like Coase, central planning as a mechanism for coping with imperfect
information and limited knowledge.
However, although this new theory faces the same kind of critique we developed for the
original Coasean position, the situation is much worse for Klein, Foss and others than for
Coase. Namely, Coase never claimed that his purpose was to vindicate Misesian theory of
economic calculation and entrepreneurship; on the contrary, as we have seen, his paper
could be read at one level as a polemic against Mises and Hayek. Austrian Coaseans on
the other hand tied themselves in a knot by claiming on the one hand that market prices
are generally superior to central planning, and at the same time that central planning is
superior to the market prices within the firm. However, they follow Rothbard in the failure
to provide any Austrian justification for the notion that planning and non-market commandeering
could be more efficient than a market in any circumstances. You can claim that
Coase is right in assuming that transaction costs represent the market failure that has to be
remedied by planning, or you can claim that prices are always better than non-market commandeering.
But, you cannot claim both in the same time!
A bilingual interdisciplinary journal 43
Contrary to Hayek and in accordance with Coase, they see the perfect information and
zero transaction costs as the conditions of market price efficiency; only in the world of shmoo
economic coordination would be carried out by contracts and market transactions. In
the real world of positive transaction costs, we need ‘planning’. But, is not the basic Hayek
lesson that we need price system and market competition exactly because we do not live in
a world of perfect information, and capital goods are not shmoo? The fact that information
in reality, as opposed to the assumptions of the model, is imperfect and limited, prompted
many economists to believe that market coordination was inefficient and had to be supplemented
or supplanted by the conscious and deliberate control of economic activity in order
to approximate the economic outcomes to the properties of the model. Hayek’s critique
of that conception was that the very essence of market is to economize and optimize the
use of scarce resources including knowledge: free competition is the best mechanism so far
discovered allowing individual people with limited information and bounded rationality
to extract from society more knowledge about the appropriate use of resources than any
one of them could have possibly possessed in isolation (Hayek, 1945). The very essence
of free competition is to discover the new knowledge about the ways to use and combine
the resources, not in applying the knowledge that we already have. The less perfect the
information is, the more we need the market prices and competition! In a world of perfect
information, we would not need markets and prices at all. We have them precisely because
information is costly, scarce, and limited.
By the same token, the fact that capital goods are heterogeneous does not mean at all
that the mechanisms of control and transformation of those goods into the final consumer
products should be guided to a larger degree by a conscious authority and withheld from
the domain of market transactions. The fact that there are positive transaction costs of
changing the modes of utilization of capital goods (the costs of ‘asset specificity’ or of ‘attribute
discovery”) does not mean that the market in capital goods is ‘inefficient’ or that we
need to supplement it by some form of central planning to correct its failure. The fact of
specificity-heterogeneity of capital goods is equally irrelevant for justifying the concept of
a firm as hierarchical organization as the imperfection or asymmetry of information is irrelevant
for justifying government regulation of the insurance business. The more heterogeneous
the capital goods are, and higher the transaction costs of switching the uses of those
goods are, the “thicker” the market in which the entrepreneur operates has to be. He needs
more information, not less, to deal with the more complicated situations, and the firm
understood as a central planning instrument would, by definition, provide less information
than the ‘market’. This does not mean that in the world of more heterogeneous capital we
would need firms less, but that firms are not central planning entities.
As we have seen, Klein and Foss enrich the theory tremendously by combining in very
creative ways Kirznerian, Knightian and Bohm-Bawerkian themes with the old Rothbardian
and Misesian theories. However, the final result is, paradoxically, to even more undercut the
initial Rothbardian position, instead of strengthening it. For example, if heterogeneity of
capital is not just the old, good, run-of-the-mill “asset specificity”, but also includes the subjective
evaluations of the various attributes of the same goods, then it is not clear what pur-
New Perspectives on Political Economy44
pose the notion of transaction costs as a cost of switching the uses of single heterogeneous
goods could play in the entire scheme. If transaction costs mean the costs of unpredictable
discovery of the new features of a given good, what is the basis for belief that this discovery
would be more likely to occur within the Coasean firm rather than outside it? One million
entrepreneurs cooperating via prices and spot contract could do an equally good job of
discovering the new features of capital goods as can do the entrepreneurs organizing the
team production. There is no basis, at least in the framework developed by Foss and Klein,
to believe otherwise. Instead of offering further support for Austrian Coaseanism, Foss’ and
Klein’s refinement actually additionally illustrates its unviability.
