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NEW PERSPECTIVES
ON
POLITICAL ECONOMY
Volume 4 Number 2
ARTICLES
2008
Salerno: Böhm-Bawerk’s Vision of the Capitalist Economic Process:
Intellectual Inﬂuences and Conceptual Foundations
Simpson: Austrian Trade Cycle Theory and Rationality
Bagus: Monetary Reform and Deﬂation – A Critique of Mises,
Rothbard, Huerta de Soto and Sennholz
Wenzel: Postmodernism and Its Discontents: Whither
Constitutionalism After God and Reason?
Editorial Board:
Josef Šíma Department of Institutional Economics,
University of Economics, Prague
Dan Šťastný Department of Economics, University of
Economics, Prague
Advisory Board:
Enrico Colombatto University of Turin
Richard Ebeling Foundation for Economic Education
Robert Higgs The Independent Review
Jesus Huerta de Soto University of Madrid
Jörg Guido Hülsmann Universite d’Anger
Language Editor: Shelly Gussis
ISSN: 1801-0938
ISSN 1801-0938
New Perspectives on Political Economy
Volume 4, Number 2, 2008, pp. 87 – 112
Böhm-Bawerk’s Vision of the Capitalist Economic Process:
Intellectual Inﬂuences and Conceptual Foundations
Joseph T. Salerno
JEL Classiﬁcation: B13, B31, B53, D46
Abstract: This paper is a prologue to Böhm-Bawerk’s mature vision of the capitalist
economic process which he elaborated in The Positive Theory of Capital originally
published in 1889. It deals with the intellectual inﬂuences and fundamental concepts
that conditioned and infused this vision. By scrutinizing these inﬂuences in conjunction
with his obscure ﬁrst monograph published in 1881, we gain important insights
into a number of heretofore neglected or under-appreciated aspects of his later work.
First, Böhm-Bawerk’s theoretical system emerged from the nineteenth–century German
subjective-value tradition in which he was immersed, and he saw his ﬁrst task as
correcting and completing the German “theory of goods” in order to provide a solid
conceptual foundation for his planned future analysis of capital and interest. Second,
the economists who had a formative inﬂuence on his thought extended beyond Carl
Menger. Third, the Böhm-Bawerkian theoretical structure was founded on a view of
the economic world pervaded with non-calculable, systemic uncertainty in which the
facts and values relating to future goods were a matter of subjective interpretation and
conjecture. This latter point is particularly important because many modern Austrians
treat Böhm-Bawerk as an equilibrium theorist deﬁcient in mathematical skills.
Finally, the theory of goods as reconstructed by Böhm-Bawerk was clearly the point
of departure for formulation of economics as a science of human action by his student
Ludwig von Mises.
Graduate Program Chair, Department of Finance and Economics, Lubin School of Business, Pace
University, New York, NY 10038, jsalerno@pace.edu.
88 New Perspectives on Political Economy
Böhm-Bawerk’s scientiﬁc lifework forms a uniform whole. As in a good play each
line furthers the plot, so with Böhm-Bawerk, each sentence is a cell in a living organism,
written with a clearly outlined goal in mind… He was a theorist, born to see – and to
explain – large relationships; to seize instinctively but with a ﬁrm hand, on the threads
of logical necessities… He gave us an all-embracing theory of the economic process – one
of the great analyses of economic life on the scale of the Classics and Marx – conceived
on a Mengerian foundation and developed from the point of view of the one problem
whose solution seemed to be still missing… The theory of the socio-economic process
is, in Böhm-Bawerk’s pages, unfolded for the ﬁrst time as an organic whole of valuations
and “objective” facts… (Schumpeter 1969, pp. 146-47, 189)
1 Introduction
Eugen von Böhm-Bawerk (1851-1914) has been justly recognized and celebrated as the
founder of Austrian capital and interest theory and as the ﬁrst economic theorist to
discover the main signiﬁcance of the phenomenon of time preference for the determination
of the interest rate. However, few beyond his direct students, such as Schumpeter
(1969), Ludwig von Mises (1978, pp. 39-41; 1990) and Richard Strigl (2000), have
come close to appreciating the full scope of Böhm-Bawerk’s contribution to economic
theory and his central role in the emergence and development of the early Austrian
school. Friedrich A. Hayek (1992, p. 112), who for more than a decade toiled in the
ﬁeld of Austrian capital theory, was also cognizant of Böhm-Bawerk’s seminal work in
elaborating and systematizing the central core of Austrian value and price theory. Of
economists who reached maturity after World War 2, Murray N. Rothbard was profoundly
inﬂuenced by Böhm-Bawerk’s overall body of work. Even more than Mises,
who adumbrated the capitalist economic process in much broader strokes, Rothbard
closely followed Böhm-Bawerk as a meticulous system-builder who placed the theory
of production at the center of his analysis of the market economy.¹
¹ Of the twelve chapters of Rothbard’s treatise, Man, Economy and State (Rothbard 1993), ﬁve chapters,
encompassing 30 percent of its 987 pages, are devoted to production theory. Moreover, the
book’s index lists 39 separate page references to Böhm-Bawerk, second in number only to references
to Rothbard’s mentor, Mises. In sharp contrast to Böhm-Bawerk and Rothbard, Mises in his own treatise,
Human Action, provides very skimpy detail on crucial areas of production theory. In fact in one
of his regular letters to the directors of the Volker Fund reporting on the status of the manuscript
Salerno: Böhm-Bawerk’s Vision of the Capitalist Economic Process … 89
This paper is in the nature of a prologue to Böhm-Bawerk’s mature vision of the
capitalist economy and deals with the intellectual inﬂuences and fundamental concepts
that conditioned and infused this vision. By scrutinizing these aspects of BöhmBawerk’s
thought, we gain important perspective on his contribution. In particular,
this endeavor sheds light on a number of heretofore neglected or under-appreciated
points. First, Böhm-Bawerk’s theoretical system emerged from the nineteenth-century
German subjective-value tradition in which he was immersed, especially its foundational
theory of goods. Second, the economists who had a formative inﬂuence on
him during the maturing stages of his thought extended beyond Carl Menger. Third,
the Böhm-Bawerkian theoretical structure was founded on a view of the economic
world pervaded with non-calculable, systemic uncertainty in which the facts and values
relating to future goods were a matter of subjective interpretation and appraisement.
The treatment that Böhm-Bawerk aﬀorded to these topics was much more
penetrating and systematic than Menger’s because it evolved out of Böhm-Bawerk’s
eﬀorts to correct and complete the German theory of goods in order to provide an unshakeable
conceptual foundation for his analysis of capital and interest. Indeed, in a
sense, Böhm-Bawerk’s mature vision of the capitalist economic process represented
a logical unfolding of German goods theory. Finally, the theory of goods as reconstructed
by Böhm-Bawerk was clearly the point of departure for Mises’s formulation
of economics as a science of human action.
Section 2 of the paper explores the primary inﬂuences on Böhm-Bawerk’s intellectual
development. Investigation into Böhm-Bawerk’s endeavor to reconstruct and
elaborate the theory of goods as the conceptual foundation for his system is undertaken
in Section 3. This method of investigating Böhm-Bawerk’s intellectual development
by analyzing chronologically his important publications of the 1880’s leading up
to his magnum opus, The Positive Theory of Capital (Böhm-Bawerk 1959) published
in 1889, mirrors the step-by-step procedure by which Böhm-Bawerk painstakingly
that would become Man, Economy and State, Rothbard (1954) lamented, “Mises has very little detail
on production theory, and as a consequence it took me many false starts and lots of what turned out
to be wasted eﬀort, before I arrived at what satisﬁed me as a good Production Theory.” Also, when
asked the question, “Is there any doubt that Mises was your primary inﬂuence?” Rothbard (1995, p.
2) responded: “I didn’t think so, but Joseph Salerno once gave a talk in which he said Man, Economy,
and State is more Böhm-Bawerk-oriented than Mises’s Human Action. I never thought of it that way,
but it may be true. When I was spelling out capital theory, I used Böhm-Bawerk primarily. I didn’t
think about it since I thought Mises was a Böhm-Bawerkian and didn’t see any contradiction.”
90 New Perspectives on Political Economy
formulated his theory of the capitalist economy. Thus, according to Böhm-Bawerk
(quoted in Hennings 1997, p. 65):
I had perceived the outlines of my theory of capital as early as 1876 [mentioning
them in an unpublished essay]… I did not want to imperil my ideas by
an undue, immature, and incomplete formulation. They were to be oﬀered to
the public when I was able to oﬀer them as a ﬁnished product in harmony with
a system of well-founded economic principles. Hence I worked for ten years at
the foundations of my theory by elaborating the theory of goods (1881), by scrutinizing
critically earlier capital theories (1884), and by developing the theory of
value (1886) – in preference to striving for popularity, as I could easily have done,
by publishing original but still immature ideas ten years earlier.
2 Intellectual Inﬂuences
Böhm-Bawerk’s primary inﬂuence was, of course, Carl Menger, the founder of the
Austrian school of economics. Furthermore, his unique vision of the capitalist economic
process can be interpreted as a logical development of the foundational ideas
on goods, economizing, value, time and uncertainty, exchange and the pricing process
laid out by Menger (1981) in his path-breaking Grundsatze der Volkwirtschaftslehre
(Principles of Economics) published in 1871. Nonetheless, all of these ideas,
including even the notion of marginal utility, were already current in the German
subjective-value tradition, which stretched back to the ﬁrst decade of the nineteenth
century and took its main inspiration from J.-B.Say (Palyi 1928; Streissler 1990; Hennings
1997, pp. 26-52). Menger’s great achievement was to integrate these concepts
in such a way as to provide the outlines of a theoretical organon based on marginal
utility that could be used to systematically analyze the causal processes determining
real prices in all goods and factor markets in the economy (Salerno 1999).
Like Menger, Böhm-Bawerk was also steeped in the German subjective-value tradition
and certainly absorbed much of it from the latter. However, Menger and BöhmBawerk
had disparate personal inﬂuences in their formative student years, and the
latter read Menger’s Principles only after he had already completed his studies at the
University of Vienna. Moreover, he probably did not make Menger’s personal acquaintance
until 1875 and might not have been in close contact with him until after
Salerno: Böhm-Bawerk’s Vision of the Capitalist Economic Process … 91
1877 (Hennings 1997, p. 10). Menger’s early inﬂuences were Peter Mischler (1821-64),
his German-born economics professor during his undergraduate years at the University
of Prague from 1860 to 1863, and Wilhelm Roscher (1817-1894), the author of the
leading German economics textbook of the day to whom Menger dedicated his Principles,
in which Roscher is also the most frequently quoted author (Streissler 1990,
pp. 33-39, 52-53).
In contrast to Menger, Böhm-Bawerk’s introduction to the German subjectivevalue
tradition in all likelihood initially came from the Swabian native Albert E. F.
Schäﬄe (1831-1903), who had immediately preceded Menger in the economics chair
at the University of Vienna and whose tenure as professor (1868-1872) coincided with
Böhm-Bawerk’s enrollment as an undergraduate there. Böhm-Bawerk reportedly developed
a serious interest in economics during this time and his course of study
would, therefore, have involved obligatory attendance at Schäﬄe’s lectures on political
economy (Hennings 1990, pp. 9, 46, 176). Another important inﬂuence on
Böhm-Bawerk in his years as a maturing economist was Karl Knies (1821-1898), who
was the most theoretically oriented economist of the older German historical school
and whose seminar in Heidelberg Böhm-Bawerk attended for a year during 1875-1876
(Streissler 1990, pp. 34-35; Hennings 1997, p. 10).²
A brief overview of Schäﬄe’s and Knies’s thought will help illuminate the unique
design of the theoretical architectonic that Böhm-Bawerk constructed on conceptual
foundations derived from Menger’s innovations in goods and value theory, which will
also be brieﬂy reviewed.
2.1 Albert Schäﬄe
Schäﬄe was one of “the two most strongly subjectivist authors” in the German branch
of the Say tradition (Streissler 1990, p. 53) and “it was mainly through the agency of
Schäﬄe that the Continental tradition of classical thought was known in Austrian
² There is no evidence that Roscher, the other leader of the older historical school, had much of a
direct inﬂuence on Böhm-Bawerk, despite the high esteem in which Menger held him and the fact
that Böhm-Bawerk attended his seminar in Leipzig in 1877 (Hennings 1997, p. 10; Streissler 1990, p.
34 fn.10). Short overviews of the career and work of Knies, Roscher and Schäﬄe can be found in Mai
1975, pp. 127, 195, 200. Roscher’s work is also reviewed in Blaug 1986, pp. 207-208.
92 New Perspectives on Political Economy
universities in the 1870s” (Hennings 1997, p. 46). Schäﬄe also evoked a great deal of
attention in Austria in 1870 with a series of public lectures criticizing socialism in the
wake of widespread labor agitation in Vienna of the late 1860’s (Hennings 1997, pp.
54-55).
In his textbook of 1867, Schäﬄe denounced the Ricardian tradition as “chrematistic,”
unduly concerned with objective properties of commodities, and emphasized
instead the subjective nature of goods and their value. Like the typical German textbook
writer in this tradition, including Menger, the primary concept for Schäﬄe was
that of goods, from which the concepts of economizing and subjective use value were
then deduced.³ Thus Schäﬄe (quoted in Streissler 1990, pp. 53, 43) wrote:
All goods become comparable in terms of value. Value [is] the signiﬁcance
of a good in the economic calculation of man. All economic calculation tries
to determine the smallest sacriﬁce necessary for full satisfaction… Value [is] a
relationship between all goods in human consciousness… [it is] predominantly of
a subjective nature. It exists in a consciousness of purpose in matters economic.⁴
Schäﬄe viewed prices as determined by supply and demand and as the objective manifestation
of value reﬂecting the community’s opinion about the values of goods.⁵
As such, prices govern all economic activities, especially production. Costs are deﬁned
as value foregone, although Schäﬄe stopped just short of developing the full
opportunity cost principle. All prices, including factor prices, are determined by
³ Recall that in Menger’s Principles (Menger 1981) chapter 3 on “The Theory of Value” is preceded by
chapter 1 on “The General Theory of the Good” and chapter 2 on “Economy and Economic Goods.”
“Commodities” or goods with objective exchange value, the central concept of the British Classical
School, do not make their appearance until chapter 7, “The Theory of the Commodity.” In general, as
Streissler (1990, p. 49) explains: “A standard German textbook will treat goods ﬁrst, then wants, then
the economy, as Rau already does in 1826; Menger uses the same sequence of subjects… Roscher uses
the series wants, goods, value, wealth, and the economy. These are called ‘the fundamental concepts’
in German economics.”
⁴ Note that Schäﬄe’s deﬁnition of value as “a relationship between all goods in human consciousness”
with its emphasis on the ranking of goods is more correctly formulated than one current Austrian
deﬁnition of value as “the relationship between a human mind and an object.” As Guido Hülsmann
has pointed out, it is impossible for an individual to “value” a single object since all values are relative.
As we shall see below, Böhm-Bawerk gave the nineteenth-century German “theory of economic goods”
its most sophisticated formulation, and it was this theory that Mises elaborated and systematized into
a general theory of means and ends or “human action.”
⁵ The following outline of Schäﬄe’s economic thought where not speciﬁcally attributed is drawn from
Hennings 1997, pp. 31-32, 37, 54-55, 86-87.
Salerno: Böhm-Bawerk’s Vision of the Capitalist Economic Process … 93
an all-embracing competitive bargaining process for which Schäﬄe coined the term
Preiskampf.⁶ The competitive bargaining process operates to equilibrate supply and
demand in the short run and drive prices toward marginal costs in the long run. Schäfﬂe
was so eager to emphasize the interdependence of competitive price determination
in the economy that he unfortunately used awkward and strained organicist analogies
for which he was ridiculed and which obscured this vitally important element
of his work. Consistent with his focus on competitive process, Schäﬄe conceived of
rents and quasi-rents as compensation for the most eﬃcient allocation of available
resources, a reward for progress and eﬃciency, and “thus the major element making
for dynamic change in the economy” (Hennings 1997, pp. 32-33).
In commenting on the debate over the fate of the working class under capitalism
that raged in the 1860s between German social democrats led by Ferdinand Lassalle
and German laissez-faire liberals led by Hermann Schulz-Delitzsch, Schäﬄe sought
to illuminate the Wertfrei economic principles involved.⁷ In criticizing Lassalle’s position,
he resorted to the concept of a “temporal structure of the economic process”
developed by one of the eminent pioneers of the German subjective-value tradition,
F. W. B. Hermann (1795-1868).⁸ Elaborating on this concept, Schäﬄe (quoted in Hennings
1997, p. 37) characterized the function of capital and the capitalist-entrepreneur
in proto-Böhm-Bawerkian terms:
It is the particular way in which labour’s services are temporally structured, in
which production is separated in time and space … which conditions the peculiar
position of workers in the economy, and which points to the basic reason for the
position of the entrepreneur … who advances out of his capital, in the form of
wages, the value of labour’s services which are not yet consumable.
He went on to argue that if the capitalist did not perform this function, then the
laborer would have to acquiesce in a lengthy wait for his labor product or else the
⁶ The use of this term as a standard to judge Schäﬄe’s inﬂuence on later economists has been suggested
by Hennings 1997, p. 90, fn. 48. The term was used regularly by Böhm-Bawerk and his own student
H. von Schullern-Schrattenhoﬀen as well as by Friedrich von Wieser, Gustav Gross and Victor Mataja,
all of whom were also taught by Schäﬄe. The word was not used by Menger and was mentioned but
not used much by Menger’s student, Robert Zuckerkandl.
⁷ Capsule summaries of the views of Lassalle and Schulz-Delitzsch can be found in Mai 1975, pp. 131,
202.
⁸ For a summary of Hermann’s career and intellectual contributions, see Mai 1975, p. 110.
94 New Perspectives on Political Economy
division of labor would be impossible. Thus capital was necessary for exploiting the
beneﬁts of the division of labor. Furthermore, it is by virtue of his capital-advancing
role that the entrepreneur becomes the director of production and pivotal agent of
income distribution. Schäﬄe concluded that Lassalle’s call to abolish entrepreneurship
was wrong because the entrepreneur was indispensable to the proper operation
of the economic process. Schäﬄe also took Schulz-Delitzsch to task for confusing
credit and capital and, in doing so, brieﬂy hinted at the systematic diﬀerence
in value between present and future goods. According to Schäﬄe (quoted in Hennings
1997, p. 37), credit involves “an exchange between values with diﬀerent maturities,”
which occurs “whenever aims in the future are attained by sacriﬁces in the
present.”
Finally, Schäﬄe propounded a remarkably precocious position on welfare economics
that anticipated the position adumbrated by Murray Rothbard (1997) nearly
a century later. Schäﬄe had argued that the equilibrium adjustment of demand and
supply brought about by the Preiskampf operating under perfectly free trade is a position
of maximum social welfare. To give a ﬂavor of Schäﬄe’s views on this issue it
is worth quoting the summary by Böhm-Bawerk (2005, pp. 133-3):
We remember that both parties to an exchange must achieve a gain that
consists of the value diﬀerences of the goods given and received in exchange.
Of course, the gain is all the greater the greater this value diﬀerence. Now unhampered
competition brings about that the competitors with the greatest value
diﬀerence actually make the exchange, that is, those buyers who attach highest
value to the desired good when compared with the medium of exchange, and
those sellers who ascribe lowest value to the exchange good when compared with
the price received. Therefore, it seems that self-interest in the market place automatically
and unwittingly assures achievement of highest possible exchange
gains and thus greatest total gain for the economic well-being of society. There
is, so it seems, economic harmony between the individual interests of the successful
traders and the common interest of society.
This thought was expressed repeatedly in the remarkable writings of Schäﬄe
on the formation of price. In it he maintains that the “natural exchange value”
as it emerges in the market with “normal economic competition” equates supply
Salerno: Böhm-Bawerk’s Vision of the Capitalist Economic Process … 95
and demand “most usefully” and “socially most beneﬁcially,” and thus “produces
the greatest socially possible quantity of pure utility.”⁹
Böhm-Bawerk (2005, pp. 134-136) proceeded to rebut Schäﬄe’s position, but his counterexamples
were predicated on his failure to perceive that values are strictly relative
and subjective and so cannot be interpersonally compared, despite the fact that this
was the implication of his own theory of exchange and price.
2.2 Karl Knies
As noted, Karl Knies was the second direct and early inﬂuence on Böhm-Bawerk’s intellectual
development.¹⁰ Although a founder of the older historical school, Knies was
one of the leading theoreticians in German economics and, by the time Böhm-Bawerk
attended his seminar, he had already published the ﬁrst volume of his three-volume
treatise on money and credit. This volume contained “a full-ﬂedged theory of capital”
which was oriented toward addressing the anti-capitalist criticisms of Marx and Rodbertus.
In addition to a discussion of the role of capital and interest in production,
Knies devoted a long chapter to a detailed analysis of the role of credit in an economy
containing a temporal structure of production. He also explicitly propounded
the idea that the common element in all forms of capital is the relationship to the
satisfaction of future wants. While Knies does not advance any major new ideas on
capital and interest in his treatise, he does provide a systematic and comprehensive
summary of the ideas of previous writers in the German subjective-value tradition,
particularly Hermann, Hans K. von Mangoldt (1824-1868), and Schäﬄe.¹¹
⁹ This is not to imply that Schäﬄe was a proponent of laissez-faire policies. He was an interventionist
who believed that in practice the Preiskampf was hampered by monopolistic elements and, therefore,
he apparently favored “social” policies aimed at transforming the labor market. Although an early
proponent of Sozialpolitik, however, Schäﬄe the consummate theoretician never joined the historicist
dominated Verein für Sozialpolitik (Hennings 1997, pp. 37, 46, 54-55, 86). Also see Schäﬄe 1894, pp.
94-96, 125-27.
¹⁰ The summary of Knies’s contributions contained in this paragraph is based on Hennings 1997, pp. 33,
37-38, 55-56.
¹¹ Curiously, in his voluminous writings, Mises does not refer to this tradition or its signiﬁcance for
the intellectual formation of his master, Böhm-Bawerk. However, Mises (1998, p. 697) did identify
Schäﬄe as one of a handful of “eminent economists,” including Vilfredo Pareto, Enrico Barone and
96 New Perspectives on Political Economy
2.3 Carl Menger
This brings us to Menger’s inﬂuence on the formation of Böhm-Bawerk’s theoretical
vision and how it compared to the inﬂuences of the latter’s teachers, Schäﬄe
and Knies. There is no denying that Menger’s Principles had a fundamental eﬀect
on Böhm-Bawerk during his maturation as an economic theorist, and that its basic
concepts pervaded all of his written work.¹² In particular he absorbed Menger’s key
insight that the central task of economic theory was to explain the exact causal processes
that determine the prices really paid in the economy. This causal-realistic theory
of price determination would be predicated on the unifying principle of marginal
utility and comprehend all markets in the economy, including factor markets. Menger
(1981, p. 49) clearly spelled out his proposed research program, which he never fully
carried out, in a passage in the preface of the Principles:
I have devoted special attention to the investigation of the causal connections
between economic phenomena involving products and the corresponding agents
of production, not only for the purpose of establishing a price theory based upon
reality and placing all price phenomena (including interest, wages, ground rent,
etc.) together under one uniﬁed point of view, but also because of the important
insights we thereby gain into many other economic processes heretofore
completely misunderstood.
The Principles, however, was only an introduction to a prospective multi-volume treatise
on economic theory that Menger never completed because he became sidetracked
by the Methodenstreit with the “younger” German historical school. Most of the book
N. G. Pierson, who had “touched upon the problem” of economic calculation under socialism. Of
Knies, Mises (1984, p. 27) wrote that he was one of the few German professors in the second and third
quarters of the nineteenth century who “wrote valuable contributions to economic theory” and whose
book, along with those of Hermann and Mangoldt, “will be remembered in the history of economic
thought.” Summaries of Mangoldt’s career and work can be found in Mai 1975, p. 147 and Blaug 1986,
pp. 147-49.
