In 2015, David Thomas and I discovered a lacuna in Austrian capital structure theory. In this article, I will (1) explain the sequestered capital lacuna; (2) discuss the circumstances, good fortune, and scholarly works (especially those of Friedrich Hayek and Roger Garrison) that led to our discovery; (3) draw attention to the utility of sequestered capital as a means for uncovering operational insights about the timing of turning points of boom/bust phenomena (e.g., the Dutch tulipmania and the 1929 boom and bust of blind investment trusts); (4) present evidence that despite our having had seven publications on the subject (several accepted enthusiastically by reviewers and editors of Austrian journals), our discoveries remain largely overlooked by Austrian scholars; and (5) conclude that integrating sequestered capital into Austrian capital theory and Austrian business cycle theory would improve the ability of Austrian scholars to defend free-market capitalism from criticisms that investment is driven by animal spirits (John Maynard Keynes), speculative orgies (John Kenneth Galbraith), and irrational exuberance (George Akerlof, J. Bradford De Long and Andrei Shleifer, Robert Shiller, Richard Thaler, etc.).

Superficial consideration of market fundamentals has permitted prominent critics of private enterprise from John Kenneth Galbraith to 2017 Nobelist Richard Thaler to maintain that premia on closed-ended funds (that is, investment trusts) prior to the stock market crash of 1929 are prima facie evidence of investor irrationality. We provide the first-ever fundamentals-focused inquiry into the pricing of investment trusts that year. Applying multiple empirical methods to a large sample of about three thousand observations, we assess the pricing and fundamentals of two informationally polar types of trusts: transparent trusts whose portfolios were published throughout the year; and blind trusts whose portfolios were unpublished until the third-quarter reporting week. Consistent with the efficient market hypothesis, when new information about blind trusts hit the market, their prices quickly corrected. This was the great correction of 1929.

Joseph Schumpeter, like Ludwig von Mises, thought of capitalism as a process that often, over time, turned luxuries into necessities. Schumpeter warned that assessments that ignored this process, which he termed creative destruction, would misconstrue the social results that arise from capitalism in practice. This article exposes the applicability of this warning to the analyses of positional-good consumption presented by Robert Frank which led him to conclude that a steeply progressive tax on consumption would constitute a free-lunch, bringing in “trillions of dollars” without the loss of “anything of enduring value.”

Hayek ( 1945 ) challenged Schumpeter’s ( 1942 ) thesis that, absent creative destruction, capitalism and socialism would become indistinguishable. Creative destruction aside, Hayek argued that given the ever-changing circumstances confronting producers and consumers, continually adjusting market prices are the only known means by which the plans of producers and consumers can rapidly be coordinated toward mutual gain. Unfortunately, by setting aside inquiry into creative destruction per se, Hayek missed opportunities to discover: 1) the unique knowledge problem applicable to new product research and development, 2) an economically sound explanation for the process of creative destruction in replacement of Schumpeter’s non-economic one. Subsequent developments in economics (e.g.: Israel Kirzner, Ludwig Lachmann, Peter Lewin, and Deirdre McCloskey) set the stage for an introduction of the role of sequestered capital in business cycle theory.

Joseph Schumpeter (1883-1950) was pessimistic regarding capitalism's ability to survive. He predicted that large firms would crowd out start-up entrepreneurs-the ones inspiring creative destruction. These entrepreneurs, he thought, would be unable to obtain sufficient funds to launch products on a competitive scale. Since 1950, a venture capital industry has emerged, which now inspires creative destruction on an unprecedented scale. Our retrospective analysis reveals that the venture capital industry evolved in Schumpeterian fashion. Finally, we argue that had Schumpeter taken Knight (1921) and Hayek (1945) into account, he might not have made the claim that capitalism requires creative destruction to endure.