Another downside of this refinement is that it makes some problems vis-à-vis ownership
over the firm that the Austrean-Coasean theory has had even worse. Namely, in the
standard Austrian theory a very sharp distinction is made between the entrepreneur and
manager; The entrepreneur is a creative force which initiates business plans, takes up and
recovers credit, makes decisions about what production processes to initiate, how much
money to invest here or there, how many workers to employ, whether to expand or scale
back the operations of the firm and so on (Mises, 1998). A manager, on the contrary, is
limited to the delegated and routine tasks. In addition to this, the entrepreneurial function
is tightly connected to the ownership of the firm: “the entrepreneur is nearly always also a
capitalist and the capitalist is also an entrepreneur”, says Peter Klein (2010). This means
that entrepreneur must hold ownership over the assets whose different attributes are to be
discovered. Klein and Foss (2012: 120) emphasize “ownership is a low cost form of allocating
the rights to attributes of assets that are created or discovered by the entrepreneurowner.”
In Foss et al (2007) they use a similar argument, but expressed in Knightian terms:
“…there is no market for the judgment that entrepreneurs rely on, and therefore exercising
judgment requires the person with judgment to start a firm…Judgment thus implies asset
ownership, for judgmental decision-making is ultimately decision-making about the employment
of resources. An entrepreneur without capital goods is, in Knight’s sense, no entrepreneur.”
(Foss et all, 2007: 1167)
One obvious problem with the identification of owner and entrepreneur is that all the
essential functions of the alleged entrepreneur-owner in the modern corporation appear
to be performed by paid employees, rather than by the owners themselves. In the modern
corporation of a great mass of individual shareholders very few of them had any idea about
the production process or the true business of the firm, and they instead hire the other
people to lead the corporation and organize the production process at all stages. In most
cases, those owners are not only excluded from making and executing the business plans,
but have actually a limited liability for the corporate performance. This is really awkward: if
it’s true that entrepreneur=owner, then the corporation represents a really anomalous form
of organization which should be expected to have a dismal record: what kind of organization
plagued by such moral hazard in which the owner reaps the benefit of a successful
business while being shielded from at least some of the consequences of failure could be
efficient? And yet, the modern corporation seems to dominate the business world. Either
it is somehow artificially privileged by the legislation, or the concept of the entrepreneur
A bilingual interdisciplinary journal 45
being identical to the owner does not hold, i.e. it must be that “managers” could exercise
successfully the entrepreneurial function.
Klein and Foss try to solve this obvious problem by claiming that there are two different
types of entrepreneurial judgement: the “original” judgement exercised by the owners
of a firm and “derived” judgement exercised by the managers and other people to whom
the rights to decide about certain issues are delegated by the owners (Klein and Foss,
2012). Obviously struggling with the fact that the CEOs and other senior managers of
modern corporations make the most important decisions about the business operations
of the firm, they redefine the entrepreneur: this is not anymore a person who owns the
corporation, makes the business plans as well as all other critical decisions (as in earlier
Austrian literature), but only the person or persons who have a residual or ultimate decision
making power. In other words, he can fire the CEOs or stop any particular business
plan.
This solution may or may not sound convincing in and of itself, but one thing is certain:
it is very difficult to square with the “attributes discovery” theory of entrepreneurship. For
the purposes of making the dubious Austrian identification of entrepreneur and owner look
more realistic, Foss and Klein are forced to empty the notion of entrepreneur of almost any
concrete content, apart from the ultimate control of assets, which is little more than an
analytic definition of the term “owner”: their “clarification” that the owner is entrepreneur
because he controls the assets amounts to little more than a claim that owner is owner because
he is the owner. And yet, while developing their theory of ownership as a “low cost
form of allocating the rights to attributes of assets that are created or discovered by the
entrepreneur-owner” they seem to have in mind a much richer notion of the entrepreneur,
who actually personally does the job of attribute discovery and is rewarded for this by the
ownership over the attributes he discovered. In other words, in the theory of attributes
discovery, the concept of the entrepreneur is much closer to the person exercising “derived
judgement”, i.e. the manager, rather than to the ‘real’ entrepreneur with his “original judgement”.