¹² Böhm-Bawerk (1962, p. 107 fn. 8) implicitly expressed the precise scope of his intellectual debt to
Menger in lauding him as “that genius … whose name it is impossible to extol too often or beyond
his deserts whenever there is any discussion of the problems aﬀecting the unshakable fundaments of
economic science” (Böhm-Bawerk 1962, p. 107 fn. 8). In the same vein, Böhm-Bawerk (1962, pp.41)
praised Menger’s Principles “as a truly epoch-making work in its establishment of this speciﬁc concept
[of what constitutes a good] and also of the supremely important basic concepts of economic science
generally.”
Salerno: Böhm-Bawerk’s Vision of the Capitalist Economic Process … 97
was, therefore, devoted to reformulating and integrating, on the basis of marginal
utility, the theories of goods, economizing, and value inherited from the German
subjective-value tradition. Menger provided only the rudiments of a theory of consumer
prices and no theory of factor pricing or the money costs of production utilized
in the economic calculations of entrepreneurs.¹³
The inﬂuence on Böhm-Bawerk of Menger’s vision of a comprehensive and uniﬁed
theory of the pricing process was reinforced by Schäﬄe’s conception of the Preiskampf,
the competitive bargaining process that operated to determine prices throughout
all markets. Moreover, Böhm-Bawerk perceived that the role of marginal utility as
the regulating principle in Menger’s discussion of an individual economy, especially
as it was elaborated into a theory of “indirect utility” or opportunity cost by Friedrich
von Wieser, naturally lent itself to extension to Schäﬄe’s competitive pricing process
operating in a money exchange economy.¹⁴
Böhm-Bawerk was further inspired by Menger’s insight that the concept of causality
was fundamental to the deﬁnition of a good and all goods occupied a place in “the
causal nexus of goods” (Menger 1976, p. 56). For Menger, goods’ production and
allocation were the objective manifestation of the causal chain that was anchored
in subjective wants of individuals. Consumer goods were valued and produced because
they were perceived as the direct cause of satisfaction of concrete human wants.
Complementary goods of successively higher orders were valued as indirect causes of
want satisfaction because their sequential combinations in a given production process
brought into being the ﬁnal, consumer good.
Menger thus recognized dual and opposite lines of causation in economic activity
binding all goods together as both cause and eﬀect. On the one hand, higher-order
goods were the objective cause of the coming into being of lower-order goods and
eventually of the satisfaction of concrete human wants. On the other hand, the subjective
valuation of higher-order goods was the eﬀect of their objective position in the
¹³ Menger did, however, outline a brilliant solution to the problem of imputing value to the individual
complementary factors of production in a Crusoe economy, a solution that would later be developed
into the Austrian variant of the marginal productivity theory of factor pricing by Böhm-Bawerk
(Salerno 1999, pp. 88-90, 98-99).
¹⁴ See Hayek (1992, p. 112) on the limited but signiﬁcant inﬂuence of Wieser’s ideas on Böhm-Bawerk in
the sphere of value theory.
98 New Perspectives on Political Economy
production process that culminated in the emergence of the directly want-satisfying
consumer good. There existed relations of substitution as well as complementarity in
the causal nexus of goods because in the Mengerian individual economy, the various
categories of concrete wants competed with one another for the satisfaction aﬀorded
by the available quantities of economic goods of all orders.¹⁵ Schäﬄe’s attempts at
“organic” explanations of the Preiskampf must have exercised a parallel inﬂuence in
alerting Böhm-Bawerk to the multiple and intersecting causal relationships binding
together markets and prices within the capitalist economic process.
Despite Menger’s admittedly enormous inﬂuence on him, the original stimulus
for Böhm-Bawerk to formulate a general theory of the economy from the standpoint
of distribution theory, and the theory of capital and interest in particular, came from
Schäﬄe and Knies and only in a negative sense from Menger (Hennings 1997, pp. 54-
66). Both of Böhm-Bawerk’s German teachers in their own way attempted to refute
the claims of socialism by working out a theory of capital and interest that accorded
a central role to the time element. In addition, both – but especially Schäﬄe – used
the theory as a point of departure to elaborate a much more comprehensive theory
of the economic process. In contrast, in Menger’s Principles, the theory of factor
pricing in general, and interest theory in particular, represented a gaping lacuna in
the application of marginal utility theory (Salerno 1999, pp. 98-99).
3 Reconstructing The Theory of Goods
The monograph Rechte und Verhältnisse vom Standpunkte der volkswirthschaftlichen
Güterlehre. Kritische Studie appeared in 1881 and was Böhm-Bawerk’s ﬁrst publication.
It was based upon the Habilitation thesis that he submitted to the University
of Vienna near the end of 1879 (Hennings 1997, p. 10).¹⁶ The work was translated
¹⁵ For the overarching importance of the concept of causality in Menger’s system, see Salerno 1999, pp.
81-83, 98.
¹⁶ Menger was one of the readers of the thesis and apparently actively campaigned for its acceptance,
which was only grudgingly given by its other reader, Lorenz von Stein (1815-1890). The thesis was
oﬃcially accepted in early 1880 (Hennings, pp. 10-11). Von Stein, a conservative or corporate state
socialist, was inﬂuenced by Louis Blanc and other French Utopian socialists (Mai 1975, p. 215).
Salerno: Böhm-Bawerk’s Vision of the Capitalist Economic Process … 99
into English as Whether Legal Rights and Relationships Are Economic Goods (BöhmBawerk
1962). However, a more accurate idea of the contents of the work is provided
by the literal translation of the German title: Rights and Relationships from the Standpoint
of the Economic Theory of Goods: Critical Studies.¹⁷ For the work is in eﬀect a
critical treatise on the German theory of goods.
In his preface to the monograph, Böhm-Bawerk (1962, p. 30) contended that
the “basic economic doctrine of the theory of goods … was in need of correction in
several respects, or at least of such revision as to make it truly comprehensive and
universally valid.” Such revision was required because goods theory embodied “concepts
and truths fundamental to every economic train of thought.” Böhm-Bawerk reemphasized
the importance of the theory of goods in his introductory chapter, where
he wrote that goods “constitute the primary material with which economic science
makes it its business to deal.” What Böhm-Bawerk (1962, pp. 32-33) found lacking in
goods theory was a clear and unambiguous answer to the question of whether legal
rights and contractual relationships were to be classiﬁed as “goods” from the point of
view of economic science. His interest in addressing this issue stemmed from his research
into the theory of capital and interest and his realization that such clariﬁcation
was indispensable to the formulation of such a theory.¹⁸
Böhm-Bawerk (1962, pp. 39-41) argued that previous economists had successfully
resolved two of the three fundamental problems posed by goods theory. First, the
economic concept of goods as things that serve as tools or means for attaining human
well-being had been more or less properly delimited from other concepts, especially
the ethical concept, of goods. Second, the problem of elaborating the various
criteria implied by the economic concept of a good – what Böhm-Bawerk calls “conditions
precedent of goods-quality” – was resolved “pre-eminently through the work
of German economists.” Starting with the work of Ludwig H. von Jakob (1759-1827)¹⁹
in 1805, the solution to the problem was progressively developed until it “attained a
form that is characterized by formal completeness and ﬁnal deﬁnitiveness” especially
¹⁷ I am indebted to Guido Hülsmann for providing this translation.
¹⁸ It is noteworthy that Schäﬄe also had addressed the status of rights and relationships in the theory
of goods in 1864 in what Böhm-Bawerk (1962, p. 32) termed “a highly signiﬁcant monograph.”
¹⁹ For an overview of the life and work of Jakob, an economist and Kantian philosopher, see Mai 1975, p.
119).
100 New Perspectives on Political Economy
in the work of Menger. The third, and unresolved, problem was enumerating “the
categories of economic good,” that is, identifying the various kinds of concrete things
that fulﬁlled the theoretical criteria of a good.
Before tackling the solution to this problem, Böhm-Bawerk (1962, pp. 41-42)
spelled out the several preconditions of a good for an economizing individual, “adher[ing]
essentially to Menger” but correcting him in “one minor respect.” For a thing
to attain the status of a good for an economizing individual, the following conditions
must be simultaneously present: 1. a human need; 2. the thing must be objectively
adapted to satisfying the need or want; 3. the individual must be cognizant of the
usefulness of the thing to satisfy the want; 4. the individual must also possess the
technical knowledge necessary to utilize the thing to satisfy his want; and 5. ﬁnally,
he must possess power of disposal over the useful thing. Böhm-Bawerk’s minor correction
of Menger lay in his listing the fourth precondition separately from the third,
diﬀerentiating general cognition of a thing’s usefulness for the attainment of one’s
end from the practical knowledge of how to actually utilize it as a means to achieve
his end.
As Böhm-Bawerk (1962, p. 42) recognized, all but the second precondition are
“less inherent in the things themselves than in the economic subjects for whom they
are or are not goods.”²⁰ From this insight, Böhm-Bawerk (1962, pp. 42-45) logically deduced
a series of propositions regarding goods that implicitly established economics
on a praxeological foundation. Goods-quality is not a purely objective attribute of a
thing, but a relationship that must exist between a thing and an economic subject.
Goods-quality may be created or destroyed purely by a change in subjective relationships
and in the absence of any change in objective conditions. A thing is never a
good per se, but always a good for a particular economic subject – “just as every good
must be good ‘for something,’ so also it must be good ‘for somebody.’” Finally, there is
a distinction between goods as concrete means to ends, which as such meet the criteria
of an economic good, and goods as non-marginal and abstract ultimate ends, such
as happiness, contentment, peace of mind and so on, which are beyond the purview
²⁰ In an article pruning the errant non-praxeological elements from the Austrian goods and value theories
inherited from Menger and Böhm-Bawerk’s, Mises (2003 p. 185) noted that the second and third
preconditions should simply be replaced with, “the opinion of the economizing individuals that the
thing is capable of satisfying their wants.”
Salerno: Böhm-Bawerk’s Vision of the Capitalist Economic Process … 101
of economic science. This last in particular is a crucial insight because it opens the
door to the praxeological conception of economics as a science of means.²¹
Up to this point, Böhm-Bawerk was recapitulating and reﬁning what he believed
to be the gist of goods theory handed down by his predecessors in the German subjective-value
tradition. One of his great theoretical breakthroughs occurred as soon as
he turned to his stated task of clarifying “the categories of economic goods.” Noting
that these categories must “ﬁnd a place for all genuine contributions to human well
being,” Böhm-Bawerk (1962, pp. 49, 50) insisted that nonmaterial “personal services”
be included alongside “material goods” as a category of good, a position that most
contemporary economists, especially French and English, had ﬁnally come to accept
but without adequately comprehending why. Focusing ﬁrst on “corporeal goods,”
Böhm-Bawerk (1962, pp. 67-68) pointed out that the usefulness of such goods in satisfying
human wants consisted of “the activation for the delivery of useful renditions
of the forces of nature residing in them.” Indeed it was impossible to conceive of the
utilization of a good in any other way than either the intentional activation or reception
of the useful renditions of services emanating from the good. The fact that the
useful renditions of service are based on natural powers that inhere in a material good
does not imply that the good itself is a purely objective phenomenon. Böhm-Bawerk
employed the example of the production and consumption of a poem to illustrate that
the good is inextricably bound up with the want-satisfaction process that traverses
and links the objective and subjective realms. Wrote Böhm-Bawerk (1962, p. 69):
Be it granted that the poet’s soul must have originated thought and emotion,
and be it further granted that only in another soul and through intellectual powers
can those thoughts and emotions be reproduced, but the path from soul to
soul leads through the physical world for one stretch of the journey and on that
stretch the intellectual element must make use of the physical vehicle, that is to
say, of the forces or powers of nature. The book is that physical material vehicle.
²¹ As Mises (1998, p. 93) pointed out, “It is customary to call the end the ultimate good and the means
goods. In applying this terminology, economists mainly used to think as technologists and not as
praxeologists. They diﬀerentiated between free goods and economic goods… Only the economic
goods are the substratum of action. They alone are dealt with in economics.” For a recent critique of
the central concepts of modern welfare economics, “collective goods” and “external beneﬁts,” based
on Böhm-Bawerk’s theory of goods, see Campan 1999.
102 New Perspectives on Political Economy
In his mature work, Böhm-Bawerk conceived the time-consuming production process
in a capitalist economy as a process that wound its course from “soul to soul” via the
competitive bargaining process in factor and, eventually, consumer-goods markets
and culminated by rendering a concrete service in satisfying speciﬁc human wants.
Böhm-Bawerk (1962, p. 77) concluded, therefore, “the concrete renditions of service
are means for the satisfaction of want in a more real sense than are goods themselves…
[I]t is not goods but … the renditions of service that emanate from those
goods which constitute the smallest independent units of our economy and that the
former (i.e., goods) constitute only complexes of the latter, that goods are therefore
a secondary category.”²² Böhm-Bawerk’s theoretical innovation in identifying renditions
of services as “the veritable basic element of our economy” followed naturally
from Menger’s praxeological emphasis on “individual concrete wants” in developing
the theory of marginal utility.²³
Having elucidated the fundamental position of renditions of service, Böhm-Bawerk
had no trouble in establishing personal services or “the means to well-being
which belong to the subjective world of the personal ego” as a category of good. He
pointed out that in a world where slavery no longer existed neither the person himself
providing the services nor the “talents, powers and qualities” that enable him to
provide such services but only the renditions of service themselves can be considered
as goods.
Armed with these two categories of goods, the renditions of service by material
goods and by human beings respectively, Böhm-Bawerk (1962, pp. 59-66, 79-83) was
easily able to show that legal claims to material goods and to partial utilization of
such goods do not constitute separate categories of good. Rather, to the extent that
they are enforceable – and only to such an extent – they are one of the preconditions
²² Böhm-Bawerk’s distinction between material goods and renditions of service forms the basis of the
Fetter-Rothbard theory of rent: “In regard to a durable good … the price of the unit service is distinguishable
from the price of the ‘good as a whole.’ It is obvious that the rents are the fundamental
prices. The marginal utility analysis has taught us that men value goods in units and not as wholes;
the unit price (or ‘rent’) is, then, the fundamental price on the market” (Rothbard 1993, 1:417-18).
²³ “The natural unit of means-of-satisfaction will be the one that corresponds to the means of satisfying
one unit of our wants or to the attainment of one unit of our purposes… For the whole make-up of the
human mind and spirit is such that it is inevitable, whenever man appraises his emotions, his needs
and his purposes … that he begins by establishing a unit of those emotions, needs and purposes”
(Böhm-Bawerk 1962, pp. 74, 76).
Salerno: Böhm-Bawerk’s Vision of the Capitalist Economic Process … 103
of a thing’s goods-quality, viz., the power of disposal over the thing. A thing does not
become a good until it becomes someone’s “property.” Outside a Crusoe economy this
requires the recognition and enforcement of the individual’s right to control the thing.
Böhm-Bawerk (1962, pp. 58-59) summarized his argument as follows: “[W]herever a
good is to serve an economic purpose, there must, under all circumstances, be present
some factual possession, some physical controlling power adequate for the economic
purpose concerned… Hence a legal right or the legalized power of disposal over a
thing is nothing more nor less than a necessary reinforcement supplied by a politically
organized state of the physical power which is needed by the owner of a good as a
condition of its economic utilization.”
The same argument applies to contractual “rights to partial utilization” of an object,
as in lease or rental contracts, which are simply rights to “renditions of service as
independent economic entities” (Böhm-Bawerk 1962, p. 81). To ascribe the status of
an independent good to such contractual rights would be redundant. Böhm-Bawerk
(1962, p. 82) used the example of hiring a taxi to drive home his point. For the taxi
passenger, “it is impossible, therefore, to speak of his power of disposal over the rendition
of service [from the taxi] as an independent good beside and in addition to the
rendition of service itself.”
Böhm-Bawerk made some of his most signiﬁcant contributions to economic theory
when he addressed the question of whether “rights to the future yield of goods”
or, what we might broadly refer to today as “ﬁnancial assets” constituted a separate
category of goods. In the case of a “payments-claim” or the legal right to demand
repayment of a debt, which Böhm-Bawerk (1962, pp. 83-85) considered to be theoretically
the most important of this group of rights, the “true goods” are “the objects
themselves that constitute the matter of the debt.” These are the anticipated renditions
of services that the creditor is entitled to claim at some deﬁnite time in the future.
The payments-claim thus endows its owner with power of future disposal over a
real thing. Hence it is not a good per se but merely one precondition of “future goodsquality”
in the same way that a property right in a thing is one of the preconditions
of “an already present goods-quality.”
Although the resolution of this issue was apparently straightforward, Böhm-Bawerk
recognized that futurity was an inherent element of economizing activity and
104 New Perspectives on Political Economy
raised profound problems that had not previously been addressed by the theory of
goods. Thus he initiated a systematic transformation of German goods theory into a
theory of action that was not completed until his student Mises published his treatise
on Nationalökonomie in 1940, which was rewritten and published in English as
Human Action in 1949. His ﬁrst eﬀorts in this direction yielded seminal analyses of
the roles in economizing of time, foresight, intertemporal valuations, uncertainty,
causality, and “wealth computation” or monetary calculation.²⁴
Böhm-Bawerk (1962, p. 87) pointed out that “economic science is not concerned
only with today,” because human beings develop “economic foresight” as soon as they
begin to strive after the “objective means” for ensuring future well-being. Once this
has occurred, “the future has gained a sure and important place in our economizing,”
and we evaluate our anticipated wants and availability of goods against our existing
wants and goods. Accordingly, “our economic behavior in the present” is “governed
by the prospective presence of future needs just as if they were already upon us in the
present.” Thus had Böhm-Bawerk introduced the concept of an intertemporal scale
of valuations.
As Böhm-Bawerk (1962, pp. 90-92) noted, however, “nothing that is future is for
us absolutely certain.” Thus when dealing with claims to future renditions of service
– whether these be in the nature of a debt claim or the ownership of a durable good
like a house – neither the actual disposal over these future goods nor, a fortiori, their
value is assured. Rather our objective power to utilize them as well as their subjective
value to us are subject to “probabilities of an inﬁnite number of degrees of probability
which will range from something bordering on complete certainty” to “mere doubtfulness”
and on to “an almost disappearing possibility.” Nonetheless, the very nature
of economizing dictates that such uncertain future advantages are taken account of
and valued in some manner. Anticipating the distinction between what Mises (1998,
pp. 105-15) later called “class probability” and “case probability,” Böhm-Bawerk did
not believe that the expected values of uncertain future goods could be objectively
calculated and summed up.²⁵ The circumstances determining the maturing of an individual’s
claim to a speciﬁc future good into actual disposal over useful renditions
²⁴ Of course, Menger had dealt with all of these topics but in a cursory and less methodical fashion
(Salerno 1999, pp. 90-93).
²⁵ Mises’s terms correspond to what are today called, much less felicitously, “risk” and “uncertainty.”
Salerno: Böhm-Bawerk’s Vision of the Capitalist Economic Process … 105
of service in the anticipated economic situation were unique and incommensurable.
According to Böhm-Bawerk (1962, p. 91-92), therefore,
[W]e cannot diﬀerentiate “sure dollars” from “probable dollars” and again
from “possible dollars” and … if we could, we should not arrive at a ﬁnal uniform
total, any more than we arrive at a sum resulting from adding apples, pears
and plums. Consequently, we can do no more than transfer the gradation in the
degree of probability from the area where it exists but cannot be expressed, the
degree of probability, to an area where it does not exist but where it can be expressed,
namely, the magnitude of the prospective advantage. That is to say we
modify the magnitude of the prospective advantage or modify the estimation of
value we place upon it.²⁶
In other words, appraising the value of a claim to a future good involved an individual’s
qualitative and subjective understanding or forecast of the unfolding of the
unique events relating to the good’s coming into being and the transformation of this
qualitative forecast into a quantitative uncertainty discount in objective and certain
present dollars. Thus, for example, legal title to a house of given durability and serviceableness
built near the San Andreas fault may be appraised at a lower value by
an individual than title to a house of the same durability and serviceableness built
elsewhere, because his power of disposal over its future renditions of service are less
probable in the ﬁrst case. Unfortunately, Böhm-Bawerk went astray by comparing
this subjective process of appraising uncertainty discounts for future goods to the
very diﬀerent case of objectively calculating the expected value of a lottery ticket.
While correctly perceiving that its “true” expected value never equaled the actual ex
post value of any individual lottery ticket, Böhm-Bawerk (1962, p. 92) leaped to an
erroneous inference: “Objectively considered, this manner of computing wealth (except
for the case of complete certainty) always leads to a result that is wrong.” In fact,
the appraisement of a future good or of an individual’s overall wealth, while always
fallible, is not always wrong, because the calculation is always instrumental to economizing
or action. If the act of production or exchange that the calculation informs
²⁶ Thus Böhm-Bawerk’s novel approach to probability reﬂected implicit awareness of the gist of the
criticism later leveled by Mises (1998, p. 107) against modern probability theory: “The problem of
probable inference is much bigger than those problems which constitute the ﬁeld of the calculus of
probability. Only preoccupation with the mathematical treatment could result in the prejudice that
probability always means frequency.”
106 New Perspectives on Political Economy
results in a surplus of utility gained over utility surrendered, then it is correct. But
this was a minor ﬂaw in Böhm-Bawerk’s path-breaking analysis of the fundamental
futurity and uncertainty that characterized all valuations and choices.
By clarifying the nature of future goods and the method of their evaluation in
the present, Böhm-Bawerk (1962, pp. 100-107) was preparing the ground for his foundational
explication of the nature and productivity of capital goods. He began by
adopting Menger’s conception of “orders of goods” and identifying as a class of future
goods the present possession of goods of “more remote order” – the term he preferred
to Menger’s “higher order.” This subclass of future goods was of “paramount importance”
because “to it belongs the entire mass of goods which constitute the capital of
our economy.”
The theoretical construction of “a serial structure, or succession of orders of goods”
embodies the idea of causality, which is intrinsic to the goods concept. For BöhmBawerk,
then, his theory of capital is nothing more than the elaboration of the logical
implications of German goods theory (1962, p. 100):
All goods, by the very terms of the concept “good” itself have one feature
in common. That feature is that they are capable of constituting a link in the
chain of cause and eﬀect – the causal chain … between human needs and the
satisfaction of those needs. Now this causal relation may be direct or remote; it
may be immediate or it may function by way of one or more intermediate links
of the chain. In the nature of things these intermediate links of the chains are
themselves goods, and the transmission of the utility takes place in such manner
that from goods of remote utility there are ﬁrst produced other goods which
are closer by one stage to the (ﬁnal) stage of direct utilization; then through
these goods there is eﬀected either the direct satisfaction of the want, or the
production of still another good which, in its turn, occupies a place that is one
stage closer to that which represents the satisfaction of the human want.
Referring to Menger’s two laws, Böhm-Bawerk (1962, p. 102) argued that the goodsquality
and value of every good of remote order is conditioned by the goods-quality
and magnitude of value, respectively, of the goods of successively less remote orders
for whose production they serve. Ultimately every link in the causal chain of goods
derives its economic signiﬁcance “from one and the same source, namely, the want.” In
Salerno: Böhm-Bawerk’s Vision of the Capitalist Economic Process … 107
defending Menger’s law of value that the total value of all goods of remoter orders are
determined by and exactly equal to the value of the goods of the ﬁrst order to whose
production they contribute, Böhm-Bawerk was the ﬁrst economist to state the law of
opportunity costs as it applies in production.²⁷
The objection that Böhm-Bawerk aimed to refute by enunciating what he later
called “the law of cost” stemmed from a misinterpretation of the empirical fact that
some of the goods of remoter order employed by a single producer, particularly the
various kinds of labor, already possessed an established value or price. This being
the case, the opponents of Menger’s law argued, how could it be reasonably maintained
that the value of the product determined the value of the labor and capital
goods expended in its production rather than the other way around. Böhm-Bawerk
responded that many goods of remoter order had “a multiplicity of ways of utilization”
and, therefore, drew upon “a multiplicity of sources of value.” He then proceeded
to elaborate this insight regarding the existence of nonspeciﬁc factors of production
into the doctrine of opportunity costs:
If a good of remote order, such as human labor, because of the multiplicity
of the possible avenues of application attains an estimation of value via a large
number of channels, then its value with respect to one single object to which
it has been applied and which is considered separately by itself, will appear to
be something deﬁnitely established and ﬁrmly determinable. And in that event,
since we are inclined to use goods of deﬁnite value for the production of other
goods only if the product can attain at least equal or perhaps greater value, than
it is easily possible that the labor, regarded from a biased viewpoint, can appear
as causing the value of the product (Böhm-Bawerk 1962, p. 103-104, fn. 5).