Friedrich Hayek’s business cycle theory withered throughout the 1930s as he admitted that its underlying model of Böhm-Bawerkian roundaboutness was incomplete and inadequate. In 1934, Hayek started a two-volume book on capital theory, completing only one volume in 1941. Curiously, Hayek ([1941] 2009) cites John Hicks’s (1939) Value and Capital but not the financial measure of roundaboutness that Hicks suggested as a substitute for Böhm-Bawerkian roundaboutness. In 1967, in “The Hayek Story,” Hicks criticized the inexplicable lags. Hayek maintained his view that consumption was sticky and responded to Hicks with a mound-of-honey analogy. Nevertheless, Hayek maintained that his business cycle theory was fundamentally correct and continued to hope that others might someday discover a capital structure theory to undergird it. Toward fulfilling Hayek’s hope, we suggest augmenting the canonical stages of production with a sequestered-capital stage where products are invented, productized, and inventoried prior to launch, uncoordinated by observable prices.

Friedrich Hayek's research focus shifted from a formal analysis of the capital structure in the early 1930s to the study of the economy of knowledge in 1945. He never, as it is too often said, abandoned economics. The abandonment narrative impedes understanding of Austrian economics generally and Hayek's works more specifically. Toward correcting the false narrative, we explore connections between his 1945 thesis and the price fan simile he set out in 1931 to facilitate understanding of the role played by emerging input prices as more capitalistic methods of production are adopted. Expanding on the price fan simile, we also seek to deepen the understanding of the allocative marvel that prices achieve in the free market system, and, consequently, the utter impracticality of using socialist calculation in place of the free market.

Closed-system circular flow models have been ubiquitous in economics for at least half a century. Because these models account for neither new-product Ru0026D, nor the attendant leakages and injections, they obscure understanding of (a) the distinction between new-product and process Ru0026D, (b) the circular flow leakages and injections attending new-product Ru0026D, and (c) Schumpeterian “creative destruction” and “swarming.” To shed light upon these matters, we present an open-system circular flow model and a price theoretic explanation of the swarming overinvestment that characterizes business cycle downturns.JEL Classifications: B20, O31, E30

The efficient market hypothesis implies that the price of a financial derivative should mirror the value of its underlying asset(s). This model is used to reconsider an historic anomaly—the large, allegedly irrational, premia on investment trusts that preceded the 1929 crash. First, we reexamine evidence—highly cited for decades—alleging anomalous premia on portfolio-publishing trusts preceding the crash. Our assessment, based on current information-gathering capabilities, shows no evidence of anomalous premia in the cases considered. Secondly, we test our model on a data set of over 3,000 price observations, using regression discontinuity in time (RDiT) designs. As expected, the prices of blind trusts quickly corrected with the disclosure of their underlying portfolios. Our findings suggest that sequestered capital, rather than irrational exuberance, was primarily responsible for the premia on trusts in 1929.

F.A. Hayek’s trade cycle theory was triumphant in the early 1930s, but withered within a decade as critics went unanswered. Hayek challenged others to “prove” theoretically, what he “knew” intuitively about business cycles. In the late 1990s, Roger Garrison responded with a logically sound and pedagogically persuasive model that answered most of Hayek’s critics. In recent years, the Garrison model has been confronted over its conflict with empirical evidence that consumption is sticky, lack of insight into the timing of either booms or busts, and inconsistency with rational expectations. To address these, we first modify Garrison’s model to identify not just the capital usages in the stages of production, but also sequestered pre-production (R&D) capital. With sequestered capital in play, sticky consumption can be logically accommodated, providing answers all three criticisms of Garrison — addressing Hayek’s challenge.

New product R&D, which precedes post-launch production, is a three-stage process. First comes idea prospecting, which leads to working prototypes. Second comes productization—the conversion of working prototypes into manufacturable products with reasonable prospects of being profitable. Thirdly, firms produce pre-launch inventories. This process often involves high risk, not only due to the large amounts of time and capital investment, but also because the secrecy maintained across lateral competitors stifles market signals that ordinarily foster economic efficiency. Reconsideration of the Austrian theory of the business cycle in this light leads to additional insights about: 1) the capital consumption that occurs during the cycle; and 2) the timing of the bust that follows a boom inspired by excessive credit expansion. Our empirical study of return volatility for the period from 1996 to 2017: 1) confirms the results of a Journal of Finance study of the preceding period from 1975–1995; and 2) validates our analysis of new-product R&D as the earliest component of the capital structure.