So, the entire theory is in a sense based on an equivocation: when the problem of
corporation should be solved, the concept of entrepreneurship is emptied of most of its
usual content and identified with a minimalistic “original judgement”; on the other hand,
when the theory of “attributes discovery” is developed this standard content is smuggled
back again into the model.
The basic weakness of the theory mimics the general weakness of the old AustrianCaoseanism
of Mises and Rothbard: the impossibility to square the logic of individual
entrepreneurship, market prices and market process, with the socialist concepts of organization,
hierarchy and commandeering taken from Coase. In Foss’ and Klein’s revision,
this is even more evident since they emphasize the concept of entrepreneurship, as well
as the heterogeneity of capital, which both fit very nicely the general Misesian paradigm,
thereby making the artificial and convoluted nature of the Coasean firm even clearer.
Foss’ and Klein’ theory, if I am allowed such a metaphor, resembles a man wearing a tailcoat,
a cylinder, the black pants, a white shirt with a bow tie, and –muddy military boots,
instead of shoes.
New Perspectives on Political Economy46
6. Conclusion
The basic claim of this paper is that the only way of making sense of the notion that a free
market is superior to central planning in the context of a world characterized by heterogeneity
of capital is to reject Coasean theory of the firm as a centrally planned ‘organization’.
Contrary to some new attempts to show that heterogeneity of capital stock (asset specificity)
entails various forms of opportunistic behaviour that invite the substitution of organizational
forms of governance for market transactions (Klein and Foss, 2012; Foss et al,
2007), I affirm that heterogeneity is actually an additional reason why the market prices are
indispensable and why organizational and planning thinking is a wrong way to conceptualize
the problem. Austrian economists who tried to fuse Misesian arguments on economic
calculation and market prices with the Coasean theory of the firm never addressed the basis
and fundamental disconnect between these two theories: the fact that Coase argues that
central planning represents a remedy for the failure of market prices efficiently to coordinate
the economic activity. The newest attempt by some Austrians to use the upgraded form
of Bohm-Bawerkian capital theory as a new way of reconciling the two is equally untenable.
All the problems and contradictions this brand of Austrian theory faces could be avoided
very simply: by rejecting the Coasean notion that a firm represents an instrument of central
planning, but rather a form of voluntary and contractual market cooperation.
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A bilingual interdisciplinary journal 49
Book Review
Inventing Freedom: How the EnglishSpeaking
Peoples Made the Modern World
by Daniel Hannan, 2013. Broadside Books,
416 p
In the political correctness ethos of our age, one of the worst crimes an academic might
commit is to make a claim of civilizational exceptionalism for a particular nation – i.e. a
particular group of people identified primarily by ethno-linguistic ties. Fortunately, Daniel
Hannan is a politician, not an academic, and thus is free to pen a book committed
to such a thesis. In Inventing Freedom, Hannan makes a bold, intricate case for the legal
and political – and therefore economic – exceptionalism of the English-speaking countries,
which he refers to as the “Anglosphere.” Hannan’s book is sure to raise the hackles of
multiculturalists and the diversity lobby, while appealing to the nativist sentiments of some
conservatives. Yet this book is no mere polemic offered up for party ideologues, such as
might emerge from the pen of a Sarah Palin or Al Franken. Hannan’s work is of a much
more nuanced, scholarly bent, and brings a deep historical perspective to issues of central
importance to the field of constitutional political economy.
Hannan’s claim is that the unique political constitution1
of the Anglosphere is responsible
for its broadly-acknowledged economic success and geopolitical dominance. In other
words, Hannan espouses the view that the Anglosphere countries are marked primarily by
their legal and political institutions, and these institutions are the most important elements
in their success. This is a bold claim, but Hannan does an admirable job articulating it with
a rich, detailed historical narrative of the ancient roots, historical evolution, and modern
refinement of this institutional framework, which Hannan sees as coming to full flower with
the US Constitution of 1787.