It is indeed a tribute to both his creative genius and his intense single-mindedness
that Böhm-Bawerk conceived the law of opportunity costs as a stepping-stone to the
clariﬁcation of a problem in the foundations of capital theory.
Although the value of goods of remoter orders is a “derived value,” it is also “prospective
in nature” and “anticipates the facts.” The reason for the “anticipatory” or
²⁷ As Hayek (1992, p. 112) noted, despite the fact that it has come to be called “Wieser’s law,” BöhmBawerk
“developed the law of costs with utmost lucidity three years before Wieser, albeit in oﬀ-hand
fashion and in an obscure part of his book.”
108 New Perspectives on Political Economy
forward-looking character of the value of remoter-order goods is precisely that they
must be transformed through time-consuming processes into goods of progressively
less remote orders before they can ﬁnally release their future utility. For BöhmBawerk
(1962, pp. 95), however, the present value placed on goods of remoter order
and on future goods in general is the result of an individual and uncertain process of
“wealth computation.” This process is “an operation replete with subjective interpretations
and insinuations.” This mental operation is designed to give the economizing
individual more than a mere listing of “the things comprising [his] wealth”; rather
it is designed to provide “some estimation of their signiﬁcance, their economic importance
… their value, in order that we may add them up and compare them with
other accumulations of wealth (Böhm-Bawerk 1962, p. 86). The uncertain, subjective
and ﬂuctuating “capital values” that are summed up into an individual’s wealth are
thus distinct from his objective possession of presently existing, concrete goods of
remoter orders that constitute “capital.”²⁸ Böhm-Bawerk (1962, p. 105) characterized
the relationship between capital value and capital in the following manner:
All capital value is an anticipation of the value of the prospective consumptible
end-product. Production, of which capital is the tool and the material (e.g.,
machines and raw materials) is the condition, the justiﬁcation and the materialization
of the value which has temporarily been ascribed to capital goods; it is
the process by virtue of which the future value of a capital good is transmuted
into the present worth of the matured consumptible end-product, the process
which leads to capital’s fulﬁllment and justiﬁcation.
Although Böhm-Bawerk did not here address the issue of how monetary calculation
of capital values guided entrepreneurs in allocating concrete capital goods, his clear
distinction between the two concepts was a seminal contribution to economic science
and was a crucial step on the road to the development of a complete theory of
monetary calculation by Mises.
²⁸ Elsewhere Böhm-Bawerk (1962, p. 97) diﬀerentiated “the materials of wealth” from the “forms of
wealth.” The former, which include, in addition to concrete capital goods, both durable and stored
consumer goods, “are patently identical with the genuine goods which in actual fact lend support to
our life and our well-being.” The latter are the appraised values of our diverse rights and relationships
that bear some probability of the promise of future renditions of service and are “mere creatures of
our subjective interpretations.”
Salerno: Böhm-Bawerk’s Vision of the Capitalist Economic Process … 109
Having thus thoroughly analyzed the category of future goods and incorporated
it into the theory of goods, Böhm-Bawerk was ﬁnally ready to pose the deﬁning, but
theretofore unasked, question of capital and interest theory that would shine new
light on the avenue to its solution. Böhm-Bawerk (1962, p. 105) ﬁrst restated his conclusion
that production, which involved “transformation of capital goods into consumptible
goods, is not a process of creating values.” Rather value is attributed to
capital goods in anticipation of their time-consuming, physical transmutation into
objects directly yielding renditions of service in satisfying concrete human wants.
Hence the “productivity of capital,” which has no existence in the dimension of value,
could not be the cause of the value phenomenon of interest. Thus, as Böhm-Bawerk
(1962, p. 106) was ﬁrst to perceive, the central question to be answered in explaining
the phenomenon of interest is: “If the prospective value of the product has already
been ascribed to the producing capital in advance, how is capital, in the course of production
to produce a ‘surplus value’?” Or more concisely: “Whence this phenomenon
of capital outgrowing itself?” Not only would this simple query become forever associated
with Böhm-Bawerk’s name, but his tenacious and meticulous pursuit of its
answer eventually yielded a brilliant vision of the dynamic capitalist economic process
that has suﬀused the works of his doctrinal descendants down to the present
day.
With his typical modesty Böhm-Bawerk (1962, p. 106) concluded that his momentous
breakthrough in capital and interest theory, which was the fruit of his ingenious
reconstruction of goods theory, was “merely a slight indication of the existence of
a problem which, in my opinion, has received far too little attention on the part of
economic science. I hope to be able to oﬀer a solution at some future time in an
independent work toward the preparation of which the present work constitutes a
preliminary labor.” These words were written in 1881, at the age of thirty. Before he
turned forty he would oﬀer to the world a solution that would propel him to the forefront
of economic theorists.
110 New Perspectives on Political Economy
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Klein. Chicago: The University of Chicago Press.
[7] Hennings, Klaus H. 1997. The Austrian theory of Value and Capital: Studies in
the Life and work of Eugen von Böhm-Bawerk. Brookﬁeld, VT: Edward Elgar.
[8] Mai, Ludwig H. 1975. Men and Ideas in Economics: A Dictionary of World
Economists Past and Present. Totowa, NJ: Littleﬁeld, Adams & Co.
[9] Menger, Carl. 1981. Principles of Economics. Trans. James Dingwall and Bert F.
Hoselitz. 2nd ed. New York: New York University Press.
[10] Mises, Ludwig von. 1978. Notes and Recollections. South Holland, IL: Libertarian
Press.
[11] Mises, Ludwig von. 1984. The Historical Setting of the Austrian School of Economics.
Auburn, AL: Ludwig von Mises Institute.
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[12] Mises, Ludwig von. 1990. “Capital and Interest: Eugen von Böhm-Bawerk and
the Discriminating Reader.” In idem, Economic Freedom and Interventionism:
An Anthology of Articles and Essays. Ed. Bettina Bien Greaves. Irvington-onHudson,
NY: The Foundation for Economic Education, Inc. Pp. 133-35.
[13] Mises, Ludwig von. 1998. Human Action: A Treatise on Economics. Scholars Edition.
Auburn, AL: Ludwig von Mises Institute.
[14] Mises, Ludwig von. 2003. “Remarks on the Fundamental Problem of the Subjective
Theory of Value.” In idem, Epistemological Problems of Economics. 3rd
ed. Ed. Jörg Guido Hülsmann. Trans. George Reisman. Auburn, AL: Ludwig von
Mises Institute. Pp. 177-93.
[15] Palyi, Melchior. 1929. “The Introduction of Adam Smith on the Continent.” In
John Maurice Clark, Paul H. Douglas, Jacob H. Hollander, Glenn R. Morrow,
Melchior Palyi, and Jacob Viner, Adam Smith, 1776-1926: Lectures to Commemorate
the Sesquicentennial of the Publication of “The Wealth of Nations.” Chicago:
University of Chicago Press. Pp. 180-233.
[16] Rothbard, Murray N. 1954. Letter to Richard C. Cornuelle (August 9). Rothbard
Papers at the Ludwig von Mises Institute, Auburn, AL.
[17] Rothbard, Murray N. 1990. “A Conversation with Murray N. Rothbard.” Austrian
Economics Newsletter 11 (Summer): 1-5, 15.
[18] Rothbard, Murray N. 1993. Man, Economy, and State: A Treatise on Economic
Principles. 2nd ed. Auburn, AL: Ludwig von Mises Institute.
[19] Salerno, Joseph T. 1999. “Carl Menger: The Founding of the Austrian School.” In
Randall G. Holcombe, ed., 15 Great Austrian Economists. Auburn, AL: Ludwig
von Mises Institute. Pp. 71-100.
[20] Schäﬄe, A. 1894. The Quintessence of Socialism. Trans. Bernard Bosanquet. 5th
ed. New York: Charles Scribner’s Sons.
[21] Schumpeter, Joseph. 1969. “Eugen von Böhm-Bawerk (1851-1914).” In idem, Ten
Great Economists: From Marx to Keynes. New York: Oxford University Press.
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[22] Streissler, Erich W. 1990. “The Inﬂuence of German Economics on the Work of
Menger and Marshall.” In Bruce J. Caldwell, ed., Carl Menger and His Legacy in
Economics. Durham, NC: Duke University Press. Pp. 31-68.
[23] Strigl, Richard von. 2000. Capital and Production. Ed. Jörg Guido Hülsmann.
Trans. Margaret Rudelich Hoppe and Hans-Hermann Hoppe. Auburn, AL: Ludwig
von Mises Institute.
ISSN 1801-0938
New Perspectives on Political Economy
Volume 4, Number 2, 2008, pp. 113 – 129
Austrian Trade Cycle Theory and Rationality
Brian P. Simpson
JEL Classiﬁcation: B53, E32
Abstract: In this paper I show that Austrian trade cycle theory is fully consistent with
rational expectations. I also compare and contrast rational expectations with an alternative
theory of rationality and show that Austrian trade cycle theory is consistent
with this alternative theory of rationality. I achieve the above by ﬁrst providing an
exposition of Austrian trade cycle theory. I then proceed to show that one would have
to associate omniscience with rationality to claim that Austrian trade cycle theory is
inconsistent with rationality. I also show that because the central bank manipulates
the money supply in an erratic manner, it is impossible to use Austrian trade cycle
theory to predict exactly when the current cycle will end and the next cycle will begin.
Further, I show that even if all businessmen and entrepreneurs had rational expectations,
the trade cycle would still occur. I show that because of the nature of the
monetary and banking system we have today, the trade cycle must necessarily occur,
and that it is supporters of the current system who have irrational expectations.
An earlier version of this paper was presented at the Austrian Scholars Conference 10 at the Ludwig
von Mises Institute in March of 2004. I would like to thank the participants in my session who gave
me helpful comments on the paper. I would also like to thank two anonymous reviewers for their
comments.
Associate Professor, National University, School of Business and Management, 11255 North Torrey
Pines Road, La Jolla, CA 92037, bsimpson@nu.edu.
114 New Perspectives on Political Economy
1 Introduction
Many criticisms of Austrian trade cycle theory (from now on ATCT) have been made.
The most potentially damaging criticism is the claim that ATCT is not consistent
with “rational expectations.”¹ This attack on ATCT says that if the central bank regularly
creates the trade cycle through a manipulation of the supply of money and
credit, businessmen and entrepreneurs should be able to learn from these repeated
episodes and not make the same mistakes over and over again. According to this argument,
by learning from the repeated episodes of the trade cycle, businessmen and
entrepreneurs should be able to prevent the central bank from continuously creating
such a cycle by counteracting the eﬀects of the central bank’s actions. In fact, according
to this argument, entrepreneurial individuals should be able to proﬁt from
the central bank’s actions. At a minimum, businesses should be able to use ATCT to
make themselves immune from the central bank’s actions if, indeed, ATCT is correct.
In essence, if ATCT is correct, businesses should be able to use it to anticipate the different
phases of the cycle by predicting when they will occur. They should be able to
proﬁt from the cycle by using the theory to position themselves appropriately based
on which phase of the cycle is approaching.
Although there have been many other arguments made against ATCT, most of
them are not very signiﬁcant. Many of them are not very strong criticisms against
ATCT. Further, many of them have been addressed. For instance, it has been claimed
that there is no historical evidence to support the theory and that the theory is too
complex to be valid. It is outside the scope of this paper to address these arguments,
as well as many other arguments. However, both of these arguments against ATCT,
and many more, have been addressed.²
As I said, the rational expectations argument against ATCT is the most potentially
damaging and, therefore, ATCT must be defended against this argument if it is
¹ For examples of authors who make such a criticism, see Tyler Cowen (1997, p. 77) and Richard E.
Wagner (1999, p. 71).
² For the claim that historical evidence does not support the theory, see Robert A. Gordon (1961, p.
360). For the claim that the theory is too complex, see Leland B. Yeager (1986, p. 380). These and
many other arguments against ATCT are addressed in Roger W. Garrison (1986, pp. 447-51). Walter
Block (2001, p. 63) also provides references to a number of criticisms and rebuttals. He also provides
rebuttal to a number of criticisms as well in that paper.
Simpson: Austrian Trade Cycle Theory and Rationality 115
to remain as a valid explanation of the trade cycle. It is important that ATCT be consistent
with rational expectations because rationality is a fundamental characteristic
of human beings. If the theory cannot be defended against this argument, it would
be proper to abandon it. Fortunately, ATCT can be defended and its abandonment is
not necessary.
In this paper, I will show that ATCT is fully consistent with rational expectations,
as that term is used by contemporary economists. I will also show that the concept
of rationality that contemporary economists use is not a very good one, in that it
does not get to the root of what it means to be rational. Because of this deﬁciency,
I will present an alternative view of what rationality is and show that ATCT is also
consistent with that.³
Some “Austrian” economists have addressed the rational-expectations criticism
of ATCT; however, these economists do not provide a complete analysis of this criticism.⁴
They do not focus on the role that changes in the rate of proﬁt have on the actions
of businessmen and entrepreneurs, they do not show how it is government oﬃcials
and economists who support ﬁat money and fractional reserve banking that have
irrational expectations, they do not expose the errors in contemporary economists’
conception of rationality, and they do not oﬀer a better alternative to the contemporary
economists’ conception of rationality. These are the major contributions I make
in defending ATCT from the rational-expectations critique.
2 Austrian Trade Cycle Theory
To understand what I mean when I use the term ATCT, I will give a very brief description
of the explanation of the trade cycle that this theory oﬀers. My exposition of the
theory essentially follows the presentations given by Ludwig von Mises, F.A. Hayek,
Murray Rothbard, and George Reisman.⁵
³ This paper is based on a portion of my dissertation. See Brian Simpson (2000, pp. 128-32).
⁴ See Ludwig von Mises (1943, pp. 251-2), Gerald P. O’Driscoll Jr. (1977, pp. 102-8), Garrison, pp. 445-7,
and Block, pp. 65-8 for examples.
⁵ See Ludwig von Mises, (1966, pp. 550-71), F.A. Hayek, (1967, pp. 32-100), Murray Rothbard, (1962, vol.
2, pp. 850-879), and George Reisman, (1996, pp. 938-40). George Reisman (2007, 2002, and 1999) also
116 New Perspectives on Political Economy
In its most basic form, ATCT says that the trade cycle results from a rapid increase
in the money supply. As the money supply expands at a rapid rate, spending, business
revenues, and proﬁts in the economy increase. This provides businesses with an
incentive to expand their investment activities. This creates the expansion phase of
the cycle.
The additional revenue and proﬁts created by the money injected into the economy
are not the only factors providing businesses with an incentive to expand. There
is also the fact that, as the money supply expands at a rapid rate, the rate of interest
is prevented from rising initially, at least to as great of an extent as the rate of proﬁt.
The rate of proﬁt rises immediately because of the additional revenue generated by
the increase in the money supply and volume of spending. However, interest rates
will not rise so rapidly (or may even fall) as the new money enters the economy. This
is due to the way most of the new money enters the economy. Due to the fractional
reserve nature of our banking system, most of the new money enters the economic
system in the form of an additional supply of credit. This increased supply of credit
initially puts downward pressure on interest rates (at least relative to the rate of proﬁt)
and provides businesses with an additional incentive to expand. This is the case because
not only do businesses face an increase in the rate of proﬁt they can earn on
investments, they face an artiﬁcially low interest rate that decreases the cost of using
debt to ﬁnance any new investments. The changes in interest rates and the rate of
proﬁt also have the eﬀect of lengthening the structure of production.
The structure of production refers to the relative production of capital goods versus
consumers’ goods in the economy; it refers to how roundabout the methods of
production are in the economy. The greater relative production of capital goods, the
more roundabout the methods of productions in the economy. More roundabout
methods of production ultimately lead to a greater absolute production of consumers’
goods, even though the relative production of consumers’ goods is less. A lower interest
rate and a higher rate of proﬁt lengthen the structure of production; that is, they
cause an increase in the relative production of capital goods because more roundabout
methods of production will become more proﬁtable relative to less roundabout
provide some excellent recent applications of ATCT that showcases its power to explain the perpetual
cycle of boom and bust.
Simpson: Austrian Trade Cycle Theory and Rationality 117
methods of production due to the compounding eﬀects involved. In other words,
lower interest rates and high rates of proﬁt increase the present discounted value of
long-term investments relative to short-term investments and thus increase investment
in the former relative to the latter.⁶
The contraction occurs when the expansion of the money supply ends (or even
just slows suﬃciently) so that spending, revenues, and proﬁts decline (or increase at
a less rapid rate) and businesses contract their activities. At this point, the economy
enters a period of recession or depression. As a part of the contraction, the rate of
interest brieﬂy rises relative to the rate of proﬁt and provides a further incentive for
businesses to contract their activities, since this means the cost of ﬁnancing investment
activities has risen. Further, the structure of production shortens due to the
changes in interest rates and the rate of proﬁt.
What does this mean for the individual businessman? During the expansion businessmen
and entrepreneurs will ﬁnd it easier to sell their goods into a growing revenue
stream. This makes it possible to operate with lower cash balances relative to
their spending. This phenomenon is witnessed in the fact that the demand for money,
as measured by the velocity of circulation of money, typically remains low, and often
declines, during inﬂationary expansions. Further, the “easy” credit policy on the part
of the central bank, and the low interest rates that are indicative of such a policy,
also makes it possible for businesses to operate with lower cash balances. This is because
with an “easy” monetary policy, businesses ﬁnd it easy to raise needed funds
in the loan market, so they do not need to hold onto as many funds to ﬁnance their
spending. When the central bank has followed such a policy for a signiﬁcant period
of time, proﬁt-seeking businessmen ﬁnd it all too tempting to take advantage of the
prevailing economic data. Eventually they make investments to expand their operations
by hiring workers and/or expanding their facilities. The expansion might occur
slowly at ﬁrst, but as long as the inﬂationary policies of the central bank continue –
and accelerate – the real proﬁt opportunities become harder to pass up. Even if businessmen
understand the opportunities may be short lived, the incentive to invest to
try and take advantage of them become stronger the longer the central bank pursues
an “easy” monetary policy.
⁶ For more on the structure of production, see Hayek, pp. 37-68.
118 New Perspectives on Political Economy
The expansion does not aﬀect all industries at the same time and to the same
extent. As was discussed above in connection with the structure of production, industries
farther removed from ﬁnal consumption tend to expand more than industries
closer to ﬁnal consumption. Further, industries that are particularly sensitive to
changes in interest rates, such as the construction industry and stock market, are also
susceptible to dramatic ﬂuctuations in their scale of economic activity. The dramatic
rise in housing prices for a number of years in the recent past (through 2006) in the
United States and the subsequent fall in prices starting in 2007 is just the most recent
example of the boom-bust cycle. The Federal Reserve’s “easy” monetary policy from
late 2000 to late 2003 fueled the dramatic run-up in housing prices through 2006. Its
“tight” monetary policy from early 2004 to mid-2007 precipitated the housing crisis
in the United States.⁷
Less recently, the tale of Cisco Systems, the maker of computer networking equipment,
during the inﬂationary expansion of the latter 1990s and the recession of the
early part of this millennium provides an excellent description of the details faced
by ﬁrms during the boom-bust cycle. During the latter 1990s inﬂationary expansion,
Cisco’s revenues grew at an annual rate of 53-percent. This is unheard of for a
multibillion-dollar company. Toward the end of the expansion, it doubled its payroll
to 44,000 employees in just one-and-a-half years. The company had 500 recruiters
just to sift through job applications. It acquired a company, on average, once every
other week. New employees were shown charts projecting a 30-percent annual increase
in the company’s stock price. This turned out to be conservative, as the stock
price doubled each year, on average, throughout the 1990s.
In the last weeks of 2000, things abruptly changed. Companies stopped buying
from Cisco, as they realized they had massively over built their computer networking
infrastructure. Revenue fell for the ﬁrst time in company history: by mid-2001 revenue
had fallen 33-percent from where it had been six months earlier. The company
had to engage in its ﬁrst-ever mass layoﬀ in 2001.
If Cisco Systems was to survive, a number of things had to be changed. During
the 1990s inﬂationary expansion, Cisco emphasized increased revenues. After the
bust hit, it had to demand proﬁts. During the expansion, Cisco had 22 groups, with
⁷ See Reisman (2007) for a detailed analysis, based on ATCT, of the housing crisis.
Simpson: Austrian Trade Cycle Theory and Rationality 119
more than 100 employees, creating customer-service policies. One group did nothing
but track the other 21. When the bust hit, company management acted to cut these
groups to one with fewer than 10 employees. During the expansion, Cisco raced to
devour start-ups and build niche products. When the bust hit, the company focused
on building fewer, more versatile products internally.⁸
While the story might be more dramatic for Cisco Systems than most companies,
the basic tale is the same: one of increased business due to a dramatic inﬂation of the
money supply and volume of spending. Once the inﬂation slows or stops, companies
hit the wall, as Cisco did in late 2000 after the slowing of the inﬂation by the Federal
Reserve starting in 1999. Revenues decline or fail to rise suﬃciently, workers must be
laid oﬀ, and investment plans that depended on the continuation of the inﬂation must
be scrapped if the company is to have a chance to survive. Fearing the harmful eﬀects
of possible deﬂation, the central bank begins to inﬂate again, using the recession or
credit crunch as an inﬂationary refueling period. This was exactly the situation faced
in the United States in early 2008. At that time the Federal Reserve used the housing
crisis as a rationalization to resume an “easy” monetary policy (as witnessed by its
targeting of a lower Federal Funds Rate).
3 Austrian Trade Cycle Theory and “Rational Expectations”
As I state, the above boom-bust cycle is created by the central bank’s manipulation
of the supply of money and credit, with the help of the banking system. If this is so,
why do businessmen and entrepreneurs repeatedly get fooled by the central bank’s
manipulation of money and credit? Why are they repeatedly duped into expanding,
only to have to eventually rid themselves of the investments they engaged in during
the expansion? Why don’t they learn from their past mistakes and prevent the central
bank from leading them into an artiﬁcial expansion? In fact, why aren’t they able to
proﬁt from the central bank’s repeated actions? This is the basic argument made
by rational expectations theorists against ATCT. In order to understand why ATCT
is consistent with rational expectations, one must ﬁrst understand what exactly is
meant by that term.
⁸ See Scott Thurm (2003).
120 New Perspectives on Political Economy
Rational expectations, as contemporary economists use the term, means that people’s
expectations of the future are not systematically wrong and that people use all
available information when forming their expectations. It says people can learn about
changes taking place in the economy and correct any mistakes they made in the past.
This is the view expressed in the famous article by John Muth that eventually led to
the development of the “rational expectations” approach in mainstream economics.
Muth states it most clearly when he says that the assumption of rationality is dropped
whenever systematic biases and incomplete or incorrect information are incorporated
into one’s analysis.⁹ Even though this does not provide a very good understanding of
what it means to form expectations rationally, ATCT does not imply that businessmen
and entrepreneurs make systematic errors or that they do not correct their mistakes.
Businessmen and entrepreneurs act fully within the limits of rational expectations,
as that term is used by contemporary economists.
The ﬁrst thing that can be said in defense of ATCT is that the same economists
who use rational expectations theory to argue against ATCT also typically recognize
that ATCT is not a very well known or widely accepted theory among economists.