Sticky aggregate consumption is a demonstrable phenomenon in economies throughout the world, but to our knowledge it has not yet been incorporated into capital structure macroeconomics. Doing so suggests an explanation for business cycles. On the heels of a technological advance, sticky consumption facilitates increased savings and lower real interest rates. These lower rates lead to accelerating elongations in the capital structure. Even though such elongations facilitate more rapid economic growth, if duplicative overinvestment in research and development occurs, economic contraction will follow the exposure of such error.

Friedrich Hayek’s research focus shifted from a formal analysis of the capital structure in the early 1930s to the study of the economy of knowledge in 1945. He never, as it is too often said, abandoned economics. The abandonment narrative impedes understanding of Austrian economics generally and Hayek’s works more specifically. Toward correcting the false narrative, we explore connections between his 1945 thesis and the price fan simile he set out in 1931 to facilitate understanding of the role played by emerging input prices as more capitalistic methods of production are adopted. Expanding on the price fan simile, we also seek to deepen the understanding of the allocative marvel that prices achieve in the free market system, and, consequently, the utter impracticality of using socialist calculation in place of the free market.

Patent, copyright, trade secret, and other exclusionary laws regarding intellectual property convert new-product research and development from a public/common good into a private good. To the extent that R&D is a private good, the argument that it, as a public good, needs to be subsidized vanishes. Yet the prima facie case for public subsidies of R&D continues to be the basis for enormous governmental transfers of resources. The explanation of unwarranted subsidies is straightforward and well known. Following a brief review, adapting this standard explanation to the case of R&D in particular, this paper offers an entirely new argument against R&D subsidies. Specifically, unwarranted R&D subsidies destabilize new-product R&D, turning a sustainable process into an unsustainable one.

Framing tulipmania in terms of sequestered capital – capital whose quantities, usages and future yields are hidden from market participants – offers a richer and more straightforward explanation for this famous financial bubble than extant alternatives. Simply put, the underground planting of the tulip bulbs in 1636 blindfolded seventeenth-century Dutch speculators regarding the planted quantities and their development and future yields. The price boom began in mid November 1636, coinciding with the time of planting. The price collapse occurred in the first week of February 1637, coinciding with the time of bulb sprouting – signaling bulb quantities, development and future yields. Also consistent with our explanation is the initial price collapse location, in the Dutch city of Haarlem, where temperature and geography favored early sprouting and sprout visibility.

Beyond private ownership of the means of production, what is the most important, or essential, fact of capitalism? Friedrich A. Hayek thought it was the economy of knowledge with which the system operated, whereas for Joseph A. Schumpeter it was the process of creative destruction. To our knowledge, the divergence of thought between these two Austrian-born economists on this fundamental question has gone unheralded in the vast literature devoted to them. In this paper we explore connections between this divergence and the thoughts they had about business cycles, and, ultimately, on the answers they gave to the question: Can capitalism survive?

Ludwig von Mises considered immediate overconsumption essential to the Austrian Business Cycle Theory (ABCT); Friedrich Hayek never agreed. Examining this disagreement, Roger Garrison concluded that Hayek’s exposition of ABCT (a stages-of-production framing without immediate overconsumption) lacked logical integrity. Garrison’s ABCT stages-of-production model, that incorporates immediate overconsumption as an essential component, has long been, and remains, the theory’s standard exposition. Unfortunately, immediate overconsumption has been rendered empirically untenable as evidence that makes it increasingly clear that consumption is sticky has emerged. By reframing ABCT in terms of the full structure-of-capital, rather than only the stages-of-production, we bring about a reconciliation of Hayek, Mises, Joseph Schumpeter and the empirical literature indicating that consumption is sticky.