Critical readers who are familiar with Hannan will be suspicious of natural biases at play
in this book. Hannan represents South East England in the European Parliament, the legislative
body of the European Union. Hannan, an unabashed and vocal conservative, came to
international prominence when his trenchant, eloquent harangue of British Prime Minister
1	 Throughout this review I will use the term “Anglosphere constitution” – with a small c – to refer, not to any
particular parchment, but to the unique pattern of legal and political institutions that typify the Anglosphere
countries as will be described below.
New Perspectives on Political Economy50
Gordon Brown went viral on Youtube in 2009.2 Building on the cross-Atlantic acclaim
for this speech, Hannan released The New Road to Serfdom: A Letter of Warning to America,
in 2010. Although Hannan hails from Peru – a son of British emigrant farmers – and is
trilingual in English, Spanish, and French, he is proudly English in the sense of upholding
what he views as England’s unique political values. Hannan is prominent amongst the Euroskeptic
movement in Britain, promoting national sovereignty and a devolution of power to
the lowest possible level of government, as opposed to the pan-European social-democratic
machinations of the continental Eurocrats.
Yet while Hannan is an artful conservative spokesman with a unique talent for firing up
the passions of Anglo-American conservatives, he is no mere demagogue. Hannan’s background,
especially his foreign upbringing, gives him a much more nuanced and informed
viewpoint, which lends credibility to his views. Moreover, his knowledge of history and his
reading of the relevant scholarship is deep and broad, giving his book an erudite, academic
flavor. Thus even those who walk away from this book still skeptical of Anglosphere constitutional
exceptionalism won’t be able to fault Hannan for not making his arguments in a
clear, calm, and compelling manner.
Anglosphere Exceptionalism:
Theory, Background and Practical Implications
Hannan’s thesis in Inventing Freedom revolves around a political economy argument, an historical
argument, and a case study writ large. I will explore each of these in turn, then connect
Hannan’s work to a broader economics and political economy literature, and finally
conclude with a strong recommendation of Inventing Freedom for students and scholars of
political economy.
The Importance of Institutions
Hannan’s political economy argument focuses on the idea that a nation’s legal and political
institutions – the manner in which it makes and enforces its laws and operates its govern-
ment – are of paramount importance to its economic success viewed in terms of the average
citizen’s standard of living. The particularly successful Anglosphere constitution, broadly
conceived, is built upon the following principles:
1.	 Primacy of the individual: individual citizens are ultimately sovereign over themselves
and their justly acquired property, and may employ (or not employ) their persons and
2	 https://www.youtube.com/watch?v=94lW6Y4tBXs
A bilingual interdisciplinary journal 51
estates in any manner they wish, so long as they do not interfere with like rights of all
others.
2.	 Representative government: as the people, individually, are ultimately sovereign, legitimacy
in government arises from them and can only be delegated to the state apparatus
(courts, police, etc.) by a representative process, through which the individual
citizens retain ultimate control of the governing bodies this process may establish.
3.	 Common law: the law is seen as ancient and universal, given by nature or God. It preexists
the state and thus the judiciary’s job is not to create law, but merely to discover
and apply it. The role of the legislature is also, then, a rather modest one of affirming
settled legal principles and establishing rules for hard and novel cases by statute. It is
not the legislature’s job to attempt to impose any particular vision of the ideal society
by forcefully rearranging people’s status and property as if they were pieces on a chess
board.
4. Rule of law: the law is supreme, as reflected in the ancient dictum “no man is above
the law.” Rule of law tames the passions and prejudices of particular men in particular
times and places, and ensures that all citizens are treated equally under the law, i.e.
that all are entitled to the same legal procedures, such as trial by jury for capital of-
fenses – and privileges, such as habeas corpus and the “right to remain silent.”
These core principles of polity and jurisprudence should be quite familiar to Anglosphere
citizens; if one did not learn them in civics class, they are easily gleaned from TV police
dramas. What is not often taught in the schools nor espoused in pop culture, however, is
how and why these principles matter for a nation’s economic performance. Hannan does
an able job of relating arguments made on this point by generations of economists, namely
that the stability of property rights that Anglosphere legal and political systems generate is
crucial not just for the day-to-day functioning of markets, but for the investments in longlived
capital goods and market innovation that generate sustained economic growth. I will
revisit this theme below after addressing the heart of Inventing Freedom – a richly detailed
account of the historical development of the Anglosphere constitution.