If this is true, it is hard to believe that many businessmen and entrepreneurs, who
are taught trade cycle theory by economists, know about the theory. Therefore, how
could they use a theory they most likely have never even heard of to protect themselves
or proﬁt from the cycle?¹⁰ One cannot be said to be acting inconsistently with
rational expectations if one does not have the knowledge necessary to correct one’s
actions. In fact, to the extent that other theories of the trade cycle that do not accurately
explain the cycle are prevalent among economists, and thus among businessmen
and entrepreneurs, if businessmen and entrepreneurs act on these theories, this
would contribute to the errors they make in connection with the trade cycle.
Further, even if businessmen and entrepreneurs did have knowledge of ATCT, and
thus would be in a position to use it to their advantage, one must remember that being
rational does not imply being omniscient.¹¹ Businessmen and entrepreneurs do not
have a crystal ball they can use to predict the future. They cannot know every move
⁹ See John F. Muth (1961, pp. 330 and 333). For a similar view, see Thomas J. Sargent and Neil Wallace
(1975, pp. 246-7).
¹⁰ A similar point is made in Block, p. 65 and Garrison, p. 442.
¹¹ Also on this point, see Block, p. 67.
Simpson: Austrian Trade Cycle Theory and Rationality 121
that a central bank, private banks, or the demand for money will make. They cannot
predict the exact lag between a change in the money supply and a change in the
volume of spending, or in which parts of the economy the new money will be spent
ﬁrst. This is true even if the central bank follows a policy of “inﬂation targeting” and,
therefore, attempts to stabilize the general rate of price increases. First, one cannot
know when or if the central bank will change its “inﬂation target.” Second, even if the
general rate of change in prices is stabilized, changes in the prices of individual goods
could still ﬂuctuate dramatically, providing an incentive for industries with favorable
price changes to expand. Further, and more signiﬁcantly, one cannot predict exactly
when the prevailing economic data will change and cause the central bank to have
to shift its policy from accelerating to slowing the inﬂation of the money supply (or
vice versa) to maintain its target. In addition, even if the central bank is targeting
a particular rate of price increase, at times it will be following an “easy” monetary
policy to maintain its target. Even if businesses are aware of the policy of “inﬂation
targeting” the “easy” monetary policy will still provide businesses with an impetus to
expand. If businessmen and entrepreneurs are continuously faced with increases in
revenues and proﬁts, and interest rates that remain low relative to the rate of proﬁt
(regardless of what policy the central bank chooses to follow), sooner or later they
will expand their business activities. Further, the longer and more rapid the increase
in the money supply and spending, the more likely businesses will expand (and the
greater that expansion will be).
ATCT does not imply that businessmen and entrepreneurs make systematic errors
because the central bank does not manipulate the money supply to create a consistent
pattern of expansions and contractions. For instance, the central bank does not
create a contraction once every ﬁve years. If this were the case, businessmen and
entrepreneurs could exploit this pattern and incorporate it into their expectations.
Recessions do not occur at an unchanging frequency; however, they occur in an erratic
manner because of the erratic manner in which the central bank manipulates the
money supply. Therefore, no businessman or entrepreneur should be able to know
what the central bank is going to do to the money supply tomorrow, next week, next
year, or in the next decade. Uncertainty in both the duration and magnitude of the
changes in the supply of money and credit is what helps to generate the cycle (or
make a particular cycle more severe).
122 New Perspectives on Political Economy
The trade cycle, in a fundamental sense, does not stem from the errors of entrepreneurs
and businessmen; it stems from the nature of the monetary and banking
system we have today. It occurs due to the nature of ﬁat money and fractional reserve
banking.¹² Fiat money gives the central bank the ability to easily manipulate the
money supply (speciﬁcally, the amount of standard money or the monetary base).
It gives them the power to increase the money supply at a rapid rate, thus creating
an expansion, and then decrease it or slow its increase, thus creating a contraction.
Further, as stated earlier, the fractional reserve nature of the banking system creates
the eﬀects in the loan market which provide further incentives to businessmen and
entrepreneurs to expand or contract their activities. The fractional reserve nature
of the banking system also makes possible potentially large and rapid swings in the
money supply due to the creation and destruction of ﬁduciary media.
Under such a system, the actions of businessmen and entrepreneurs cannot be
expected not to create the trade cycle. This is the case because if the money supply is
being increased at a rapid rate, the incentives to expand are in place and it will only
be a matter of time before businesses begin to expand. They may not expand if the
increase in money and spending is short-lived or at a very low rate, but the longer
and more rapid the increase, the higher the proﬁts are that can be earned, the lower
interest rates will be relative to the rate of proﬁt, and thus the more likely it is that
businesses will expand their activities. In other words, the incentives to expand their
activities in response to rapid increases in the money supply exist whether businessmen
and entrepreneurs know about and believe in ATCT or not; whether they can use
the theory to their advantage or not; and whether they know how the money supply
is changing and aﬀecting the economy or not. Those incentives are in place due to
the nature of our ﬁat money monetary system and fractional reserve banking system.
If the increase in the money supply continues long enough, and at a rapid enough
rate, the movement in the rate of proﬁt and interest rates creates a strong incentive
to expand, and eventually, in order to attempt to proﬁt from the prevailing economic
data, businesses will expand.¹³
¹² One does not actually need both ﬁat money and fractional reserve banking at the same time to create
the trade cycle; both are suﬃcient by themselves to create the cycle. However, the two together have
the potential to create much wider swings in the cycle. Further, fractional reserve banking provides
a much stronger inﬂuence in creating the trade cycle than does ﬁat money.
¹³ See Block, p. 66 and Garrison, p. 446 on this point also.
Simpson: Austrian Trade Cycle Theory and Rationality 123
This brings me to the actual role of expectations in the trade cycle. As I have
said, businessmen and entrepreneurs are not omniscient, and it is diﬃcult for them
to know exactly how an increase in the money supply will aﬀect the demand for their
products from year-to-year. However, when the increase is fairly slow and constant,
businessmen and entrepreneurs can easily take it into account and it will not cause
them to expand. They will simply adjust their prices, borrowing, and spending accordingly.
Here, because the increase in money, spending, and credit is slow and
steady, businessmen’s expectations tend to accurately reﬂect the changes in these
parameters, and the actions they take based on these expectations tend to be in line
with what is actually occurring in the long run, so no cyclical expansion and contraction
take place.
It is only when the increase in demand for their products, due to an increase in the
money supply, is greater than expected, that the incentive to expand will be present.
It may be that businesses do not expand immediately when spending for their products
is greater than expected. They may adjust their prices initially to adapt to the
changing conditions. However, if spending for their products repeatedly outstrips
their expectations, and the rate of proﬁt continuously remains high relative to interest
rates, sooner or later businessmen and entrepreneurs will expand in response to
these incentives. In essence, when businessmen and entrepreneurs expect to be able
to proﬁt from the increase in money and spending, they will expand their activities.¹⁴
Hence, one can see that expectations (whether “rational” or “adaptive”) can easily be
incorporated into ATCT. However, such expectations will not prevent the trade cycle
from occurring.
Some businessmen and entrepreneurs may even realize that the expansion is only
temporary and that the relatively high proﬁts and low interest rates will come to an
end. However, this might not stop them from making investments based on the prevailing
distorted data. To the extent that they think they can divest at the right time
or that any losses they might incur due to the eventual contraction will be more than
oﬀset by the gains from the expansion, they will have a strong incentive to engage
in such investments. Businessmen and entrepreneurs cannot escape the prevailing
economic data. All they can attempt to do is proﬁt from it, and, again, the longer
¹⁴ For more on this, see Reisman (1996, pp. 588, 938-40, and passim).
124 New Perspectives on Political Economy
and more extreme the expansion, the greater the incentive for businessmen and entrepreneurs
to make such investments.
Businessmen and entrepreneurs may make errors during the trade cycle due to
uncertainties associated with the size and duration of the expansion, or due to the
readily available supply of money and credit during the expansion; however, these
errors are not systematic, and businessmen and entrepreneurs cannot, ultimately, be
blamed for such errors or for the existence of the trade cycle. Responsibility for the
trade cycle, and the errors businessmen and entrepreneurs make in connection with
it, must ultimately be placed where it properly belongs: on the institutions of ﬁat
money and fractional reserve banking, and the economists and government oﬃcials
who support such institutions. It is economists and government oﬃcials that have
created the system within which businessmen must act. Businessmen are merely
reacting to the incentives provided by a system that is fundamentally ﬂawed. It is
ﬂawed because it creates an environment where the trade cycle is inevitable.
If anyone is making systematic errors, it is the government oﬃcials and
economists who support the institutions of ﬁat money and fractional reserve banking.
They repeatedly commit the error of supporting a monetary and banking system
based on these institutions, despite the ﬂaws that are inherent in the system, and in
spite of the fact that these ﬂaws have been recognized by Austrian economists and
other economists for more than a century. If contemporary economists and politicians
acted in accordance with rational expectations, when faced with the repeated
episodes of boom and bust that such a system creates, they would learn from their
mistakes and correct their errors. That is, they would take the necessary actions to
abandon the current system and replace it with its opposite, the only system that renders
monetary induced trade cycles virtually impossible: a 100% reserve gold based
monetary and banking system.
I am not going to discuss the virtues of a 100% reserve gold based monetary and
banking system. That would fall outside the scope of this paper and would take at
least another paper to address. If one wants to read about the virtues of gold and
100% reserves, see the relevant readings in von Mises, Rothbard, or Reisman.¹⁵
¹⁵ These include Ludwig von Mises (1981, pp. 456-459, and 480), Rothbard in Leland B. Yeager (1962, pp.
94-136), and Reisman (1996, pp. 951-63).
Simpson: Austrian Trade Cycle Theory and Rationality 125
4 Austrian Trade Cycle Theory and a Better Understanding of Ratio-
nality
It is important, at this point, to discuss an alternative theory of rationality. Contemporary
economists’ concept of rationality is the source of much confusion in economics,
including the source of much of the confusion regarding the validity of ATCT.
The arguments I have made up until this point in defense of ATCT are based on the
deﬁnition of rational expectations as used by contemporary economists. However,
this deﬁnition is not a very good one because it does not get to the most important
characteristic of rationality. A good deﬁnition must be based on the most important,
or essential, characteristic(s) of a concept. Aristotle was the ﬁrst philosopher to recognize
the importance of deﬁning terms based on essential characteristics.¹⁶ With
respect to man, for instance, Aristotle identiﬁed man’s deﬁning characteristic as his
rational faculty. What Aristotle was referring to when he spoke of the rational faculty
was man’s reasoning mind.¹⁷ Reason is the tool that identiﬁes and integrates the material
provided by man’s senses.¹⁸ It allows him to think at the conceptual level (i.e.,
in terms of concepts, principles, and ideas). It is the faculty that separates man from
the lower animals.
Based on the nature of man’s rational faculty, to be rational means to use reason
or, equivalently, to base one’s thoughts and actions on the facts of reality and logical
analyses of those facts. Likewise, to act on emotions or on ideas not based on facts
and logic is to act contrary to reason and rationality. If one is rational one will not
make systematic errors, but not making systematic errors is just an eﬀect of acting
rationally; it is not rationality itself. Therefore, to deﬁne rationality based on the
absence of systematic error (which is what contemporary economists do) is to take
an eﬀect, or non-essential characteristic, of rationality and make that the essence of
rationality.
¹⁶ To see Aristotle’s statements regarding deﬁnitions, see Richard McKeon (1947, pp. 76-77).
¹⁷ On Aristotle’s deﬁnition of man, see W.D. Ross (1928, pp. 130, 980, 1095, and passim).
¹⁸ On this deﬁnition of reason, see Ayn Rand (1964, p. 22). For more on the Aristotelian method of
deﬁnition and this view of rationality, see Ayn Rand in Harry Binswanger (1986, pp. 117-21, 404-5, and
407-10) and the references provided there.
126 New Perspectives on Political Economy
As long as businessmen and entrepreneurs use reason or act based on facts and
logic, they are acting rationally. Further, as long as they form their expectations based
on reason, their expectations are rational. In many cases, it can be rational to base
one’s expectations on past experience alone (if that is the only information one has
available or is the only information that one believes to be relevant). Therefore, socalled
adaptive expectations can be rational. Further, a person can make mistakes
and still be rational. The focus of the concept rationality is on the process by which
one attempts to gain knowledge, not on the outcome of that process. Of course, if one
is rational, he will take the necessary steps to correct any mistakes he might make.
Some may think that diﬀerences between deﬁnitions are just semantic diﬀerences,
that deﬁnitions are essentially arbitrary statements of what a concept is, and that
diﬀerences in deﬁnitions do not play a very signiﬁcant role in intellectual life or in
economics. However, such a belief is grossly mistaken. Deﬁnitions are not arbitrary.
The deﬁnition of a concept helps to distinguish one concept from all other concepts,
and it determines what concretes in reality we identify with a particular concept. A
deﬁnition can help or hinder one’s conceptual understanding of what something is.
Good deﬁnitions help us achieve a clearer understanding of what something is. Poor
deﬁnitions lead to confusion and false conclusions.¹⁹
If deﬁnitions were truly arbitrary, one could literally deﬁne something to be anything
one wanted. For instance, a horse could be deﬁned as a doughnut shaped ﬂotation
device. If such a method of deﬁnition were taken seriously, it would lead to
confusion and false conclusions on a massive scale. Fortunately, those who claim
that deﬁnitions are arbitrary usually do not act consistently on that belief. However,
to be in a position where we must rely on the inconsistencies of people is, indeed, to
be in a very precarious position.
A proper understanding of rationality takes the focus away from whether or not
a person is making errors and places the focus on the process that one uses to attempt
to gain knowledge. To put the focus on the absence of error is to associate
¹⁹ The false conclusion that ATCT is not consistent with rational expectations is just one example of the
false conclusions to which bad deﬁnitions lead. For more on the cognitive function of deﬁnitions, see
Leonard Peikoﬀ (1991, pp. 96-105). Also, for another good economic example of the confusion and
false conclusions to which a bad deﬁnition leads, see Reisman (1996, pp. 920-2). There he shows the
misunderstandings created by contemporary economists’ deﬁnition of inﬂation as rising prices.
Simpson: Austrian Trade Cycle Theory and Rationality 127
omniscience with rationality. It is this confusion that leads some economists to say
that ATCT does not incorporate “rational expectations.” By putting the focus on the
process of using reason, or acting based on facts and logic, one can eliminate this
confusion and the inappropriate distinction between various types of expectations
(such as adaptive expectations and rational expectations). One can also understand
that being rational does not guarantee that one will not make errors. Finally, one
can say that in the context of a ﬁat money, fractional reserve monetary and banking
system, businessmen and entrepreneurs are acting as rationally as possible given the
fundamentally ﬂawed nature of the system within which they must act.
5 Conclusion
As one can see, ATCT is perfectly consistent with rational expectations, as contemporary
economists use that term, and it is also consistent with a better understanding of
rationality. Businessmen and entrepreneurs do not need to make systematic errors
in order for ATCT to be able to explain the trade cycle. However, one must always
keep in mind that being rational does not imply omniscience. Businessmen and entrepreneurs
cannot see the future and know exactly how long an expansion will last.
As long as businessmen and entrepreneurs are acting based on facts and logic, they
are acting rationally, even when they do make errors. Furthermore, businessmen do
not create the economic system within which they act and, therefore, cannot escape
the incentives that such a system creates. Namely, they cannot escape the incentives
created by a ﬁat money, fractional reserve monetary and banking system. Such a system
is a breeding ground for periodic economic disasters. The rational thing to do is
to get rid of this system and replace it with a stable system – a 100% reserve gold based
monetary system – within which more rapid rates of economic progress can occur.
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[1] Binswanger, Harry ed. 1986. The Ayn Rand Lexicon: Objectivism From A to Z
(New York: Penguin Books)
128 New Perspectives on Political Economy
[2] Block, Walter. 2001. “Yes, We Have No Chaﬀ: A Reply to Wagner’s ‘Austrian Cycle
Theory: Saving the Wheat While Discarding the Chaﬀ,’” The Quarterly Journal
of Austrian Economics, vol. 4, no. 1: 63-73
[3] Cowen, Tyler. 1997. Risk and Business Cycles: New and Old Austrian Perspectives
(New York: Routledge)
[4] Garrison, Roger W. 1986. “Hayekian Trade Cycle Theory: A Reappraisal,” Cato
Journal, vol. 6, no. 2: 437-453
[5] Gordon, Robert A. 1961. Business Fluctuations, 2nd ed. (New York: Harper and
Row)
[6] Hayek, F.A. 1967. Prices and Production, 2nd edition (New York: Augustus M.
Kelley)
[7] McKeon, Richard, ed. 1947. Introduction to Aristotle (New York: Random House)
[8] Mises, Ludwig von. 1981. The Theory of Money and Credit (Indianapolis, IN: Liberty
Fund)
[9] Mises, Ludwig von. 1966. Human Action, 3rd ed. (Chicago: Contemporary Books,
Inc.)
[10] Mises, Ludwig von. 1943. “‘Elastic Expectations’ and the Austrian Theory of the
Trade Cycle,” Economica, vol. 10: 251-252
[11] Muth, John F. 1961. “Rational Expectations and the Theory of Price Movements,”
Econometrica, vol. 29, no. 3: 315-335
[12] O’Driscoll, Gerald P., Jr. 1977. Economics as a Coordination Problem: The Contributions
of Friedrich A. Hayek (Kansas City, MO: Sheed, Andrews, and McMeel,
Inc.)
[13] Peikoﬀ, Leonard. 1991. Objectivism: The Philosophy of Ayn Rand (New York:
Meridian)
[14] Rand, Ayn. 1964. The Virtue of Selﬁshness (New York: Signet)
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[15] Reisman, George. 2007. “The Housing Bubble and the Credit Crunch,”
http://georgereisman.com/blog/2007/08/housing-bubble-and-credit-
crunch.html
[16] Reisman, George. 2002. “The Stock Market, Proﬁts, and Credit Expansion,”
http://www.capitalism.net/articles/Stock%20Market,%20Profits,%20Credit%
20Expansion.htm
[17] Reisman, George. 1999. “When Will the Bubble Burst?”
http://www.capitalism.net/articles/stockmkt.htm
[18] Reisman, George. 1996. Capitalism (Ottawa, IL: Jameson Books)
[19] Ross, W.D., ed. 1928. The Works of Aristotle Translated into English (London:
Oxford University Press)
[20] Rothbard, Murray. 1962. Man, Economy, and State, 2 vols. (Los Angeles: Nash
Publishing)
[21] Sargent, Thomas J. and Neil Wallace. 1975. “‘Rational’ Expectations, the Optimal
Monetary Instrument, and the Optimal Money Supply Rule,” Journal of Political
Economy, vol. 83, no. 21: 241-254
[22] Simpson, Brian. 2000. Trade Cycle Theory: A Market Process Perspective, Ph.D.
Dissertation (Fairfax, VA: George Mason University)
[23] Thurm, Scott. 2003. “After the Boom: A Go-Go Giant of Internet Age, Cisco is
Learning to Go Slow,” The Wall Street Journal, May 7th: A1
[24] Wagner, Richard E. 1999. “Austrian Cycle Theory: Saving the Wheat while Discarding
the Chaﬀ,” Review of Austrian Economics, vol. 12: 65-80
[25] Yeager, Leland B. 1986. “The Signiﬁcance of Monetary Disequilibrium,” Cato
Journal, vol. 6: 369-399
[26] Yeager, Leland B., ed. 1962. In Search of a Monetary Constitution (Cambridge,
MA: Harvard University Press)
ISSN 1801-0938
New Perspectives on Political Economy
Volume 4, Number 2, 2008, pp. 131 – 157
Monetary Reform and Deﬂation – A Critique of Mises,
Rothbard, Huerta de Soto and Sennholz
Philipp Bagus
JEL Classiﬁcation: E50, P11, P21, P31
Abstract: In this paper I will analyze the reform plans proposed by Ludwig von Mises,
Murray N. Rothbard, Jesús Huerta de Soto, and Hans Sennholz. Though their contributions
to monetary reform are signiﬁcant, their fear of deﬂation leads them to
consider monetary reforms that are theoretically inconsistent and ethically problem-
atic.
I would like to thank Walter Block, William Barnett II, Guido Hülsmann, Mateusz Machaj, Mark
Thornton and two anonymous referees for their helpful comments and the Ludwig von Mises Institute
for ﬁnancial help.
Associate Professor of Economics at the University Rey Juan Carlos in Madrid and Visiting Scholar at
the University of Economics, Prague, philipp.bagus@urjc.es.
132 New Perspectives on Political Economy
1 Introduction
Austrian economists generally agree that the actual monetary system is, to say the
least, imperfect, leading to redistributive inﬂation and business cycles. Therefore,
many Austrian economists, as does Huerta de Soto in his recent treatise Money, Bank
Credit, and Economic Cycles, propose monetary reform plans to eliminate those characteristics
of the monetary system. Many of them agree that the desirable aim of a
monetary reform is a 100% gold standard, i.e., a system where all bank notes and demand
deposits are completely covered by gold. Even though there are disagreements
about how this reform should be reached, these proposals have one characteristic in
common: an attempt to avoid deﬂation.¹,² In this paper I will analyze the reform
plans proposed by Ludwig von Mises, Murray N. Rothbard, Jesús Huerta de Soto, and
Hans Sennholz. Though their contributions to monetary reform are signiﬁcant, their
fear of deﬂation leads them to consider monetary reforms that are theoretically inconsistent
and ethically problematic.
2 Ludwig von Mises
Mises’ plan for monetary reform can be found in “Monetary Reconstruction” in the
1953 English edition of his theoretical monetary treatise The Theory of Money and
Credit.³ Here Mises proposes the reestablishing of the classical gold standard, which
he praises throughout his writings (Mises 1998, 468-473 or Mises 1980, 480-481). Notably,
Mises advocates a return to the gold standard in which gold is actually used
as money. Mises’ primary reason for advocating the return to the classical gold stan¹
In this essay, deﬂation always means monetary deﬂation.
² Barnett and Block (2004) maintain that Mises and Rothbard opposed any change in the extant stock of
money (inﬂation and deﬂation), apparently whether it is commodity money or not. Hence, Barnett’s
and Block’s view supports the point made here.
³ Earlier versions and variations of his proposal are his 1919 essay “Der Wiedereintritt DeutschÖsterreichs
in das Deutsche Reich und die Währungsfrage” in Schriften des Vereins für Sozialpolitik
158. Leipzig: Duncker & Humblot and his 1923 essay “Die geldtheoretische Seite des Stabilisierungsproblems”
in Schriften des Vereins für Sozialpolitik. 164: 2. Munich & Leipzig: Duncker
& Humblot and his essay “Noninﬂationary Proposal for Postwar Monetary Reconstruction” written
in 1944 and published in Ebeling (2000) (ed.) Selected Writings of Ludwig von Mises: The Political
Economy of International Reform and Reconstruction, Vol. 3. Indianapolis: Liberty Fund. Pp. 71-118.
Bagus: Monetary Reform and Deﬂation – A Critique of … 133
dard is that “it makes the determination of the monetary unit’s purchasing power
independent of the measures of governments” (Mises 1980, 480).
But how should this return to the classical gold standard be accomplished? Mises
proposes a three-step reform for the U.S.⁴ First, the issuing of any further ﬁduciary
media, i.e., bank notes or bank deposits not backed completely by gold, will be forbidden.
This implies a rigid 100 percent reserve for all future bank notes and deposits.
Second, and at the same time, a free market for gold is to be established. People are
free to buy, sell, hold, import, export, lend, or borrow gold, while the government
must restrict itself from intervening in the gold market. Third, once the market has
established a somewhat stable price for gold, this market rate will be declared the
new legal parity. The unconditional convertibility of dollars into gold and vice versa
will be secured by a state-run “Conversion Agency.”
Two main critiques against Mises’ proposal should be made here. First, even
though Mises’ proposal implies the cancelation of interventions into the monetary
realm, it involves other interventions and is centrally planned. Second, his plan tries
to avoid deﬂation without any theoretically consistent justiﬁcation. First, let us consider
the critique that his reform is a managed reform, containing several interventions.
In fact, Mises’ proposal contains new interventions besides the abolition of
already existent interventions. Mises assumes without any demonstration that additional
interventions would be necessary for the sake of liberalization. In fact, Mises’
centrally planned monetary reform seems to be in contradiction to his other writings
where he points out the deﬁciencies of central planning.⁵ Even more surprising
is that in The Theory of Money and Credit, only a few pages before he presents his
reform plan, Mises criticizes central planning in regard to money:
Money is the commonly used medium of exchange. It is a market phenomenon.
Its sphere is that of business transacted by individuals or groups of
individuals within a society based on private property ownership of the means
of production and the division of labor… The goal of their [governments and po⁴
See Mises (1980, 490-495). In his 1944 article Mises (2000, 104-106) has four steps. The additional
step in this earlier plan, which preceeds the three discussed here, consists in balancing the national
budget without engaging in further inﬂation.
⁵ See for instance, Mises (1962) for his endorsement of classical liberalism and Mises (1996) for his
critique of interventionism.
134 New Perspectives on Political Economy
litical parties] policies is to substitute “planning” for the alleged planlessness of
the market economy. The term planning as they use it means, of course, central
planning by authorities, enforced by police power. It implies the nulliﬁcation of
each citizen’s right to plan his own life. (1980, 478)
After his criticism of economic central planning, is it not a contradiction on his part
to propose a centrally planned and conducted reform? Can an economist propose the
correct government interventions to achieve the ideal economic system? Considering
his opposition to government intervention in the market, why does he not call for a
simple but immediate retreat of the state from the monetary sphere?⁶ Did he think
that this would result in chaos, even though he did not think the abolition of other
government interventions would lead to chaos? Or did the usually uncompromising
Mises just want to make his proposal more appealing? In light of these questions his
monetary proposal is puzzling to those who are familiar with his work. There is a
likely explanation for this inconsistency; however, for the moment, let us turn to the
details of his plan.
Mises’ plan explains how the government should install a gold standard. Ironically,
we ﬁnd these details only a few pages following his critique of central planning.
Here, Mises fails to see that even with the advice of such a brilliant economist of his
own caliber, a central agency, while it can trigger a reform,⁷ lacks the information
required to manage an unambiguous and perfectly orchestrated reform. More precisely,
the central agency lacks the information that the individuals have about their
speciﬁc circumstances and their valuations. This information would be necessary to
ﬁnd a monetary unit or a new parity consistent with valuations of market participants
and, thus, to coordinate the transition toward the new monetary system.
Not surprisingly, Mises oﬀers some rather arbitrary features and peculiar details
in his plan. The ﬁrst ambiguity of his plan consists in the time frame that runs from
the installment of gold in a free market to the announcement of the new legal parity.
⁶ A note on semantics: I do not understand the abolition of interventions as an intervention, as one
might suggest. This procedure is not another intervention but rather a cessation of further interven-
tion.
⁷ For instance, Dulbecco and Renard (2003) show that by decentralization the Chinese government
triggered the economic reforms of China. I would like to thank an anonymous referee to bring this
paper to my attention.
Bagus: Monetary Reform and Deﬂation – A Critique of … 135
As Mises states:
Once the market price has attained some stability, the time will have come
to decree this market rate as the new legal parity of the dollar and to secure its
unconditional convertibility at this parity. (1980, 492)
But what does “some stability” mean? This “stability” is of course arbitrary and not
operational. Markets are never in equilibrium, if that is what Mises meant by “stability.”
Moreover, it leaves room for discretionary decisions of the central agency, namely
deciding when “some stability” is reached. In public choice terms we might expect
decision makers to be biased in a certain direction. Therefore, it does not even seem
to be correct to speak of a market price of gold. The material value of a paper dollar in
terms of an ounce of gold is close to zero. The paper dollar only gains value because
people are expecting a new legal parity that eﬀectively converts the dollar in a gold
substitute. This promulgation of the new legal parity is an intervention, and as such,
it is vulnerable to the whims of the central agency. Market participants will try to
anticipate this intervention, guessing what the new parity will be.⁸ As a result, a free
market price of gold is simply not possible in Mises’ proposal.⁹
There are other ambiguities in Mises’ plan. For instance, in his earlier 1944 plan
Mises states that,
[f]or the interval preceding the promulgation of the dollar’s new gold parity,
the heights of the ad hoc gold deposit required for every additional dollar should
be ﬁxed in accordance with the market price (in terms of dollar’s) plus a margin
of ten percent. (2000, 106)
Why should it be ten percent and not nine or eleven? Herein lies the problem. In
planning an intervention thoroughly, one needs to plan the details.¹⁰ And in planning
⁸ Another problem is the stabilization of the exchange rate of gold and the US dollar that is implied in
setting a new legal parity not backed by 100% reserves. Stabilization or ﬁxation of exchange rates can
incite speculative attacks. In an attack, in the worst case a speculator does not lose, but can win when
the exchange rate depreciates. See on this Yeager (1976, 248-49 ). A spectacular example of such an
attack was the 1992 attack of George Soros on the ﬁxed exchange rate of the British pound.
⁹ In the ﬁnal phase of Mises’ reform, of course, gold has become money and there are many free market
prices of goods and services in terms of gold.
¹⁰ An exception might be interventions leading to a transition. For instance, the decentralization in the
Chinese economic reform triggered a transition process. See Dulbecco and Renard (2003).
136 New Perspectives on Political Economy
the details of interventions one is in ambiguous territory. This planning of details
occurs again, when Mises goes on to advise the regulation of “the issue of additional
fractional coins by the government” (Mises 2000, 106). There he claims it unnecessary
to have those coins covered 100 percent by gold, thereby, allowing for a small inﬂation
and a seignorage for the government.
Interestingly Mises calls for another intervention within one year after the gold
standard is installed:
Moreover, the Treasury is bound to withdraw from circulation, against the
new gold coins, and to destroy, within a period of one year after the promulgation
of the new legal gold parity of the dollar, all notes of ﬁve, ten, and perhaps also
twenty dollars. (1980, 494)
Of course, the one year period and the “perhaps” is arbitrary. However, the intention
that Mises pursues with this intervention is farsighted and in the long tradition in the
U.S. of opposing the banks’ issuing of small-denominated notes.¹¹ Mises intends this
intervention to encourage the circulation of gold coins, thereby, making it more diﬃcult
for the government to nationalize gold and introduce ﬁat paper money. However,
the use of government intervention to circulate gold coins seems counterproductive
to the larger goal of installing a monetary system resistant to government intervention.
This is so because what is essential with respect to a lasting and sound monetary
system is that the public no longer believes that government intervention into monetary
aﬀairs is necessary. By using government force to install a gold standard, the
illusion that the government needs to plan, possesses the capacity to plan, and has
the right to impose this plan in order to improve monetary aﬀairs is reinforced.
Moreover, as Herbener points out, the conversion agency that Mises proposes to
unconditionally convert gold into dollars and vice versa is a government agency and
thereby, provides a governmental foothold into the monetary system. The Federal
Reserve System (Fed), which Mises leaves in its place, could also function as such a
foothold to expand government power into the monetary system especially in times
¹¹ See, for instance, Rothbard on the Jacksonians being anxious to eliminate small-denominated notes
(2002, 105).
Bagus: Monetary Reform and Deﬂation – A Critique of … 137
of “crisis” (Herbener 2002a, 14).¹² The continuing existence of government intervention
into the monetary system in the form of the banking regulations of the Federal
Reserve System or the business of the Conversion Agency must also be problematic
from Mises own point of view, as he claims that government interventions are not
stable. They lead to consequences that the interventionists do not want. Therefore,
interventionists are faced with two options: either abolish the intervention or intervene
further in order to combat the unintended consequences.¹³
Mises likely regarded it as necessary to deviate from the path of straight liberalization
to overcome resistance and opposition against a monetary reform. Therefore,
he argues for a rather long-term transition process involving the government and a
newly created Conversion Agency. However, he fails to answer the important question
that economists dealing with transition can seek an answer for: “If the reform
agents deviate from a clear-cut reform path in the short-run, what are the mechanisms
that can keep them committed to the reform process in the long-term?”¹⁴
Now let us turn to the second main critique of Mises’ proposal and the question
why Mises does not immediately call for monetary freedom but for a state managed
reform. Jeﬀrey Herbener oﬀers an answer, suggesting that Mises wants to avoid a
deﬂation (2002b, 90 and 2002a, 14). Indeed, Mises is rather deﬂation phobic.¹⁵ Not
only does he wish to avoid monetary deﬂation, but price deﬂation in certain cases as
well, as inferred by a statement he makes while discussing the proposal of introducing
an international paper money:
If all nations were to agree upon an international currency consisting of international
paper money issued by a world bank or of national paper money
unconditionally redeemable in deposits with a world bank, it would be necessary
to provide for future increases in the amount of this international paper money or
of these deposits. If such an expansion of the quantity of the circulating medium
were to be prevented for all time, the increasing demand for money, arising from
economic progress and the intensiﬁcation of trade and commerce, would result
¹² See also Salerno (1982) who criticizes monetary reform plans which leave space for governmental
institutions therefore serving as a foothold for the government in the monetary system.
¹³ See Mises (1996, 8-9).
¹⁴ I owe this point to a comment by an anonymous referee.
¹⁵ For a critique of Mises general view on deﬂation, see Bagus (2003, 24-26).
138 New Perspectives on Political Economy
in a permanent tendency towards falling prices. The system would have a deﬂationary
eﬀect. (2000, 83, italics added)
Mises does criticize proposals for an international paper money because of the difﬁculty
of distributing the “necessary … future increases” of this money. His reasoning,
however, does suggest that these increases are necessary to prevent prices from
falling. His monetary reform plan also prevents prices from falling by freezing the
amount of ﬁduciary media. This might be perceived as a strategy of reform sequencing.
In the environment of price controls (minimum wage), resulting price deﬂation
may result in unemployment etc. That may be then deliberately misinterpreted as a
result of the “monetary freedom.” This in turn could damage any (if only marginal)
gains of “monetary freedom.”
It is possible that similar considerations inﬂuenced Mises’ argumentation. However,
the problem with Mises’ approach is that he does not explain that his plan is
conditioned by strategic considerations. By not clarifying this, he gives the impression
that falling prices are a danger for the economy. Yet, falling prices per se are
not an economic problem for the economy as a whole.¹⁶ Entrepreneurs can make
proﬁts even when prices fall. What is important is not the general movement of the
price level but the price diﬀerential between buying and selling prices. When selling
prices fall and buying prices fall even faster, the price diﬀerential increases, allowing
entrepreneurs to make even higher monetary proﬁts. Of course, there might be
entrepreneurs that commit errors and do not bid prices down suﬃciently, buying
at prices at which they run into losses. However, why would this kind of error (of
bidding too much for factors of production) necessarily be higher in times of falling
prices than in times of rising prices or in times of generally stable prices? In times of
inﬂation, buying prices might actually rise faster than selling prices.
Moreover, the ineﬃcient entrepreneur who continuously buys at prices that are
too high will eventually be driven out of the market. His assets then would be taken
over by entrepreneurs who abstained from buying, waiting for this opportunity to
come. This procedure, of course, is the normal market process, independent of the
question whether there exists a general tendency towards rising or falling prices.
¹⁶ On this point for instance, see Hülsmann (2003, 51-52 ) and Salerno (2003, 83-85).
Bagus: Monetary Reform and Deﬂation – A Critique of … 139
In Human Action, Mises gives us another indication why he does not allow for deﬂation
in his monetary reform stating that “[d]eﬂation and credit contraction no less
than inﬂation and credit expansion are elements disarranging the smooth course of
economic activities, and sources of disturbance” (1998, 564). However, Mises fails to
see that with his freezing of existing ﬁduciary media, he might also actually trigger a
recession “disarranging the smooth course of economic activities.” This is so because
there might be a credit driven boom underway when Mises’ reform is introduced. In
a credit expansion there is a relative reduction of the interest rate that is not caused
by an increase in real savings.¹⁷ The reduction of the interest rate boosts the value
of capital goods, making projects, particularly in the higher, more interest dependent
stages of production, look more proﬁtable than they would have been otherwise.
When owners of the factors of production do not increase their savings suﬃciently,
but spend their income on consumption goods, this makes consumer goods prices
rise relative to capital goods. It becomes obvious that the investments in the higher
stages of production must be abandoned. Factors of production will be shifted back
to the lower stages of production. However, the boom can go on if further credit
is extended to entrepreneurs in the higher stages of production, who keep buying
factors of production at rising prices. Thereby, the relative increase in prices of consumer
goods is delayed. With Mises’ reform, credit expansion is suddenly stopped.
There are no further injections of credit. Hence, consumer goods prices will increase
relative to prices in higher stages of production. This implies a relative increase of accounting
proﬁts in stages of production close to consumption and a relative increase
in the interest rate, ﬁnally leading to accounting losses in companies relatively more
distant from consumption.¹⁸ Thus, with Mises’ reform, existing malinvestments will
be purged. Yet, this will not happen as quickly as it would with a credit contraction.
Later on in his essay on monetary reconstruction, it becomes even clearer why
Mises wants to prevent deﬂation. He points out that “the eﬀects of a deﬂation …
would not heal the wounds inﬂicted by the inﬂation of the two last decades. They
would merely open new sources” (1980, 498). He is right that the individuals who
¹⁷ This is not necessarily so, since entrepreneurs might have anticipated the eﬀects of the credit expansion
and bid them into the interest rate, as Hülsmann (1998) has pointed out.
¹⁸ For the microeconomic details of the boom and bust in the Austrian Business Cycle Theory, see Huerta
de Soto (2006, 347-384).
140 New Perspectives on Political Economy
lost in terms of relative wealth during the inﬂation are not necessarily the ones who
would proﬁt from a deﬂation. He is also correct that there will be a redistribution
of wealth by the deﬂation. However, he fails to prove his point that this redistribution
opens new wounds, or that this particular result of redistribution would be bad.
Every liberalization from government intervention into the economy brings about a
redistribution from those who are currently proﬁting from the intervention to those
who are suﬀering from it. Of course, the liberalization of the monetary system also
leads to a redistribution and restructuring of the production (possibly even a massive
one). But it is hard to see that this redistribution and restructuring of the production
according to free market choices of consumers would be something inherently bad
that must be avoided. It is possible that Mises wanted to prevent the restructuring
of the production according to choices of consumers, because he wanted to make his
reform plan more appealing.
The passages Mises writes following the discussion of his reform plan indicate
that his deﬂation phobia is not based on a priori reasoning but rather on his historical
understanding of past deﬂations. He critiques the deﬂationary path the United
Kingdom chose after the Napoleonic wars claiming that the British “stirred social unrest”
(1980, 498). He is, of course, right. If a massive intervention into the market
economy were to be eliminated, social uproar on the part of those who proﬁted from
the prior intervention would occur. For example, the abolition of slavery in an economy
whose social and productive structures rest on the institution of slavery might
lead to “social unrest” by slave owners. There might also be an outcry on the part of
those who were suppressed by the intervention if they do not get any compensation.
Mises provides another historical example that explains his animosity toward deﬂation.
He claims that the United Kingdom repeated the “error” of a deliberate deﬂation
after World War I: “As the labor unions would not tolerate an adjustment of
wage rates to the increased gold value and purchasing power of the pound, a crisis of
British foreign trade resulted” (1980, 498). It is true that unions can settle for wage
rates higher than the market rate if they are given the legal privilege to do that. However,
when the unions have the power to lift wages over market clearing rates, they
can do that irrespective of what the general tendency of prices is. They can do that
when prices are generally stable, falling, or rising. They can do that when prices are
Bagus: Monetary Reform and Deﬂation – A Critique of … 141
continuously falling at a slow rate or when there is just one big price drop. This is
why the “stubborn” union argument against deﬂation fails. Mises goes on with his
historical interpretation, stating that “[…] in the opinion of the masses, conditions
gave an apparent justiﬁcation to the Keynesian fallacies” (1980, 499). His interpretation
might be true and explains his aversion to deﬂation. However, here Mises speaks
as an economic historian about a unique historical case and not as an theoretical economist.
He, thus, does not oﬀer theoretical reasons why deﬂation would be harmful,
but rather argues that in this speciﬁc historical case aided by the prevailing public
opinion, deﬂation gave rise to a justiﬁcation of Keynesian fallacies. Yet, he cannot
and does not prove that deﬂation necessarily leads to the implementation of Keynesian
fallacies. He fails, therefore, to make a case against deﬂation based on economic
theory.
In summary, Mises develops an interventionist plan for monetary reform. While
he favors the cancellation of some interventions, he supports the introduction of others.
It seems that he resorts to the state to manage a monetary reform because he fears
the opposition to straight liberalization and the eﬀects of the deﬂation that can occur
when the monetary sphere is completely liberalized.
3 Murray N. Rothbard
The role of deﬂation in Rothbard’s plans for monetary reform towards a 100 percent
gold standard changes over the years. In 1962, he speaks of two possible ways to
establish a 100 percent gold standard, one involving deﬂation:
[W]e have essentially two alternatives, polar routes toward 100 percent gold:
either to force a deﬂation of the supply of dollars down to the currently valued
gold stock, or to “raise the price of gold” (to lower the deﬁnition of the dollar’s
weight) to make the total stock of gold dollars 100 percent equal to the total
supply of dollars in the society. Or we can choose some combination of the two
routes. (1991, 66)
Here Rothbard unnecessarily restricts the options that can lead to a 100 percent gold
standard. For example, the government could force the supply of dollars down to a
142 New Perspectives on Political Economy
level even lower than $35 per ounce, for example to $20 per ounce which was the earlier
deﬁnition of the dollar in the U.S. Rothbard oﬀers no particular reason that would
speak against such a measure.¹⁹ Moreover, a reform involving a complete and immediate
privatization of monetary aﬀairs, i.e., the abstention of further intervention into
the monetary system, might also evolve into a 100 percent gold standard.
Continuing on, Rothbard states that,
… we have built deﬂation into an absurd ogre, and have overlooked the
healthy consequences of a deﬂationary purgation of the malinvestments of the
boom, as well as the overdue aid that ﬁxed income groups, hit by decades of inﬂationary
erosion, would at last obtain from a considerable fall in prices. A sharp
deﬂation would also help to break up the powerful aggregations of monopoly
unionism, which are potentially so destructive of the market economy. At any
rate, while the deﬂation would be nominally sharp, to the extent that people
would wish to save much of their present cash holdings, they would increase voluntary
savings by purchasing bank debentures in lieu of their deposits, thereby
fostering “economic growth” and mitigating the rigors of the deﬂation. (1991, 67)
Rothbard makes four arguments in favor of deﬂation as a means of returning to a
stable monetary standard: 1) purgation of malinvestments, 2) redistribution in favor
of ﬁxed income groups, 3) a possible break of union power, and 4) an increase in voluntary
savings. Surprisingly, in spite of these arguments Rothbard does not commit
himself to the deﬂationary course back to the legal parity of dollar with 1/35 ounce of
gold. His reason is simply because there is “no particular reason to be devoted to the
$35 ﬁgure at present time” (Rothbard 1991, 67).
In 1983, in The Mystery of Banking, Rothbard dismisses the ﬁrst way to establish
a 100 percent gold standard involving deﬂation stating that “[t]he old deﬁnition of
the dollar as 1/35 gold ounce is outdated and irrelevant to the current world” (1983,
263).²⁰ Now he endorses the second way and proposes the following plan: “In short,
¹⁹ One might argue that Rothbard thought deﬂation of a certain amount would become too disruptive.
However, in this article he does not make that argument explicitly, but on the contrary names
arguments in favor of price deﬂation without elaborating on the “rigors” of price deﬂation.
²⁰ Another place where his proposal to redeﬁne the dollar to back all notes and deposits by gold can be
found in “Aurophobia: or, Free Banking on What Standard?” in The Review of Austrian Economics,
Vol. 6, No. 1 (1992), pp. 97-106. In The Case Against the Fed (1994), Rothbard basically upholds his
Bagus: Monetary Reform and Deﬂation – A Critique of … 143
the new dollar price of gold (or the weight of the dollar), is to be deﬁned so that
there will be enough gold dollars to redeem every Federal Reserve note and demand
deposit, one for one” (Rothbard 1983, 264). His plan is to hand over the gold that
was nationalized in 1933 from the Fed to holders of Federal Reserve Notes and to
the banks. With the new deﬁnition of the dollar all existing banks would have 100
percent gold reserves for the deposits. He seems to consider it as an advantage of
his reform plan that “each bank will have 100 percent reserve of gold, so that a law
holding fractional reserve banking as fraud and enforcing 100 percent reserves would
not entail any deﬂation or contraction of the money supply”(Rothbard 1983, 265). He
acknowledges the argument that banks receive part of the nationalized hoard as an
undeserved gift, allowing them to back demand deposits. Furthermore, he agrees
that banks should be held responsible for fraud, but only after the reform has taken
place. He justiﬁes this view by pointing out that with his plan “we have the advantage
of starting from Point Zero, of letting bygones be bygones, and of insuring against a
wracking deﬂation that would lead to a severe recession and numerous bankruptcies…
[O]ne wonders whether a policy equally sound and free market oriented, which can
avoid such a virtual if short-lived economic holocaust might not be a more sensible
solution” (Rothbard 1983, 268).
Rothbard’s plan is surprising in the sense that it contradicts or omits the economic
and ethical theories and insights which he himself developed. Let us ﬁrst turn to
the economic insights he neglects. As mentioned earlier, in 1962 Rothbard names
four advantages of deﬂation. Moreover, in his 1963 America’s Great Depression, he
clariﬁes in detail the advantages of deﬂation in the form of a bank credit contraction
1983 plan with the only diﬀerence being not to outlaw fractional reserve banking, calling it a “second
best” solution. It should be noted that he would only support fractional reserve banking if the
FED were outlawed, as well as governmental deposit insurance and lender-of-last-resort function and
governmental bailouts. And then only because he judges that “any problem of inﬂationary credit or
counterfeiting would be minimal … it would suﬃce as an excellent solution for the time being, that is,
until people are ready to press on to full 100 percent banking.” (1994, 150-151) In his 1995 Take Money
Back (http://www.mises.org/rothbard/moneyback.asp) (parts of which were published in September
and October 1995 issues of the Freeman), Rothbard, again, calls for redeﬁning the dollar, but he acknowledges
that his reform entails an “undeserved” gift for banks. Interestingly, he mentions the
possibility of letting the banks collapse without explicitly endorsing this possibility. The question
remains why Rothbard, throughout his lifetime, remained vague and indecisive in his plans for monetary
reform although he held clear-cut positions on nearly every other issue.
144 New Perspectives on Political Economy
in a recession.²¹ He gives several reasons why the bank credit contraction speeds up
the readjustment and recovery in a recession. First, falling prices tend historically to
encourage greater savings and
the accounting illusion of the boom is reversed: what seems like losses and
capital consumption may actually mean proﬁts for the ﬁrm, since assets now
cost much less to be replaced. This overstatement of losses, however, restricts
consumption and encourages saving; a man may merely think he is replacing
capital, when he is actually making an added investment in the business. (Rothbard
2000, 17-18)
Since it is a lack of savings in relation to consumption that has led to the recession,
the recovery is quickened. Continuing on, Rothbard names another beneﬁcial eﬀect
of the credit contraction.²² The credit contraction leads to less money in the hands
of entrepreneurs, mainly those who are located in the higher stages of production expanded
during the artiﬁcial boom. Accordingly, the demand for factors of production
falls, lowering the factor prices and income. Hence, the price diﬀerentials between
buying and selling prices increase.
Also, it is hard to understand why Rothbard considers the likelihood of recession
and “numerous bankruptcies” as a reason to avoid a reform plan that involves deﬂation.
He himself makes it clear that if a company is forced into bankruptcy because
there is a falling price level and its debt burden becomes too heavy, the bankruptcy
only involves transfers of ownership between the legal claimants of companies. This
is so because in case of bankruptcy there is a redistribution from equity holders to
creditors.²³ Production must not necessarily be disturbed by this redistribution.