The Ancient Roots of the Anglosphere Tradition
Hannan’s major theme is that England, and by extension the Anglosphere, has a unique
legal and political institutional structure that is ancient, having emerged from the mists of
Germanic and Nordic precursor civilizations, and had already taken on a complete, coherent
form by the time of the watershed events of 1066 and 1215. Although the latter date is
generally associated with the first documented limit upon royal power with Magna Carta,
Hannan argues that by this time “the rights of Englishmen” were so well-established that
they were already considered ancient.
While the system of English rights and liberties, along with its unique common lawbased
courts, was well-established by the Middle Ages, it was refined and articulated by
New Perspectives on Political Economy52
renowned English jurists such as Coke and Blackstone in the 17th
and 18th
centuries, when
it began to take on the form that is still familiar to residents of common law countries to this
day.3
The ascendance of this common law tradition, and the individual rights cum limitations
on governmental power that it entailed, engendered a conflict between the libertarian
and absolutist elements in Anglo-American society. This conflict came to a head in what
Hannan refers to as the “Anglosphere civil wars.”
The first of these – the English Civil War – culminated in the Glorious Revolution,
which Hannan describes as “the moment when the Anglosphere took off, developing into
a small-government, individualist, mercantile state-system” (p. 193). The Glorious Revolution
also brought on its heels the English Bill of Rights, which in its establishment of individual
rights and limitations on government powers, anticipated the ultimate refinement
of the Anglosphere constitution which emerged from the American Revolution (which
Hannan labels the “Second Anglosphere Civil War”) in the form of the Declaration of
Independence and the US Constitution. Noting that the literal sense of the word revolution
indicates “a full turn of the wheel,” Hannan suggests that the revolutions of both 1689 and
1776 should not be seen as advances away from an ancient, repressive oligarchy and towards
a bright new free and equal future, but indeed as a restoration of the ancient traditions of
freedom under the law.
Case Study: Anglosphere Dominance
The Anglosphere civil wars pitted Whigs versus Tories, or, broadly speaking, supporters of
the maximal individual liberty and the rule of law versus supporters of royal prerogative and
absolute state authority. The Whigs came out on top in both contests, which, as Hannan argues,
set the path for the stellar economic growth and geopolitical dominance of the British
Empire, followed by the United States, in the 19th
and 20th
centuries. This success is not surprising
in light of the core economic claim about the importance of institutional structure.
Hannan applies this idea broadly to the Anglosphere countries of today, which are defined
as those that inherited their legal and political institutions from Mother England.4
3	 The Petition of Right, for example, which was written under Coke’s leadership and presented by Parliament
to King Charles I in 1628, is widely seen as the predecessor to the 3rd
, 5th
, 6th
, and 7th
amendments to the US
Constitution.
4	 Hannan lists Australia, Canada, New Zealand, the United Kingdom, and the United States as the core Anglosphere
nations; broader definitions also include Ireland, Singapore, Hong Kong, South Africa; some even
stretch the concept to encompass India. It is important to note that, although these countries are largely
English-speaking, ethnicity is neither a feature nor a requirement of Anglosphere identity. As Hannan notes
repeatedly in the book, the Anglosphere has been able to grow geographically and encompass many different
nationalities precisely because its core values are built on political ideas about the nature of man, law, and government,
rather than on ethnic identity.
A bilingual interdisciplinary journal 53
Owing precisely to their institutional heritage, they are, not surprisingly, among all nations
economically the wealthiest and politically the most free. One does not need to compare
nations’ real per capita GDP figures to realize this. As Adam Smith had already noticed
by 1776, the standard of living in Anglosphere countries is remarkably higher than the rest
of the world, including both the 3rd
world and the “developed” nations of most of Europe.
Again emphasizing the linkage between institutions and development, Hannan cites the
consistent ranking of Anglosphere countries among the top of economic freedom indices,
such as that published by the Heritage Foundation.5
What does this mean in practical
terms for entrepreneurs? As Hannan states, “Above all, common law has proved the surest
defense of property rights. Today, companies from all over the world pay premiums to sign
their contracts in common-law jurisdictions. They do so because they have confidence in
the impartiality, security, and fairness of the system” (p. 330).