In addition to Rothbard’s own argument, it must be added that there are not necessarily
more bankruptcies in times of a falling price level as compared to times of
rising prices. Only entrepreneurs who do not anticipate the falling prices and buy
at prices that are too high will incur losses.²⁴ When, in addition to this, they are
²¹ See Rothbard (2000, 14-19).
²² See Rothbard (2000, 18).
²³ See Rothbard (2000, 51).
²⁴ It should be noted that the underlying monetary policy and its eﬀects on the credit markets make
the anticipation of price movements more diﬃcult. Entrepreneurs cannot only suﬀer losses because
they do not anticipate a price deﬂation but also if they retreat from an overheated market too early.
Bagus: Monetary Reform and Deﬂation – A Critique of … 145
in debt, their real debt increases and they face the risk of bankruptcy. These entrepreneurs
commit errors in their anticipation of the future state of the market or
rely on government intervention to bail them out (for example on the continuation of
government interventions into the monetary system or, more speciﬁcally, on further
credit expansion). Bankruptcies are normal for a market economy. And what does
“numerous bankruptcies” mean? Would a certain number or percentage of bankruptcies
be unacceptable, requiring the help of the government? Again, a high number
of bankruptcies does not mean that production is necessarily hampered. Assets are
taken over by the new owners, for example the creditors, who have an interest that
production continues and is immediately adjusted towards consumer wants.
Let us now have a look at Rothbard’s ethical theory elaborated in his book The
Ethics of Liberty (1982), written just before his 1983 proposal for monetary reform.
Applying Rothbard’s theory of ethics to his proposal, we must conclude that his plan
for monetary reform fails to match his ethical positions. He claims that fractional
reserve banking is fraudulent because banks issue more money titles than they have
received money proper and promise to redeem the money title into money proper
on demand. As the promise cannot be fulﬁlled, this constitutes fraud and fraud is
implicit theft.²⁵ And what is to be done in the case of theft? According to Rothbard,
justice demands that the
criminal must pay double the extent of theft: once, for restitution of the
amount stolen, and once again for the loss of that he had deprived another…
[F]or proportionate punishment to be levied we would also have to add more
than double so as to compensate the victim in some way for the uncertain and
fearful aspects of his particular ordeal. (Rothbard 1998, 88-89)
Therefore, according to Rothbard’s reasoning, if banks and bank equity owners are not
able to pay that amount, the bank assets and their personal assets would be turned
over to the victims: the depositors. If this would not be suﬃcient, bank owners would
have to work for the remainder of what they could not pay (86).²⁶
²⁵ See Rothbard (1991, 50-51).
²⁶ See Rothbard (1998, 86): “The ideal situation, then, puts the criminal frankly into a state of enslavement
to his victim, the criminal continuing in that condition of just slavery until he has redressed
the grievance of the man he has wronged.” Another cause for punishment of banks could be made by
146 New Perspectives on Political Economy
Strangely enough, in outright contradiction to his theory, Rothbard does not recommend
that. On the contrary, he calls for a transfer of the nationalized gold to the
fractional reserve banks.²⁷ That gold was stolen from the bank depositors who are its
just owners and should be handed back to them. Inconsistently, Rothbard claims the
elimination of taxpayer bailouts as an advantage of his reform (Rothbard 1994, 150);
however, from the point of view of his ethical theory, his proposal entails a last giant
bailout of the criminal banks. Rothbard also claims that his plan would “have the
advantage of starting from Point Zero, of letting bygones be bygones”(Rothbard 1983,
268). Rothbard’s “Point Zero” is, however, the result of a governmental intervention
that prevents punishment of the banks. Would it not rather be a real “Point Zero”
to let an unsound banking system collapse by abstaining from further interventions
into the monetary system, instead of maintaining a status quo that results from privileges?
Moreover, one wonders, why Rothbard upholds his plea for letting bygones be
bygones, since in his ethical theory there is not anything like a statute of limitations.
Justice is not a question of time.²⁸ Therefore, the amnesty for banks that Rothbard’s
reform establishes is inconsistent with his writings on ethics.
With great insight, Rothbard analyzes the economic consequences of deﬂation,
showing that it is not something inherently bad or that it must be prevented. Applying
his ethical theory to fractional reserve banking would certainly wipe out the
existing banking system and lead to a deﬂation entailing the consequences that Rothbard
analyzed favorably. He fails to endorse a deﬂation that is in line with both his
economic and ethical theories, but rather passes over his economic insights and contradicts
his ethical theory calling for a managed reform. The question as why he does
this is hard to answer and rather puzzling.
pointing to their relationship to the state, which is from Rothbard’s point of view “a coercive criminal
organization” (172). Fractional reserve banks, by inﬂating the money supply and buying government
bonds, help to ﬁnance the criminal activities of the state directly and indirectly. Hence, fractional
reserve banks are guilty not only of defrauding customers but also of operating in symbiosis with a
criminal organization. Also, a case could be made for punishing bank employers who – knowingly or
not – collaborated within this criminal symbiosis. For the question of a “libertarian Nuremberg Trial,”
see Block’s discussion of this in the Rothbardian tradition (2004 and 2006).
²⁷ While this transfer is in contradiction to Rothbard’s ethical theory, it is an interesting idea to overcome
the threat of resistance against monetary reform posed by the major beneﬁters of the current system
– the ﬁnancial sector.
²⁸ Rothbard (1982, 42): “… the theory must hold true for all men, whatever their location in time or
place.”
Bagus: Monetary Reform and Deﬂation – A Critique of … 147
4 Jesús Huerta de Soto
In his recent treatise Money, Bank Credit, and Economic Cycles, Huerta de Soto elaborates
a sophisticated plan of monetary reform in the Rothbardian tradition (Huerta
de Soto 2006, 715-812). His ideal monetary system involves three components: complete
freedom of choice in currency, complete banking freedom, and the fulﬁllment
of traditional legal rules (a 100 % reserve requirement on demand deposit contracts).
In order to achieve this ideal, he proposes a twofold strategy. On the one hand, he
argues that it is important to educate the public about the beneﬁts of the ideal monetary
system. On the other hand, a short-term policy of a gradual progress towards
that system must be adopted. Huerta de Soto divides his reform in ﬁve stages. In
the ﬁrst stage the central bank is still legally “dependent” on the government. It centrally
plans the whole monetary sphere. In the second stage the central bank becomes
legally “independent” and a monetary growth rule of approximately 4%-6% is
installed.
In the following third stage, a 100 percent reserve requirement for banks is set with
a monetary growth rule of 2 percent. This 100 percent rule is achieved in a curious way.
First, bank assets above the bank’s equity are transformed into mutual funds. Then
during a certain period of time, depositors get the option to change their deposits
into shares of this mutual fund. “Each depositor to select this option would receive
a number of shares strictly proportional to the sum of his deposits with respect to
the total deposits at each bank” (Huerta de Soto 2006, 792). The 100 percent reserve
requirement is then made by just printing the paper money necessary to back all
remaining deposits and giving it to the banks.²⁹ No further issuing of ﬁduciary media
will be permitted. But would that not involve a gift to the banks? Huerta de Soto
acknowledges this argument by criticizing Rothbard:
In general we agree with the transition program formulated by Rothbard.
However we object to the gift he plans for banks, a contribution which would
²⁹ At this point we are faced with a curious question: Would anyone stick with his deposits and not
transform them into shares of the mutual fund? Before the reform, the deposits were “backed” or
“supported” by the assets the banking system was holding (loans, etc.). These assets form now part
of the mutual fund and are substituted by paper. Thus, it seems unlikely that many depositors would
stick with their deposits.
148 New Perspectives on Political Economy
allow them to keep the assets they have historically expropriated from society.
In our opinion, it would be perfectly justiﬁable to use these assets toward the
other ends we discuss in the text. (2006, 795-796, fn 100)
What are these ends? The ends are the replacement of outstanding treasury bonds
and the partial or total liquidation of other state liabilities, like social security pension,
etc. That means that the holders of treasury bonds and other state liabilities
receive the mutual funds left over by the reform at the prevailing market rate. In
other words, the shares of the mutual funds that do not correspond to the banks’
equity and are not claimed by depositors, replace treasury bonds at the prevailing
market price.³⁰ Any remaining shares would also replace other state liabilities. The
banks’ holdings of treasury bonds are simply canceled.³¹
At the fourth stage, the central bank is abolished and complete banking freedom
subject to traditional legal principles prevails. The price of gold is redeﬁned, similar to
Rothbard’s plan, in order to make all paper money redeemable in gold. A 100 percent
gold standard is in place.
At the ﬁfth stage, the gold standard would spread to the world. Here Huerta de
Soto calls for an international agreement of a single gold standard. This requires the
creation of ﬁxed exchanges rates between all currencies in prior stages. This would
allow us to “uniformly assess the entire world supply of ﬁduciary media and to redistribute
among the economic agents and private banks of the diﬀerent countries the
stocks of gold held by the world’s central banks. This redistribution would be carried
out in exact proportion to the sum of deposits and bills in each.” (Huerta de Soto,
2006, 802). At the ﬁfth stage the complete freedom in monetary aﬀairs would also
allow for the emergence of new monies.
While Huerta de Soto’s reform is unmatched in details and strategically interesting,
there are some problems with it. First of all, his reform is a managed reform
which does not leave room for free market developments. For example, in arguing
for his gold standard reform, Huerta de Soto writes that,
³⁰ Before this replacement depositors have the option to switch their deposits into shares of mutual
funds.
³¹ Here, we face a problem. According to Huerta de Soto, treasury bonds should be included as part of
the mutual funds because these bonds are assets as well. However, if the treasury bonds are canceled,
former depositors, now mutual fund owners, lose a portion of their assets, that according to Huerta
de Soto should belong to them.
Bagus: Monetary Reform and Deﬂation – A Critique of … 149
[i]t is impossible to take a leap in the dark and establish an artiﬁcial monetary
standard which has not emerged through an evolutionary process. Hence the
new form of money should consist of the substance humanity has historically
considered money par excellence: gold. (2006, 799)
It is true that gold was money for a long time. But in many countries silver was also the
dominant currency in the retail economy. Moreover, other currencies existed prior
to gold. One cannot know a priori which money would prevail in a free competition
today. It might be gold, it might be gold and silver, or it might be another money.
Why should it not be left to free decisions of individuals which monies are used from
the beginning of the reform onward?
Of course, with an interventionist reform we are left with arbitrariness. For example,
how long should these stages last, and how long should depositors have the
option to switch to mutual fund shares, or why is it ﬁve stages? And why should
money growth be 4 percent – 6 percent and later 2 percent; and why should this
monetary growth be used to ﬁnance state activities or buy gold?
Here we come to some strategic problems. On ﬁrst sight, one of the main advantages
of Huerta de Soto’s proposal for an ideal monetary reform is it moderateness.
But this can also be a disadvantage. The long-term objectives can be forgotten. At
every stage there is the danger that steps will be taken in the wrong direction. The
reform is easily reversible, as the inﬂuence of the state in the monetary sphere is only
very slowly displaced. As William Lloyd Garrison expresses this, “[g]radualism in theory
is perpetuity in practice.” Another example of gradualism is Huerta de Soto’s comments
about the Soviet Union. Why does he argue that due to its huge gold reserves,
the Soviet Union could change its monetary system immediately to a pure gold standard,
while other countries would have to wait?³² Why could other countries not go
immediately to a pure gold standard? Huerta de Soto gives no convincing argument
why other countries have to wait to get rid of recessions. It is possible that he thinks
it is not possible to convince people of directly going to a pure gold standard, but how
can we convince people to go there, if we advocate a ﬁat paper money system with
4-6 percent growth in the ﬁrst place? Another related strategic problem with his plan
is that the state’s planning of the reform could foster the belief in the state’s ability to
improve monetary aﬀairs.
³² See Huerta de Soto (2006, p. 805).
150 New Perspectives on Political Economy
A point that could make the introduction of his reform very diﬃcult is that Huerta
de Soto argues for the introduction of a gold standard on a world wide scale in order
to “prevent the transition from having any unnecessary, real eﬀects”.³³ Yet, ﬁrst
mover countries would have an advantage of adopting a pure gold standard. They
would receive the gold at still relatively low prices, while countries which adopt such
a standard later would have to pay higher prices. These “real eﬀects” are not something
that must be prevented. Furthermore, countries probably would not agree to
ﬁxed exchange rates that Huerta de Soto’s plan suggests because this would imply a
redistribution of gold. They would not agree upon the exact rate of exchange.
So where do all these detailed interventions stem from? As with Mises’ and Rothbard’s
plan, the details and interventions Huerta de Soto’s plan seem to be based on a
fear of deﬂation. Indeed, Huerta de Soto points out that his reform like Rothbard’s is
not deﬂationary.³⁴ He seems to imply that deﬂation in a monetary reform should be
prevented.³⁵ Unfortunately, Huerta de Soto does not see the advantages of deﬂation
as a fast purge of malinvestments and unsound banks, as possibly increasing savings,
and as increasing pressures to abolish regulations.
Another critique against Huerta de Soto’s reform is that it defends the status quo
irrespectively of how this status quo was arrived at. He himself sees it as a weak
point in Rothbard that banks receive a gift in the privatization of nationalized gold.³⁶
That implies Huerta de Soto employs, at least partially, an ethical point of view in his
argumentation for a monetary reform. He also writes about the “aggregate wealth the
banking system has expropriated”(Huerta de Soto, 2006, 794). So, why is he against a
gift to the banks but in favor of an amnesty for their expropriation? Should depositors
not be compensated and all bank assets turned over to depositors? Moreover, should
not the nationalized gold be given back directly to the population? And why are
ﬁnanciers of the government (holders of treasury bonds) being rewarded with shares
in the mutual fund?
³³ See Huerta de Soto (2006, p. 802).
³⁴ See Huerta de Soto (2006, 796 fn. 100).
³⁵ This seems also be implied in his view of the British deﬂations after the Napoleonic Wars and after
WW I. See Huerta de Soto (2006, 447-448). There he speaks of “unnecessary pressure” for the
economic system.
³⁶ See Huerta de Soto (2006, 797, fn. 100).
Bagus: Monetary Reform and Deﬂation – A Critique of … 151
In sum, Huerta de Soto’s proposal is a sophisticated elaboration on Rothbard’s
plan. Its strategic advantages must be recognized and his ideal monetary system
might be a desirable goal. Yet, the way he proposes to get there is too time consuming,
too interventionist, involves unjustiﬁed conservation of the status quo, and
has arbitrary distributional eﬀects. All these eﬀects result from his attempt to avoid
deﬂation and make the reform more appealing.³⁷
5 Hans Sennholz
Even though Hans Sennholz does not expose a detailed monetary reform, he certainly
argued in his work for severe changes in the monetary system. Sennholz³⁸ in Age of
Inﬂation (1979)³⁹ and later in Money and Freedom (1985) oﬀers one of the most radical
and most libertarian proposals for changes in the monetary system: “We seek
no reform law, no restoration law, no conversion or parity, no government cooperation:
merely freedom”(Sennholz, 1985, 77). What is to be done speciﬁcally to “remove
government from all monetary aﬀairs” (Sennholz 1979, 149)? Sennholz oﬀers three
speciﬁc points (1979, 149-50): First, all legal tender must be repealed. Second, the
central bank must be abolished,⁴⁰ and third, the compulsory monopoly of the mint
is to be eliminated.
Sennholz’ laissez-faire approach is far more consistent than it is in the aforementioned
reform plans oﬀered by other Austrian economists. He does not want to impose
any result of his reform but merely remove government interventions: “Government
need not establish the gold standard by any conscious or deliberate act,”
because people may choose it again (1979, 158). Because Sennholz does not mention
time at this point, it seems that he calls for an immediate removal of government
from the monetary sphere. He rightly states that in today’s ideological climate, the
³⁷ Confronted with my critique, Huerta de Soto acknowledged most of the points and made clear that
his proposal was not intended to be the theoretical best reform.
³⁸ In his Phd thesis, How can Europe survive (1955, 296-99), written under Mises, he still embraced Mises’
reform plan.
³⁹ Some of the relevant parts of Age of Inﬂation appeared before as “In Search of Monetary Stability” in
The Freeman, February 1977, pp. 80-90.
⁴⁰ He does not touch the interesting question who should get the nationalized gold, now controlled by
the central bank.
152 New Perspectives on Political Economy
change he proposes is out of political reality. He does not explain how to make his
proposal feasible. But that is for Sennholz – at least at this point of his discussion
– not the important question. He is not willing to compromise economic principles
and indicates that this might actually be an advantage in the eﬀectiveness of the plan:
We need not here enter a discussion of who is more practical and eﬀective:
he who uncompromisingly seeks to draw his conclusions and reveal irrefutable
truths, or he who permits his deliberations to be colored by that which is more
popular. (1979, 150)
It is curious that Sennholz does not mention deﬂation in respect to his plan. This
might actually be the reason why his initial proposal is more radical and free market
than the aforementioned plans. However, the immediate removal of government
from monetary aﬀairs and especially the abolishment of the central bank will probably
involve a deﬂation. When the prestige of the central bank and state regulations
vanish, people may immediately make a run on their banks. In a fractional reserve
banking system without a central bank, this in turn may purge the whole system involving
the deﬂation of the ﬁduciary media. Even if there are no initial bank runs
when the central bank is dissolved, conﬁdence, which is essential for a fractional reserve
banking system, is likely to be shaken during the next recession. This recession
has probably already been induced by the abstention from further credit expansion.
A bank run might occur at this time, and this purge would involve a substantial credit
contraction, likely followed by declining prices.
Interestingly enough, only a few pages later, Sennholz takes a huge step back from
an unconditional immediate liberalization of the monetary sphere and, somewhat,
revises his plan. His “revised plan” entails four objectives (Sennholz, 1979, 166-67).⁴¹
The ﬁrst and second objectives consist in the freedom to trade, hold, and use gold.
The third object is the freedom to mint coins. However, the Federal Reserve System,
stays in place (166), which is an outright contradiction to Sennholz’ very own statement
that government intervention in the monetary sphere be ended. He predicts
⁴¹ This version of Sennholz’ plan is very similar to Henry Hazlitt’s plan which can be found in Hazlitt’s
The Inﬂation Crisis, And How To Resolve It (1978), pp. 175-190 and in his (1975) essay “To Restore
World Monetary Order.” Hazlitt, as Sennholz, seems to shy away from a complete abstention from
government intervention into the monetary realm, because he dreads deﬂation (1978, 190 and 1975,
74). Like Sennholz, Hazlitt does not elaborate why deﬂation must be avoided.
Bagus: Monetary Reform and Deﬂation – A Critique of … 153
that a “parallel standard” with both ﬁat paper and a gold standard would prevail.⁴²
As gold outcompetes ﬁat money, Sennholz predicts that to save the dollar the U.S.
government might decide to make its money convertible to gold as well.
Where in these few pages does Sennholz shift from total abstention from government
intervention into the monetary sphere to a “parallel standard” stem from?⁴³ As
with the other economists mentioned earlier, it might have been the fear of deﬂation.
As Sennholz states: “Prices and wages would have to be drastically cut, which
no modern society could withstand in an orderly fashion.” Why could a modern society
not withstand this? Sennholz gives no explanation for that. He just assumes it
as self-evident. But why can union power not be broken? This could be done at the
same time governmental monetary interventions are ended. If the power of unions
were not broken, there would be an immense pressure to break the rigidities that
state interventions impose on the price system after the reform.
A severe problem of a “parallel standard” that Sennholz proposes is that it would
not really be free competition between the government money and gold. Government
could and very likely would subsidize its own currency via its taxation power.
Sennholz himself states that the FDIC could stay in place.⁴⁴ Government subsidies
could give the government money an advantage that might prevent its currency from
being outcompeted by gold.
Moreover, as Joseph Salerno (1982, 12) vividly points out:
[…] there looms the distinct possibility that the political authority may use
the occasional, but highly visible, ﬁnancial crises and bank failures which follow
the inﬂationary booms as a pretext for regulation of the banks “in the public
interest.” Having thus regained its ﬁrst crucial foothold, the government would
be well on its way to reimposing its monopoly over money.
In sum, Sennholz proposes changes of the monetary system very close to a free market
solution. Perhaps frightened by the possibility of an unpopular deﬂation, he dilutes
his plan, neglecting the advantages a deﬂation could have.
⁴² For a brilliant critique of monetary reforms proposing a parallel private gold standard see Salerno
(1982, 10-14).
⁴³ A “parallel standard” does not correspond to a free market but rather to a “mixed economy.”
⁴⁴ See Sennholz (1985, 81).
154 New Perspectives on Political Economy
6 Conclusions
Mises, Rothbard, Huerta de Soto, and Sennholz oﬀer plans of monetary reform that
entail numerous state interventions into the economy, inconsistencies, arbitrariness,
and tactical ambiguities. Their proposals contradict their own ethical and political
principles, and seek to engineer an improved institution of money. All of these problems
seem to stem from the authors’ attempts to preserve the status quo and to avoid
alleged chaos, their reliance on a problematic economic theory of deﬂation, or the
attempt to gain acceptability by avoiding a deﬂation. Yet, a good reform must fulﬁll
three complementary criteria. Monetary reform must be based on a sound economic
theory. Monetary reform should be ethically just, and it should leave the maximum
space possible for an entrepreneurial process to determine the exact results. A reform
that fulﬁlls these criteria, would probably also bring about deﬂation. However, deﬂation
is not something inherently bad. Rather, it can be seen as a corrective process
that is part of creating a stronger ﬁnancial market. Because of this inherent importance
of deﬂation in the return to a sound monetary system future research should
be directed to more in-depth analysis of deﬂation.
Bibliography
[1] Bagus, Philipp. 2003. “Deﬂation: When Austrians Become Interventionists.”
Quarterly Journal of Austrian Economics 6 (4): 19-35.
[2] Barnett II, Willian and Block, Walter. 2004. “On the Optimum Quantity of
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[3] Dulbecco, Philippe and Renard, Marie-Francoise. 2003. “Permanency and Flexibility
of Institutions : The Role of Decentralization in Chines Economic Reforms.”
The Review of Austrian Economics 16 (4): 327-346.
[4] Hazlitt, Henry. 1975. “To Restore World Monetary Order.” In Sennholz ed. Gold
is Money. Westport, Co.: Greenwood Press: 61-76.
[5] Hazlitt, Henry. 1978. The Inﬂation Crisis, and How to Resolve it. New Rochelle,
N.Y.: Arlington House.
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[6] Herbener, Jeﬀrey M. 2002a. “After the Age of Inﬂation: Austrian Proposals for
Monetary Reform.” Quarterly Journal of Austrian Economics 5 (4): 5-19.
[7] Herbener, Jeﬀrey M. 2002b. “Ludwig von Mises on the Gold Standard and Free
Banking.” Quarterly Journal of Austrian Economics 5 (1): 67-91.
[8] Hoppe, Hans-Hermann. 1994. “How is Fiat Money Possible? -or, The Devolution
of Money and Credit.” The Review of Austrian Economics 7 (2): 49-74.
[9] Hoppe, Hans-Hermann. 2001. Democracy The God That Failed – The Economics
and Politics of Monarchy, Democracy, and Natural Order. New Brunswick, New
Jersey: Transaction Publishers.
[10] Hoppe, Hans-Hermann. 2006. The Economics and Ethics of Private Property –
Studies in Political Economy and Philosophy. 2nd ed. Auburn, Ala.: Ludwig von
Mises Institute.
[11] Hülsmann, Jörg G. 1998. “Toward a General Theory of Error Cycles.” Quarterly
Journal of Austrian 1 (4): 1-23.
[12] Hülsmann, Jörg G. 2003. “Optimal Monetary Policy.” Quarterly Journal of Austrian
Economics 6 (4): 37-60.
[13] Huerta de Soto, Jesús. 2003. “The Theory of Dynamic Eﬃciency.” in Backhaus,
Jürgen, Hejmann, Wim, Nentjes, Andries, van Ophem, Johan (ed.) Economic
Policy In An Orderly Framework: Liber Amicorum For Gerrit Meijer. Münster:
Transaction Publishers.
[14] Huerta de Soto, Jesus. 2004. “Historia Conjetural, Ciencia Economica, y Etica
Social.” In Huerta de Soto. Estudios. 2nd ed. Madrid: Union Editorial: 105-120.
[15] Huerta de Soto, Jesus. 2006. Money, Bank Credit, and Economic Cycles. Auburn,
Ala.: Ludwig von Mises Institute.
[16] Mises, Ludwig von. 1919. “Der Wiedereintritt Deutsch-Österreichs in das
Deutsche Reich und die Währungsfrage.” In Schriften des Vereins für Sozialpolitik
158. Leipzig: Duncker & Humblot.
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[17] Mises, Ludwig von. 1923. “Die geldtheoretische Seite des Stabilisierungsproblems.”
In Schriften des Vereins für Sozialpolitik. 164: 2.Munich & Leipzig:
Duncker & Humblot.
[18] Mises, Ludwig von. [1944] 2000. “A Noninﬂationary Proposal for Postwar Monetary
Reconstruction.” In Ebeling (ed.) Selected Writings of Ludwig von Mises:
The Political Economy of International Reform and Reconstruction, Vol. 3. Indianapolis:
Liberty Fund. Pp. 71-118.
[19] Mises. Ludwig von. [1949] 1998. Human Action: A Treatise on Economics.
Scholar’s Edition. Auburn, Ala.: Mises Institute.
[20] Mises, Ludwig von. [1953] 1981. The Theory of Money and Credit. Indianapolis:
Liberty Fund.
[21] Mises, Ludwig von. 1962. The Free and Prosperous Commonwealth: An Exposition
of the Ideas of Classical Liberalism, New Jersey, N.Y.: D. Van Nostrand.
[22] Mises, Ludwig von. [1977] 1996. Critique of Interventionism. New York: Foundation
for Economic Education.
[23] Rothbard, Murray N. 1983. The Mystery of Banking. Richardson & Snyder.
[24] Rothbard, Murray N. 1991. The Case for a 100 Percent Gold Dollar. Auburn, Ala.:
Ludwig von Mises Institute.
[25] Rothbard, Murray N. (1992). “Aurophobia: or, Free Banking on What Standard?”
The Review of Austrian Economics 6 (1): 97-106.
[26] Rothbard, Murray N. 1994. The Case Against the Fed. Auburn, Ala.: Ludwig von
Mises Institute.
[27] Rothbard, Murray N. 1995. Taking Money Back. Available at:
http://www.mises.org/rothbard/moneyback.asp
[28] Rothbard, Murray N. 1998. The Ethics of Liberty. 2nd ed. N.Y.: New York University
Press.
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[29] Rothbard, Murray N. [1963] 2000. America’s Great Depression. 5th ed. Auburn,
Ala.: Ludwig von Mises Institute.
[30] Rothbard, Murray N. 2002. A History of Money and Banking in the United States:
The Colonial Era to World War II, Auburn, Ala.: Ludwig von Mises Institute.
[31] Salerno, Joseph T. 1981. “The Gold Standard: An Analysis of Some Recent Proposals.”
Cato Institute Policy Analysis (September 9).
[32] Salerno, Joseph T. 2003. “An Austrian Taxonomy of Deﬂation: With Applications
to the U.S.” Quarterly Journal of Austrian Economics 6 (4): 81-109.
[33] Sennholz, Hans. 1955. How can Europe Survive? Toronto, New York, London: D.
Van Nostrand.
[34] Sennholz, Hans. 1979. Age of Inﬂation. Bellmont, Ma.: Western Islands.
[35] Sennholz, Hans. 1985. Money and Freedom. Spring Mills, Pa.: Libertarian Press.
[36] Yeager, Leland B. 1976. International monetary Relations: Theory, History, and
Policy. 2nd ed. New York: Harper & Row.
ISSN 1801-0938
New Perspectives on Political Economy
Volume 4, Number 2, 2008, pp. 159 – 186
Postmodernism and Its Discontents: Whither
Constitutionalism After God and Reason?
Nikolai Wenzel
JEL Classiﬁcation: B52, D8, P48, Z12, Z13
Abstract: Modern institutions rely on philosophical appeals – speciﬁcally the ideas
of the Enlightenment Project (Modernity). Truth exists, along with natural rights,
and we are to use the human faculty of reason to discover them and conduct our
aﬀairs accordingly. Institutions follow. After three centuries of dominance, the modern
project is now facing serious challenges from two sources. First, the post-modern
alternative rejects the notion of a knowable truth in favor of radical relativism; reason
has serious limitations, and there is no absolute appeal. Second, a pre-modern
claim, in the form of a fundamentalist religious revival, has been calling for a return
to Covenant; an appeal to Scripture and tradition is increasingly challenging modern
claims. An attack on modern philosophy, and the replacement of modern mental
models with pre- or post-modern alternatives, will necessarily have deep constitutional
implications – for the way we organize our aﬀairs, but also for the liberties that
modern institutions are meant to protect. In sum, whither constitutionalism after
God and Reason?
Department of Economics, Hillsdale College, Hillsdale, Michigan, USA, nwenzel@hillsdale.edu.
For discussion and comments, thanks to Christopher Martin, the Rev. Andrea Martin, Matt Mitchell,
Nathaniel Paxson, Peter Boettke, Richard Wagner, Charles Steele, participants in the Summer 2005
Mercatus-Earhart research workshop, the 2005 meeting of the Society for the Scientiﬁc Study of Religion,
Larry Iannaccone and the 2005 Workshop in religion, economics and culture at George Mason
University, the 2006 Public Choice Society meeting, and a 2007 lecture organized by the Praxis Political
Economy Club at Hillsdale College. Thanks also to an anonymous reviewer and the editors of New
Perspectives on Political Economy for helpful comments, and to Jenny Bowser for research assistance.
And, as always, special thanks to the Henry C. Simons Circle at George Mason University for support
and feedback. Financial assistance from the H.B. Earhart Foundation and the Mercatus Center at
George Mason University is gratefully acknowledged. Much of the background material presented
here is drawn from my 2008 entry in the Oxford Handbook of the Sociology of Religion. The usual
caveat applies.
160 New Perspectives on Political Economy
Introduction
We may very well be coming to the end of an intellectual era. At the very least,
new forces are challenging the shared philosophical foundations and mental models
that have characterized Western Civilization for the past three centuries. Even
if it is not facing its twilight, the Enlightenment Project (Modernism) is undergoing
radical shifts.
On the one-hand, Post-modernism is emerging as a serious challenger to the
modern project. More than a mere academic parlor-game, more than a technical
and obscure fad for the salons of Europe, more than a fancy for a select few high
priests at departments of cultural studies and English at scattered US universities,
the Postmodern contender has been throwing its weight around. The eﬀects of the
radically relativist philosophy are evident in Western thinking, conscious and unconscious,
from the unspoken mental models of popular culture to the explicitly articulated
models of high culture.¹
On the other hand, parallel to the post-modern rejection of modernity’s bold
claims, there is emerging a pre-modern religious radicalization in the West. Whereas
mainstream religion has been dwindling over the past century in the West, there has
been a signiﬁcant migration towards more fundamentalist churches, especially in the
US (where religious scholars speak of a Fourth Great American Awakening).² Like
Postmodernism, this shift towards religious fundamentalism makes claims against
the modern worldview, and is proposing to supplant at least a portion of the modern
appeal to reason with a pre-modern appeal to the presumptive authority of tradition.
But, as we will see, the pre-modern backlash is mostly relevant for explaining the rise
of Postmodernism.
The transformation is clearly not complete, and the Modern has not been supplanted,
nor is it certain that it will ever be. But, increasingly, post- and pre-moder¹
The new metaphysics, epistemology, and ethics that are emerging are the subjects of much vaster
studies. I will thus focus this paper on a general postmodern worldview, which includes elements of
all three of these ﬁelds of philosophy. Beyond institutions, the likely implications for all of civilization
could be staggering, from the arts and sciences, to politics and education, to social norms, and beyond.
For philosophical details, see Pippin (1999), Harvey (1989) or Yack (1986).
² The international phenomenon of radical Islam falls under this category, but it is complex enough to
be the subject for another paper; see Wenzel (2008).
Wenzel: Postmodernism and Its Discontents: Whither Constitutionalism … 161
nism are coming to represent challenges to the prevailing modern worldview, with
new mental models, and new heuristics for engaging and understanding the world,
the individual’s place in it – and the ensuing institutions, formal and informal.
This paper examines the possible consequences of shifts in philosophy on the
modern constitutional project, from post- and pre-modern tensions. Section one
starts with the philosophical foundations of the modern project, and Section two
examines the postmodern challenger to Modernism. Section three looks at the premodern
backlash to help explain the postmodern phenomenon. Section four oﬀers
a case study on postmodernism and constitutionalism, that of the proposed EU Constitution.
The ﬁnal section concludes.
But, ﬁrst, a methodological disclaimer.
Disclaimer
It is always with some trepidation that I, a political economist and not a trained
philosopher, venture into the realm of philosophy. I am, after all, reminded of Buchanan’s
(1975, xvi) warning that “I have read some, but by no means all of the primary
and secondary works [in political philosophy]. To have done so would have required
that I become a professional political philosopher at the cost of abandoning my own
disciplinary base. As an economist, I am a specialist in contract.” I am also called
to methodological humility by Rothbard’s (1995) lament that “it is no crime to be
ignorant of economics, which is, after all, a specialized discipline… But it is totally
irresponsible to have a loud and vociferous opinion on economic subjects while remaining
in this state of ignorance.” I sincerely hope I am not engaging in this very
behavior vis-à-vis philosophy.
And, yet, as an economist, I must study philosophy to make sense of human action,
and I am convinced there are strong gains from trade to be reaped in the interaction
between political economy and philosophy. After all, F.A. Hayek – himself an
economist – reminds us that the “facts of the social sciences” are the opinions and
beliefs that people hold (Hayek 1979[1952], 47 and 64 and the eponymous essay in
Hayek 1948, 57-66); individuals build up an understanding of the world based on their
162 New Perspectives on Political Economy
“views and concepts” thereof (Hayek 1979[1952], 40). Philosophy is thus supremely
relevant – nay, crucial – to understanding the process of economic choice, especially
for such fundamental, value-laden decisions as constitutional political economy and
the institutions adopted to deliver the desired political goods. I will thus ask readers
trained in philosophy to bear with me and forgive my rough-around-the edges,
practical approach – while also begging the indulgence of more technical economists
whose comparative advantage leads them to a specialization that includes infrequent
examination of the philosophical foundations of economic choice.
1 Philosophical Foundations of Modernity and Contemporary Chal-
lenges
So, why does all of this philosophical stuﬀ matter for constitutionalism? Simply put,
modern institutions rely on philosophical claims. They are a manifestation of the
overall modern worldview regarding the proper organization of human aﬀairs.
Starting roughly in the 17th century, Modernism³ substituted the pre-modern appeal
to faith with an appeal to reason – human reason to ﬁnd a knowable truth. Without
lapsing into details, the implications for political theory and everyday life ring
familiar, as they are still with us today: the modern nation-state, with legitimacy derived
from the people rather than the monarch’s divine right; the supreme authority
of reason (over tradition or faith); natural rights and the states instituted for the explicit
purpose of protecting them; free markets; and the mastery of nature through
science and technology (Pippin 1999, 4-5). Harvey (1989, 12) explains how the purpose
of the modern project was
to use the accumulation of knowledge generated by many individuals working
freely and creatively for the pursuit of human emancipation and the enrichment
of daily life. The scientiﬁc domination of nature promised freedom from
scarcity, want, and the arbitrariness of natural calamity. The development of
rational forms of social organization and rational modes of thought promised
liberation from the irrationalities of myth, religious superstition, release from
³ Out of simplicity, I am lumping together two very diﬀerent – and often antithetical – strains of Modernity,
videlicet the Scottish/British/American and the French/German/Continental. See below for de-
tails.
Wenzel: Postmodernism and Its Discontents: Whither Constitutionalism … 163
the arbitrary use of power as well as from the dark side of our human natures.
Only through such a project could the universal, eternal, and the immutable
qualities of all humanity be revealed.
Habermas (1983, 9) adds that the early Moderns had “the extravagant expectation that
the arts and sciences would promote not only the control of natural forces but also
understanding of the world and of the self, moral progress, the justice of institutions
and even the happiness of human beings.” Modernism was a hopeful, excited project,
an optimistic unleashing of the human spirit and previously untapped human creativity,
after an earlier stiﬂing by the bonds of tradition and faith – an “enthusiastic
alternative to a static and contemplative system” (Kors 1998).
Modernism oﬀered a new epistemological appeal, detached from earlier religious
conﬁnes and the presumptive authority of tradition. Kors (1998), in a deliberate simpliﬁcation
and distillation of Aristotle’s Metaphysics, explains the pre-modern epistemology
as follows:
Europe in the seventeenth century still had a traditionalist and subsistence
culture. For that culture, past inheritances had a presumptive authority because
they had stood the test of time and been successful parts of what had permitted
mankind to survive… In the educated world, that intellectual inheritance was a
fusion of Aristotelian (and other Greek) philosophy and of Christian theology; it
was known as “scholasticism” or, more precisely, as Aristotelian scholasticism.
Its means of teaching and persuasion was the disputatio (disputation), based
upon (in order of importance) intellectual authorities, logical deduction from
these authorities, and the appearances of the world. This system dominated
the universities and schools of Europe. Thinkers believed that it brought coherence
to the world, explaining the nature of all things… By distinguishing among
all beings in terms of the degrees of their “perfections,” scholasticism created a
“great chain of being” that permitted us to know contemplatively the value of all
things. The science of ﬁnal causes (teleology) permitted us to know contemplatively
the purposes of things, and to grasp how, under God’s design, all things
strove for God’s created order. The seventeenth century marked a momentous
assault upon all aspects of the Aristotelian scholastic synthesis.
Kors (1998, 11) further explains that “supernatural authority was based on Scripture,
as correctly understood by appropriate authorities. Natural authorities were based on
164 New Perspectives on Political Economy
the presumptive authority of the past (what had stood the test of time) – above all, the
Greeks.” In the next step, “the authority of ancient authors and texts was integrated
into Christian theology and intellectual life, especially when the thought of those
ancient authorities helped to explicate the truths of the Christian faith.” The premodern
system was not, then, devoid of reason. Rather, reason was used in a process
“by which one derived what follows logically from things known by authority.”
Harvey (1989, 13) explains that the subsequent shift to Modernity was “a secular
movement that sought the demystiﬁcation and desacralization of knowledge and social
organization in order to liberate human beings from their chains.” Even as it broke
from the earlier religious monopoly, Modernity did not shed transcendent foundations
entirely. Rather, the Enlightenment can be described as a felicitous marriage
between God and Reason, with its most vivid expression in Jeﬀerson’s Declaration
of Independence: “We hold these truths to be self-evident, that all Men are created
equal, that they are endowed by their Creator with certain unalienable rights, that
among these are Life, Liberty and the Pursuit of Happiness.” Truth and rights exist
exogenously, and we must endogenously use the human faculty of disciplined reason
to discern them. Modern institutions, especially constitutions, follow. Again in the
words of Jeﬀerson, “to secure these rights, governments are instituted among Men.”
Although the ultimate political good to be secured was diﬀerent, the same broad principle
applied in the French tradition of the state as expression of Rousseau’s general
will, later picked up and reﬁned in Hegel’s philosophy of the state.
Constitutions originate in human reason and eﬀort, but they rely on meta-appeals.
Philosophy underlies institutions, both consciously and unconsciously. As Pippin
(1999, 43) explains, “if the principles appealed to in political life are to be justiﬁed,
they must be justiﬁed as much more than the way we go about things; the principles
must be binding ‘for any rational agent’.”
For all the prevalence of the modern project, and its ﬁrm grip on our collective
mental models, two powerful challengers are emerging. The ﬁrst is postmodernism,
the second a pre-modern appeal to religious fundamentalism. Both of these philosophical
challenges are signiﬁcant because they make claims on our mental models,
our way of engaging the world (generally, see Harrison and Huntington 2000,
North 1990, and Pejovich 2003). Instead of struggling with each new situation we
Wenzel: Postmodernism and Its Discontents: Whither Constitutionalism … 165
face, reinventing the proverbial wheel on a case-by-case basis, we employ heuristics
(meta-skills of understanding and action). Philosophical systems constitute the very
foundations that shape our conscious and subconscious understanding of, and approaches
to, the world. A change in the prevalent worldview – our predominant sense
of who we are, what truth is and how it is to be known, what is right, and how human
society ought to be organized – will necessarily have implications for the way we lead
our lives. A questioning of Modernity’s philosophical foundations thus implies, ipso
facto, a questioning of modern constitutional arrangements.
For the sake of clarity, the following table summarizes the basics of each philosophical
current; section two oﬀers details on postmodernism, and section three on
fundamentalism.
Modernism Postmodernism Pre-Modernism
Summary Reason Radical relativism Fundamentalism
Philosophical
Appeal
Reason to discover
natural rights
Competing and
contingent
narratives
Presumptive
authority of the
past
Purpose of
Government
Protect natural
rights
Imperialistic
attempt to impose
narratives
Fulﬁll natural order
In closing, I should note immediately that, out of simplicity, I am conﬂating two very
diﬀerent (and often contradictory) schools of Enlightenment thought, videlicet the
Scottish and Continental Enlightenments. This is admittedly a dangerous conﬂation
– if far too common (even such serious thinkers as Bauman 1989, Giddens 1990, and
Gellner 1992 conﬂate the two enlightenments); but it bears important consequences
for understanding postmodernism, a point to which I return below.
166 New Perspectives on Political Economy
2 The Postmodern Challenger
2.1 Postmodernism – A Primer
Postmodernism emerged from the horror and destruction of World War II in Europe,
but its roots extend back to the 19th century.⁴ The philosophy stands in stark contrast
to Modernism. As explained above, Modernism substituted the pre-modern appeal
to faith with an appeal to reason – human reason to ﬁnd a knowable truth. It was a
hopeful, excited project, an optimistic unleashing of the human spirit.
But the modern project was not without its doubters. As early as the 19th century,
the very premises of Modernism began to be called into question. What began as
doubts about the limitations of reason (initially brushed aside by Modernism’s conﬁdent
optimism) evolved into a fuller critique. Modernism was seen to be spiritually
weakening at best and downright destructive at worst. Pippin (1999, xii) describes
“the widespread nineteenth century suspicions (at least on the European continent)
that … the two greatest accomplishments of world civilization, modern natural science
and technology, and a progressive, liberal democratic culture, were … slowly
and inexorably enervating and spiritually destroying that very culture.” In many ways,
such early grumblings foreshadowed much of the 20th century’s ugliness.
The horrors of World War II galvanized the theoretical concerns. Pippin (1999, 7)
explains that
the great self-conﬁdence and progressivism characteristic of the modern enterprise
and especially what seemed its nineteenth-century fruition, all looked
even more diﬃcult to accept after the historical horrors of the twentieth century.
The fact that “art, intellectual pursuits, the development of the natural sciences,
many branches of scholarship ﬂourished in close spatial, temporal proximity
⁴ The focus of this paper is the eﬀect of postmodernism on constitutionalism, rather than a detailed
explanation of postmodern theory. Terms such as simulacra, diﬀérance, the Other and (k)nots are
thus eschewed, as are such technical subtleties as described by Connor (2004: 4): “How one capitalized
or hyphenated – ‘post-modern,’ ‘Post-Modern,’ ‘postmodern,’ or ‘Postmodern’ – seemed to many
to matter a great deal, along with whether one chose to refer to ‘Postmodernism,’ ‘postmodernity,’
or simply ‘the postmodern’.” Such details are beyond the present scope, and the interested reader is
invited to visit the literature for greater depth that goes beyond the limited scope of this review (see,
e.g., Lyotard 1981, Habermas 1983, Huyssens 1984, Harvey 1989, Bauman 1992, 1995 and 1997, Bertens
1995, Natoli 1997, Sim 2001 or Connor 2004).
Wenzel: Postmodernism and Its Discontents: Whither Constitutionalism … 167
to massacre and the death camps” has raised for many doubts about not only
modernity’s self-assurances, but about all of Western culture, has raised the issue:
“Why did humanistic traditions and models of conduct prove so fragile a
barrier against political bestiality.”
Harvey (1989, 13) echoes this thought, explaining that “whether or not the Enlightenment
project was doomed from the start to plunge us into a Ka aesque world,
whether or not it was bound to lead to Auschwitz and Hiroshima, and whether it has
any power left to inform and inspire contemporary thought and action, are crucial
questions.”
According to the alternative school of Post-modernism, the modern project,
“laudable though it may have been at one time, has in its turn come to oppress humankind,
and to force it into certain set ways of action” (Sim 2001, vii). Where some
saw aberrations or challenges within the modern project, Postmodernism saw necessary
and logical consequences: colonialism; fascism/communism and industrially
planned genocide; the destruction of the natural environment in the name of unfettered
progress and technology; the North’s “exploitation” of the South; the horrors
of modern warfare, compounded by the methodical application of the very science
and technology initially meant to liberate us; and the spiritual poverty and alienation
of mass consumerism. Harvey (1989, 13) explains that “there are those – and this
is… the core of post-modernist philosophical thought – who insist that we should, in
the name of human emancipation, abandon the Enlightenment project entirely.” The
postmodern rejection of the modern project is thus both (a) theoretical and methodological,
and (b) applied and political.
On the theoretical and methodological side, we see a “rejection of many, if not
most, of the cultural certainties in which life in the West has been structured over
the last couple of centuries” (Sim 2001, vii). Speciﬁcally, Postmodernism attacks the
very core of the modern project, questioning the existence of the truth and the ability
of human reason to ﬁnd it. As a radical alternative, Postmodernism holds that all
knowledge is a product of environment, and that we should thus speak of contingent
“narratives” rather than absolute truths. Naturally, diﬀerent people will have diﬀerent
narratives, as they have diﬀerent cultural, intellectual, economic and sociological
backgrounds. So, instead of a modern contest between absolutes, we see a postmod-
168 New Perspectives on Political Economy
ern comparison of narratives, where none has a legitimate right to exclude any other.
Everything is contingent on context and background, and there is no “inside track”
to truth (see Natoli 1997).
On the applied and political side, Postmodernism rejects any claim of absolute
truth as the attempt to impose one worldview over others. In the vocabulary of Postmodernism,
such claims are referred to as attempts to impose a “master voice” or
“meta-narrative.” “Postmodern politics then becomes a continuous negotiating of various
compromises as to what meanings and values are to be represented in the social
order and to what degree. Outcomes here are relative to time and place and the already
established dispositions of power” (Natoli 1997, 18). There follows a suspicion
of certainty, a predilection for dialogue and process over decisive result, and the replacement
of absolute “meaning” with relative “interpretation.” Pippin (1999, 41) explains
that “for many so-called postmodernists, modernism represents the last game
played by Western bourgeois high culture, an elitist code designed only to preserve
and celebrate the … point of view of an exhausted but still immensely powerful middle
class.” Postmodernism thus challenges the main tenets of modern political economy.
The modern nation-state becomes an instrument of centralized repression of minority
voices; the supreme authority of reason ends up being but the “voice” of those in
power attempting to impose their views as “the master voice” over all other narratives;
natural rights are not universal values, but a Western concept, imposed on the rest
of the world by “cultural imperialism” or simply brute force; free markets are seen
as the freezing of one particular institutional arrangement that beneﬁts those who
have the power to expand their wealth; and the mastery of nature through science
and technology becomes an excuse for “ecocide” in the empty name of progress.
2.2 A Sidebar Note: Post-“Modernism”… But Which “Modernism”?
As indicated above, “modernity” is often used as a catch-all for parallel, if antithetical,
philosophical movements. Most strikingly, Giddens (1990, 172) asserts that “totalitarianism
and modernity are not just contingently, but inherently, connected.”