Hannan and the Economists
While Hannan’s focus, and the major contribution of this book, is on the historical development
of the Anglosphere constitution, his work meshes very well with the stories being told
by many economists. Acemoglu, Johnson, and Robinson (2001) have made a compelling
empirical case for the importance of institutional structure in economic development, and
Acemoglu and Robinson more recently produced a sweeping historical narrative account of
how institutional differences, in many cases stretching far back into the mists of time, have
had a lasting impact on the economic performance observed in societies today (2012). Acemoglu
and Robinson sort nations into two groups: those with “inclusive” institutions that
allow widespread participation in political and economic realms, and those with “extractive”
institutions that allowed a narrow set of elites to exploit a politically and economically
powerless peasant or slave class.
North, Wallis, and Weingast (2009; henceforth NWW) refined and augmented this idea
with specific focus on the role of institutional change in economic development. They develop
a framework featuring two polar types of polity: the “limited access society” or natural
state, and the “open access society,” each defined in terms of its institutional structure.
Natural states vest sovereignty among a narrow set of elites, who enjoy economic rents
solely on the basis of their elite status. While natural states allowed human societies to
eclipse the violence and uncertainty of tribalism, and thus allowed for some stability and
economic growth, it took the advent of open access societies to fertilize the industrial and
technological progress that has characterized the past several centuries in the West. Open
access societies, as the name implies, allow a much broader participation in the political
5	 http://www.heritage.org/index/
New Perspectives on Political Economy54
and economic realm, thus opening up peaceful economic competition6
which pushes down
rents and spurs innovation as main wealth-generating activity.
The inclusive societies of Acemoglu and Robinson, as well as the open access societies
described by NWW, feature just those norms that Hannan sets out as the core Anglosphere
principles: individual sovereignty, rule of law, and limited government. Thus as the Anglosphere
epitomizes the institutional structures requisite for greatest economic success, the
enviable performance of the Anglosphere nations on this count should come as no surprise.
This renewed focus on institutions in the economics literature is a welcome development.
But it is not a new discovery by any means; one can find this institutional focus at
least as far back as Adam Smith: “Little else is requisite to carry a state to the highest degree
of opulence from the lowest barbarism, but peace, easy taxes, and a tolerable administration
of justice; all the rest being brought about by the natural course of things.” (Stewart 1829,
p. 64). A renewed focus came with Mises and Hayek in the 1920s and 30s in the setting of
the socialist calculation debate. The Austrians argued that, even assuming a truly benevolent
dictator, socialism was doomed in practice due to its institutional shortcomings. They
pointed out that abolishing private property in the means of production would eliminate
market exchange and thus market prices – the main tool used by businessmen to calculate
profit and loss expectations upon which all economic decisions are ultimately based. Thus,
socialism would destroy the institutional basis of the market economy.
Another Austrian theme that fits well with Hannan’s hypotheses is the idea that the
knowledge essential for the functioning of an advanced economy with widespread division
of labor is dispersed – not available to any centralized authority. Hayek argued that
decentralized institutions like markets can marshal and organize this dispersed knowledge
in an economically coherent manner through a concise communication system of price
signals (1948). In contrast to sluggish and punctilious centralized bureaucracies, markets
are flexible and adaptable to constantly changing local circumstances, and thus allow for
innovation and progress in the economic system. In like manner, the knowledge required
for a proper administration of justice7
is dispersed, and thus justice is best served under a
decentralized, organic, bottom-up legal system – exactly what the Anglosphere gets with its
common law tradition.
A related linkage can be seen between Hannan and modern Hayekians in their argument
that decentralized institutions, whether economic (e.g. competitive markets) or political
(e.g. localized law courts), are “robust,” or resilient against destabilizing shocks. Boettke
and Leeson (2004), for example, note that robust institutional structures function well
6	 As opposed to predatory competition. Mises highlights this distinction between peaceful, economic competition,
which he terms “catallactic competition,” and the violent struggle over a fixed pool of resources, which he
labels “biological competition” (1998, p. 274). For competition of the catallactic sort to prevail, what’s needed
is something the animal kingdom lacks, but fortunately man can discover and apply: a legal and political structure
that recognizes the autonomy and dignity of each individual – in other words, sound institutions.