Perhaps… but which modernity? Totalitarianism as a consequence of the Continental
Enlightenment, certainly; of the British Enlightenment, unequivocally not. The
Wenzel: Postmodernism and Its Discontents: Whither Constitutionalism … 169
British (Locke, Hume, Ferguson, etc.) emphasized humility, reason grounded in faith
(and vice-versa), and a healthy acceptance of human nature, whereas the Continentals
(Rousseau, Hegel, Comte, etc.) lapsed into a hubristic cult of reason, leading
to social engineering, a complete negation of the individual in favor of some putative
“common” good – and, bluntly, Auschwitz and the Gulag. For details on the two
Enlightenments, see Hayek 1948, 1967, 1978 and 1979[1952], Boettke 2000, and Himmelfarb
2004.
As much as I shudder to conﬂate the two lines of thought, I must resign myself
to the fact that they are indeed conﬂated in the popular – and intellectual – mind.
The postmodern reaction – if it is indeed a reaction to Auschwitz, the Gulag, the
growth of the state at the expense of individual autonomy, the destruction of the environment
through ill-deﬁned property rights, and the industrialization of war, all of
which are necessary and inevitable consequences of the Continental Enlightenment
– makes perfect sense. In other words, Postmodernism is indeed “the highest form
of Modernity,” if only of the Continental type.⁵ However, if we return to the humility
of the Scottish Enlightenment, grounded in self-inquiry, honest doubt and a foundation
of “faith within reason,” then there is room to question the vast shortcomings
of (prevalent/conﬂated/Continental) Modernity, without lapsing into the nihilism
and linguistic obscurantism of Postmodernism. As in so many other cases, Hayek
(1967, 120) captures the problem neatly: “it was Rousseau and not Hume who ﬁred
the enthusiasm of the successive revolutions which created modern government on
the Continent and guided the decline of the ideals of the older liberalism and the
approach to totalitarian democracy in the whole world.”
Although it is a necessary sidebar note, this is ultimately a problem best left for
another forum.
2.3 Constitutional Implications of Radical Relativism
Constitutionalism, if it is to be successful, must rely on an acceptance of some notion
of principles over expediency. Elster (2000) writes of a sine qua non for successful
constitutionalism: a polity’s willingness to be bound. Without that willingness, that
⁵ To use the phrase from an anonymous reviewer.
170 New Perspectives on Political Economy
deferral of immediate power in the name of long-term constitutional order, there can
be no binding, and thus no constitutionalism. Whether a constitution is ultimately a
contract (Buchanan 1975, Brennan and Buchanan 2000) or a coordinating mechanism
(Hardin 1999, Wenzel 2007b), constitutionalism requires an acceptance that rules,
long-term stability and constitutional principle, must all prevail over the temptations
of in-period politics. If the validity of an appeal to principle is discarded – as it is by
postmodern claims – constitutionalism will be weakened, or destroyed.
Constitutionalism rests not only on an appeal to principle over expediency,⁶ but
also on dynamic sacriﬁce in the name of stability and rights. If Postmodernism prevails,
constitutionalism is apt to whither away into a set of by-laws, with the good
increasingly deﬁned by those who have the votes. Or the guns. In the recent words
of a popular news magazine, constitutionalism may increasingly become “politics by
other means.” This is already the case in most European countries, whose Kelsen-style
constitutional councils many consider to be essentially third chambers of the legislature
(see, e.g. Stone 1992 and Provine 1992). Their nomination, by the executive and
legislature, is temporary rather than lifelong, and they are often approached by legislative
political factions that fear they might lose through traditional parliamentary
channels. Generally, see Kelsen (1942).
On the US side, we are starting to see much the same thing. In response to a recent
Supreme Court ruling on takings,⁷ a leading member of the US Congress declared that
“it is a decision of the Supreme Court … so this is almost as if God had spoken.” Asked if
she agreed with the decision, the Representative asserted “the Supreme Court has decided
… that that was appropriate, and so I would support that.”⁸ No mention of rights
or principle. No mention of abuse of human power against natural rights. Note the
subtle but troubling diﬀerence between such a postmodern hagiographic claim and
⁶ See Buchanan’s (1981) enjoiner that “what is now needed is widespread adoption of a genuine ‘constitutional
attitude,’ a proclivity or tendency to examine issues from a constitutional perspective, as
opposed to the pragmatic, short-run utilitarian perspective that seems to characterize modern academic
scholarship as well as day-to-day political discussion and action.”
⁷ Kelo v. City of New London (2005). This decision vastly broadened the deﬁnition of “public interest,”
allowing local governments much more latitude in claiming eminent domain to seize and redistribute
private property for the purpose of increasing tax bases. An outrageous violation of natural rights, individualism
and the spirit of the Declaration of Independence and Constitution … and a quintessential
example of expediency over principle.
⁸ US Representative (now Speaker of the House) Nancy Pelosi, press conference, 6/30/05.
Wenzel: Postmodernism and Its Discontents: Whither Constitutionalism … 171
the alternative (modern) explanation that we accept to be bound by the Court’s bad
and immoral decision in the name of stability and constitutionalism (while continuing
to ﬁght it). The state and procedure have been raised to a quasi-religious status.
This is not surprising, as the emergent postmodern worldview denies the very existence
of truth. All is narrative and competing at that. Might makes right. Neuhaus
(1986) observes that in Roe v. Wade (the US Supreme Court decision legalizing abortion),
“for the ﬁrst time in American jurisprudence, the Supreme Court explicitly excluded
philosophy, ethics, and religion as factors in deliberation…” Regardless of one’s
views on Roe, it seems rather uncontroversial that the debate did have philosophical
bases and ramiﬁcations. The Court backhandedly recognized this, explains Neuhaus:
“Knowing that such a decision should nonetheless have the appearance of moral justiﬁcation,
the court searched for some covering ‘value’ and came up with the value of
privacy. Much of the course of public reasoning in America can be read from the fact
that our highest appeal is no longer to Providence but to privacy.”⁹
3 A Return to Covenant? The Pre-Modern Challenge
The literature points to a decline in mainstream religion (Repstad 1996, Roof and
Aagedal 1996, Iannaccone 1998, Greeley 1996), with a parallel rise in fundamentalism
(Roof and McKinney 1987, Johnson 1986, Neuhaus 1986, Iannaccone 1998, Greeley
1996). Johnson (1986) explains that
What seems to have happened is that as the mainline churches began to decline
they sought the protection of ecumenicalism … and the common platform
of ever more extreme forms of liberalism. This move provoked an angry conservative
response from their disenfranchised rank-and-ﬁle that took the form of a
new … variety of ecumenicalism… This popular ecumenicalism is based upon a
common reassertion of traditional moral values and of belief in the salient articles
of Christianity not as symbols but as plain historical fact.
⁹ This explanation has a distinct pre-modern (rather than modern) ﬂavor – but speaks elegantly about
postmodern trends.
172 New Perspectives on Political Economy
On the American side, some authors even speak of a Fourth Great Awakening (see
Johnson 1986) or a “neocon reformation.”¹⁰
Before the Enlightenment revolution, religion formed the bulk of Western mental
models, as appeals were made to faith, Scripture, tradition and the authority derived
from them. The Modern project tempered and modiﬁed this exclusivity, but did not
entirely reject an appeal to religion. Rather, the Enlightenment project blended the
two, grounding appeals to human reason within a sense of the eternal and human
use of that very reason to discover natural law and live according to it. The current
trend in religious fundamentalism is diﬀerent, and does not ﬁt comfortably within the
modern tradition. Rather, it would increasingly supplant Scripture and the presumptive
authority of tradition for secular debate and reason. Neuhaus (1986) writes that
“intellectually, what is now called neoconservatism not only represents disillusionment
with earlier liberal policies but in many cases stands as a challenge to reigning
assumptions of the secular Enlightenment.” He continues, explaining that the
movement is sometimes called “traditionalist” or the “back-to-basics movement.”
But that is to deﬁne it much too narrowly, in terms that register speciﬁc
“issues” on the political screen of today and tomorrow. The movement is in large
part a mood, the protest in large part an uneasiness – about the public loss of
transcendence, about a perceived moral vacuum at the heart of our public life,
about the absence of a sense of interest-surpassing content…
To be sure, fundamentalism is not, per se, a postmodern phenomenon – quite the
contrary, it rejects Modernism’s secularism and Postmodernism’s rejection of truth;
in fact, fundamentalism could best be described as pre-modern, as it returns to an
appeal to faith and authority over reason. But fundamentalism is, in many ways,
a reaction to Postmodernism, and thus bears mention in this review – not for the
details of fundamentalism, which are best left to other essays, but to demonstrate
how fundamentalism emerged, in large part, as a reaction to the radical relativism of
Postmodernism.
On this point, generally, see Stark and Bainbridge (1985) and Berger (1999). Although
the verdict is not entirely clear, it strikes me that the rise in fundamentalism
¹⁰ This trend includes not only traditional religious groups, but also others concerned with the overall
decline in American values and morality (Neuhaus 1986).
Wenzel: Postmodernism and Its Discontents: Whither Constitutionalism … 173
represents the reverse of the postmodern medal. Just as Postmodernism questioned,
then rejected, the Modern project after the upheavals of the 19th century and the horrors
of the 20th began to cast doubt on the strength and viability of modern claims,
the rise in religious fundamentalism can be seen as a reaction to both Modernism and
Postmodernism. If the horrors of the 20th century are seen as fundamental failures
(and inevitable) of Modernism, a pre-modern rejection makes just as much sense as a
post-modern one. The direction of the counter-claim is just that – a question of direction.
In fact, Neuhaus (1986) writes that the current rise in fundamentalism goes beyond
traditional religious forces, to incorporate many who are troubled by a perceived
decline in values. It may thus make sense to label the current fundamentalist trend
as an anti-postmodern backlash (as the two are not only mirror opposite responses to
the same perceived problem, but also exhibit a stunning chronological overlap). Just
as the Modern project was borne largely of a religious reformation and followed by
a counter-reformation, the current intellectual landscape can be divided into three
competing forces, three heuristics, three overarching mental models: prevailing but
struggling Modernism; the postmodern “Reformation” of radical relativism; and the
pre-modern “Counter-Reformation” of tradition, faith, and scriptural literalism. See
Wenzel (2008).
Interestingly, this pre-modern phenomenon is not conﬁned to any one religion.
Just as Christianity was inextricably associated with the pre-modern view, it also fed
many modern staples, such as the inherent dignity of the individual or limited government.
The same can be said of the other major religions, which can be made to
ﬁt within pre-modern, modern or post-modern epistemologies (again, see Wenzel
2008).
4 A European Case Study
As an illustrative case study, the EU Constitution can be seen as the result of the emergence
of postmodern thought from the university to the statehouse (Petroni 2003 and
2004, and Wenzel 2007a). Likewise, many aspects of the current transatlantic divide
can be explained as an intellectual clash between a postmodern Europe (with its insistence
on listening to competing narratives, diplomacy over force, and shying away
174 New Perspectives on Political Economy
from what it sees as “simplistic” absolutes in international relations) and a modern US
(with its rhetoric of “axis of evil,” and eﬀorts at bringing human rights to the world).
Standard Public Choice stories and geopolitical/economic realities go some way in
explaining these phenomena – whether one views the EU as a coordination game, or
as the unintended consequence of a supra-national bureaucracy (see, e.g. Langlois
1992 and 1994, Anderson 1984 and Kagan 2002). But, for all their descriptive powers,
these two traditional stories of institutional change do not suﬃciently explain the
overall thrust of the European Constitution.
4.1 The EU Constitution – a Bizarre Document
Beyond length and lack of clarity, the EU Constitution is bizarre at best; in fact, Pini
(2003) has gone so far as to describe it as “a constitutionalist’s delusion,” “a political
aberration,” and “not a constitution – not theoretically, not practically.” As the 126page
behemoth reads more like a spending bill than a constitution, I simplify the
analysis into three salient representative themes: citizenship, rights, and strategic
obfuscation.
4.1.1 Citizenship and Identity
In the American model, government derives its legitimacy up from the people. There
is no such sense in the European case, where the constitution comes ﬁrst, then citizenship
derives from the document. The oddity continues with a tautological deﬁnition
of identity: the constitution is based on a sense of “Europeanness” that is itself
derived from the constitution. European identity – rather than natural law in the
American tradition, or the popular will in the continental Rousseau-Hegelian tradition
– has become the philosophical foundation (see, generally, Petroni 2004). Similarly,
delegates to the Constitutional Convention agonized over the proper wording
and substance for the philosophical foundations of Europe. Although some delegates
pushed for inclusion of a reference to Europe’s Christian heritage, that wording was
deemed too controversial, and was replaced by a milder acknowledgement of Europe’s
“Graeco-Roman and Enlightenment tradition” (de Jasay 2003a and 2003b).
Wenzel: Postmodernism and Its Discontents: Whither Constitutionalism … 175
4.1.2 Rights
The fundamental purpose of a constitution is to establish the basic parameters of
sound government and protect rights – to “impose signiﬁcant constraints on government,
whatever form it takes (majority rule or otherwise)” (Barry 1990; see also Hayek
1960, Pini 2003, and European Constitutional Group 2004). The European constitution
does neither. By its sheer size, it cannot be said to set up basic parameters.
Instead, it attempts to set up the detailed mechanics of European federalism. Furthermore,
Pini (2003) worries that the constitution, instead of limiting state power
and protecting rights, is not suﬃciently abstract and removed from the foibles of inperiod
politics (as a good constitution should be), and that it “adds rules, as always”
(see also European Constitutional Group 2004). The length and detail of the document
underscore the radically diﬀerent philosophies of the American and European
documents. The former sets forth the limits of state action, establishing “islands of
regulation in a sea of liberty.” Its European cousin, conversely, establishes “islands of
liberty in a sea of regulation” (see Barnett 1991 and 2004). Just as citizenship is granted
from the top down, so are rights. Petroni (2003) explains that there are no individual
rights under the EU constitution: rights are those given by the constitution to the
people. In this top-down spirit, the EU constitution places greater emphasis on (socalled)
positive than negative rights – along with the governmental responsibilities
in “guaranteeing” them.
4.1.3 Muddle, obscurity and subterfuge
The mere length of the EU Constitution makes it a delight for sadistic law professors.
The text of the US Constitution is comparatively simple and straightforward, yet has
generated volumes of controversy and interpretation. So one can only imagine the
seeds of confusion, conﬂict and interpretation strewn in the long and complex European
text. A plausible story has been told that the lawyers and judges co-opted
the original European project (see Petroni 2003 and Wenzel 2007a for details). By
making things more legalistically complicated, these high priests of constitutional
interpretation stand to gain.
176 New Perspectives on Political Economy
But the story does not end there. Howe (2004) explains the institutional mission
creep and jurisprudence of European legal interpretation. The European Commission
(the EU’s executive arm) has been “using powers for one purpose to serve a quite
diﬀerent … purpose.” The EU Constitution’s “general provisions … will encourage the
Commission and the ECJ [European Court of Justice] to interpret EU powers even
more broadly than they do at present.” Furthermore, the Court has not been an innocent
bystander in this process. In addition to expanding its own powers and Union
powers through creative interpretations and through the principle of acquis communautaire,¹¹
the Court has been manipulating jurisdiction. Howe (2004) explains how
the Court “interprets the legal texts which it enforces largely by reference to their ‘objects
and purposes.’ This means … that identically worded provisions in two diﬀerent
treaties can be interpreted to have very diﬀerent eﬀects.” In a telling example, Petroni
(2004) describes how the Constitution clearly deﬁnes “human health” as a function
speciﬁcally reserved for the member-states and shielded from EU jurisdiction. Simultaneously,
the Constitution enumerates “public health” as a European Union function
– but does not deﬁne a distinction between “human health” and “public health”!
Robinson (2004) explains that such “constitutional muddle” is intentional, and
has served the purposes of European centralizers. Unable to obtain their political
goals immediately, they have resorted to legalistic obfuscation and unclear constitutional
verbiage to achieve their aims through “subterfuge,” “confus[ing] the citizens
of various member states [in Europe’s] ‘Journey to an Unknown Destination’.” Again,
the lawyers, judges and Convention delegates remain the high priests in the interpretation
of an intentionally confusing document; the incentives are clear. Such selfserving
interpretation would seem to parallel the political sleight of hand we are now
witnessing in the constitution’s imminent ratiﬁcation. Having failed to convince the
people, and having failed by referendum, politicians of EU member countries are now
adopting the constitution via the back door of parliamentary majority.
¹¹ Basically, once an EU-level power, always an EU-level power, even in diﬀerent but “similar” cases – as
deﬁned, of course, by the Court.
Wenzel: Postmodernism and Its Discontents: Whither Constitutionalism … 177
4.2 A Postmodern Explanation
4.2.1 Citizenship and Identity
In a postmodern context, which eschews one “overarching story” in favor of competing
narratives, Europe is the new galvanizing factor. Rather than the modern nationstate,
postmodern Europe is an umbrella that gives voice to regional and personal
interests; “one of the main points of postmodernism … is that ‘the most particular
is the most universal.’ So when it comes to ‘identity’ the trick for the constitutional
experts writing the constitution was to express that by being very much themselves,
they would be more European” (Prado 2004). The European umbrella, along with the
constitutional refusal to derive legitimacy from the people or nation-states, is a reﬂection
of “[Postmodernism’s] ‘anything goes’ pluralism and its delirious celebration
of diﬀerence.” (Sim 2001, 28)
4.2.2 Rights
In a Postmodern worldview, natural rights are viewed with a great deal of suspicion,
as culturally contingent impositions. Far better to emphasize positive “rights” (which
are much more ﬂuid and subject to interpretation). The same goes for the safe, descriptive
allusion to the “Graeco-Roman and Enlightenment heritage” over any appeal
to Christianity and its tendency to impose a “meta-narrative.” Naturally, a more traditional
explanation would point to a pragmatic catering to Europe’s large Moslem
minorities or Turkey’s possible entry into the EU. But, again, the traditional story
makes more sense with an added ideological/philosophical explanation.
4.2.3 Textual Obscurity
The lack of clarity in the European Constitution goes beyond mere lawyers’ games
and is better understood as postmodern interpretation over clear meaning. Prado
(2004) explains that
178 New Perspectives on Political Economy
[a] Constitution is, like every text, made out of language. Thus, given the
metaphoric nature of language … a Constitution written in the 21st
century is very
open to a postmodern … analysis… Plus, given the fact that many governments
will ask their citizens to approve the Constitution via referendum, the openness
to interpretation of every text (a main issue in postmodernism) will play a big
role. Every government will have to ‘interpret’ the Constitution in a certain way
to make it palatable to its own citizenry. That’s postmodern practice – “meaning”
is never “closed”.
Again, the referendum is now moot, but the intent remains. Postmodernism sheds a
whole new light on the EU Constitution’s textual obscurity and the European Court’s
interpretation of a treaty’s purpose over its text.
4.3 Other European Preferences
Space considerations prevent more detail, but other aspects of European policy are
also made clear within a postmodern understanding. Europe’s quasi-religious preoccupation
with environmental protection over economic growth, along with its adoption
of the precautionary principle over rational, mathematical risk assessment, reﬂects
the postmodern concern with scientiﬁc apprentices turning against their modern
sorcerers. Europe’s lack of military power and reluctance to use force can be understood
as a (postmodern) state of “perpetual peace” through diplomacy, in contrast
to the (very modern) Hobbesian world of military force in which the US continues to
live (Kagan 2002). Europe’s predilection for diplomatic and bureaucratic process and
dialogue – over results – can be understood as a postmodern consideration of competing
narratives rather than imposition of one narrative as the “meta-narrative.” And
the list goes on.
As for the actual document, a critical mass of its voters has rejected the proposed
Constitution of 2003. But we have not heard the last from the European constitutionalists
and centralizers. We are already witnessing a new constitutional incarnation,
if in the form of a treaty to be ratiﬁed by compliant legislatures rather than ﬁckle
voters. In the meantime, the draft Constitution oﬀers great insight into the prevailing
Weltanschauung in Europe. From the university to the statehouse, ideology has
Wenzel: Postmodernism and Its Discontents: Whither Constitutionalism … 179
emerged. For details on the EU Constitution as Postmodern document, see Wenzel
2007a.
Possible Futures and Concluding Thoughts
A change in worldview, a change in the heuristics employed to make epistemological
and ethical decisions (consciously or not), means a change in the intellectual foundations
and underlying claims of institutions. As heuristics and philosophical appeals
change, we may see a postmodern rejection of constitutionalism in favor of increasingly
unfettered rule of the “popular will” (constitutions are, after all, claims of principle
over majoritarian power). Alternatively, we may see a move towards pre-modern
religious elements (with a commensurate decline in attention to real meta-issues).
We are already seeing elements of both.
As explained above, the fundamentalist backlash is mostly useful for understanding
Postmodernism.¹² Postmodernism, on the other hand, already goes a long way
towards explaining current intellectual movements. It also presents great leverage
for understanding certain institutional changes. Beyond the European case study
presented above, Postmodernism also helps to understand the current trend of extraconstitutional
amendment of the US constitution. If Postmodernism has not overtaken
prevailing US mental models completely, this does not mean that the ideology
has been quarantined in Europe or resides exclusively at isolated departments in
scattered American universities. Postmodernism is not just a cute way of interpreting
literature, to the delight of sadistic faculty and the terror of students. Postmodernism
is slowly creeping into the American worldview, as it already has in Europe. The intel¹²
Woodberry and Smith (1998) explain that, although fundamentalists have great public visibility and
“impressive mobilization of activists, [their] political impact has been minimal. Many of [their] victories
have been symbolic, such as inﬂuencing the working of the [US] Republican party platform…
Most scholars now believe that [fundamentalism as a political force] will not disappear but will not
become a dominant inﬂuence in politics either.” Furthermore, fundamentalist activists “have little
power to determine how their movements will be framed in the national media or to inﬂuence which
people and statements will be highlighted to represent their causes.” The worries from the ideal-type
pre-modern revolution would thus appear to be exaggerated. Conversely, the ﬁrst three religious
awakenings in America were strong factors in sociopolitical changes of great historical weight: the
US Revolution, the Civil War, and 20th
Century Progressivism (see Johnson 1986). So the verdict is
still open. And, again, this holds in the West; see Wenzel (2008) for more detailed speculation on
Islam.
180 New Perspectives on Political Economy
lectual landscape and subconscious heuristics are changing, as Postmodernism gains
ground. Huyssens (1984) asserts that
What appears on one level as the latest fad, advertising pitch and hollow
spectacle is part of a slowly emerging cultural transformation in Western societies,
a change in sensibility for which the term “post-modern” is actually, at
least for now, wholly adequate. The nature and depth of that transformation are
debatable, but transformation it is. I don’t want to be misunderstood as claiming
that there is a wholesale paradigm shift of the cultural, social and economic
orders; any such claim clearly would be overblown. But in an important sector
of our culture there is a noticeable shift in sensibility, practices and discourse
formations which distinguishes a post-modern set of assumptions, experiences
and propositions from that of a preceding period.
It is, naturally, impossible to predict exactly what will happen to constitutionalism in
the face of such tectonic shifts in the intellectual landscape. It is, however, certain that
there will be eﬀects (some are already visible). Simply put, ideas have consequences.
Institutions, generally, have philosophical foundations; they represent the political
implementation of the prevailing worldview about the proper arrangements of human
aﬀairs. Modern institutions, speciﬁcally, rest on the Enlightenment Project’s
premises, including a clear vision of Man in the Universe, the use of reason to discover
natural rights, and the use of constitutions (and other institutions) to protect
those rights.
Either way, the intellectual landscape is undergoing radical changes. There will
be changes in the institutions that govern human aﬀairs. That much is certain. The
pre-modern, religious fundamentalist challenge to modern institutions appears to be
currently limited. Postmodernism, on the other hand, is already gnawing at the very
core of our mental models and institutions.
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