7	 Note here that the functioning of the market is built upon a sound legal system, as Smith noted in 1755 and
of course as Hannan stresses in Inventing Freedom.
A bilingual interdisciplinary journal 55
in general by tapping dispersed knowledge and engaging many competing, overlapping
agents in widespread networks of production and exchange. Thus, if a negative shock –
such as natural disaster, honest human error, or outright fraud and rapaciousness – should
strike and even destroy several nodes of a network, the remaining nodes and linkages in
the system can still marshal the requisite knowledge and resources to maintain some level
of productivity or effectiveness. A competitive, decentralized, overlapping production and
distribution process for, say, coffee, will ensure that every market and café is continually
and reliably supplied on a daily basis, despite any number of afflictions – bad weather in
the tropics, shipping delays, human error transcribing and processing orders, fraudulent
activities by a handful of dishonest agents, etc. – that would stymie the efforts of a centralized
bureaucracy. In like manner, a decentralized legal system, while it might occasionally
miscarry justice, will generally be able to recognize pertinent circumstances of time and
place applicable to a particular case, and see to it that justice is, therefore, generally served
well. Although Hannan does not apply the particular “robustness” jargon, he acknowledges
this basic concept in pointing out the difference between a top-down and bottom-up constitutional
structure: “the contracting out of human rights to a charter, necessarily interpreted
by some state-appointed tribunal, left the defense of freedom in a small number of hands. If
those hands failed, freedom failed. In the Anglosphere, where the defense of freedom was
everyone’s business, dictatorship and revolution were almost unknown” (p. 332).
Conclusion
In all, Hannan’s book is of immense interest to students of political economy; Hannan lays
out a compelling story about the fundamental role of institutions, and particularly constitutional
structure, in economic development and the realization of the ideal of a free, open
society. For economists and political scientists who adhere to the notion that institutions
matter, Hannan’s book provides a rich historical case study worthy of their attention; for
Hannan, institutions not only matter, but are the crucial element in national development,
both of a flourishing, prosperous economy, and a polity of dignified, autonomous, free
people.
Tyler Watts
Assistant Professor, Economics, Fred Hale School of Business – East Texas Baptist University,
Marshall, TX.
twatts@etbu.edu
New Perspectives on Political Economy56
References
Acemoglu, Daron, Simon Johnson and James A. Robinson (2001) ‘The Colonial Origins
of Comparative Development: An Empirical Investigation.’ American Economic Review
91 (5): 1369–1401.
Acemoglu, Daron and James A. Robinson (2012) Why Nations Fail: The Origins of Power,
Prosperity, and Poverty. Crown Business.
Boettke, Peter J. and Peter T. Leeson (2004) ‘Liberalism, Socialism, and Robust Political
Economy.’ Journal of Markets and Morality 7 (1): 99–111.
Hannan, Daniel (2010) The New Road to Serfdom: A Letter of Warning to America. Harper.
Hayek, Friedrich A. (1948) Individualism and Economic Order. University of Chicago Press.
Mises, Ludwig von (1998) Human Action. Ludwig von Mises Institute.
North, Douglass C., John Joseph Wallis and Barry R. Weingast (2009) Violence and Social
Orders: A Conceptual Framework for Interpreting Recorded Human History. Cambridge
University Press.
Stewart, Dugald (1829) The Works of Dugald Stewart (Vol. VII). Cambridge: Hilliard and
Brown.
A bilingual interdisciplinary journal 57
list of articles
Jan Winiecki: Lessons From Developmental Strategies Over The Last
Hundred Years ..................................................................................................5
Daniil Gorbatenko: Austrian Business Cycle Theory Without Unrealistic
Constructs........................................................................................................12
Jan Winiecki: Lessons From Developmental Strategies Over The Last
Hundred Years ................................................................................................29
BOOK REVIEW
Tyler Watts: Inventing Freedom:
How the English-Speaking Peoples Made the Modern World
by Daniel Hannan, 2013. Broadside Books, 416 p.......................................49
www.cevroinstitut.cz