“Bonn conquered!” Schumpeter telegraphed his fiancée triumphantly in October 1925 when he heard that he had beaten out his Viennese rival, von Mises. Somewhat to his own surprise, he was eager to go. Although his chair was in public finance, he had been promised that he could lecture on pure theory. In early November he and Annie were married in the presence of just two witnesses before embarking on a leisurely tour of luxury spas in northern Italy. They arrived in Bonn just before the start of the spring term.
Schumpeter and his wife soon became the most glamorous couple in Bonn. In a typically grandiose gesture, Schumpeter rented an imposing stucco mansion overlooking the Rhine where Kaiser Wilhelm had lived as a student. By the time Annie attended her first faculty tea, Schumpeter had invented a new identity for her. Instead of a super’s daughter who had worked as a bank teller in Vienna and an au pair in Paris, he presented her as the pampered offspring of a prominent Viennese family who had been educated at an expensive French finishing school. Schumpeter’s crushing debts forced him to moonlight as a journalist and public speaker, but everyone who knew him agreed that he was happier than he had been in years. Among other things, Annie was pregnant with their first child.
The idyll was not to last. The sudden, unexpected death of his mother in mid-June was a severe blow. For most of his life, she had been “the great human factor,” and he often spoke of “his unconditional attachment to her, his unbounded confidence in her.”19 Two weeks after Schumpeter returned from her funeral in Vienna, he suffered a second horrible loss, witnessing Annie’s “terrible death” during childbirth.20 Their baby boy lived less than four hours.
The Biedermann fiasco and the loss of the only two people to whom he felt close scarred Schumpeter permanently. He would need more than a decade just to pay off his debts, and he never got an opportunity to rebuild his fortune. Half a dozen years later, Schumpeter wrote in a letter from Singapore:
There is no real liberation. I can’t get rid of bad memories and premonitions . . . mistakes, failures, hardships, etc. and the year 1924, never stand out so clearly before my eyes as when I am on a beautiful boat, seemingly comfortably safe on a still Ocean. And the feeling of decadence, intellectual and physical often condenses into direct forebodings of death.21
Yet on the future of capitalism, Schumpeter remained remarkably sanguine. Israel Kirzner, the economist, observed that the questions that drove research on business cycles in the 1920s were: Can capitalism work?22 Can an economy with private property and free markets survive? Karl Marx had believed that panics and slumps were generated by the economic system and would eventually destroy it. Alfred Marshall had taken the opposite view, attributing recessions to random shocks that originated outside the economy. Schumpeter stood Marx on his head by viewing the business cycle as intrinsic but essentially benign. As “commonly, prosperity is associated with social well-being, and recession with a falling standard of life. In our picture they are not, and there is even an implication to the contrary.”23
Despite frequent crises and depressions since 1848, he pointed out, production and living standards had risen by multiples. Growth had occurred in spurts because innovations were not “evenly distributed in time . . . but appear, if at all, discontinuously in groups or swarms.”24 Innovation bred imitators, another burst of investment, and secondary rounds of innovation. Then investment subsided and consumer goods flooded the market, driving down prices and pushing costs higher. The squeeze on profits resulted in recession.
Constant dislocations were the downside to innovation, rising productivity, and higher living standards. In Schumpeter’s theory of economic development, booms were followed by busts—“perennial gales of creative destruction”—but the economy was inherently stable. If the system was in jeopardy, the threat originated in politics. Marx and Engels saw recessions as signs of failure and sources of instability. Schumpeter took the opposite view. Since the cycle produced development, depressions were healthy, a way to drive out inefficient firms and force companies to trim costs and rationalize their operations. The death of firms and industries was as inevitable as the death of human beings. Nothing lasted, Schumpeter observed: “No therapy can permanently obstruct the great economic and social process by which businesses, individual positions, forms of life, cultural value and ideals sink in the social scale and finally disappear.” But death also made room for new life. Growth required managerial talent, labor, and other resources to be shifted from old to new industries. Thus if nations wanted progress, they had to accept slumps. Like it or not, he liked to say, “the pattern of boom and bust is the form economic development takes in the era of capitalism.”25
Innovations as huge as electricity or as small as toothbrushes are “primarily responsible” for the recurrent “prosperities” that revolutionize the economic organism and the recurrent “recessions” that are due to the “disequilibrating impact of the new products or methods.” Recessions produced enormous suffering—rising unemployment, declining wages, losses, and bankruptcies—but didn’t last long. “The phenomena felt to be unpleasant are temporary,” Schumpeter wrote, while “the stream of goods is enriched, production is partly reorganized, costs of production are diminished, and what at first appears as entrepreneurial profit finally increases the permanent real incomes of the other classes.”26 He insisted that constant change was a requirement for economic stability, just as motion is needed to keep a bicycle upright.
In Bonn, he had plunged into two separate books, cultivated a group of bright young students, written dozens of newspaper columns, and spent hundreds of hours on the lecture circuit speaking to German business groups. He had justified his compulsive activity as necessary to pay off his staggering debt but had used it as an anesthetic. The diary into which he emptied his battered heart every night was little more than a catalog of regrets and self-recrimination. Since his mother’s funeral, he had never once returned to Vienna.
In the fall of 1927—two years after the deaths of his mother and Annie—Schumpeter accepted an invitation to teach at Harvard and came to the United States for a second time. He was perhaps not as enamored as he had been in 1912, but he was stunned by American opulence, energy, and optimism. A few financial experts were warning of a speculative bubble in the stock market. In an essay written in the spring of 1928, he readily acknowledged that the boom might well be followed by a plunge in stock prices and a period of falling output and high unemployment. But he concluded, “The instabilities, which arise from the process of innovation, tend to right themselves, and do not go on accumulating.” Thus, he explained, capitalism was “economically stable, and even gaining in stability.”27
• • •
A tall, dark-haired, slightly shabby young man who vaguely resembled Leon Trotsky sat in the main reading room of the New York Public Library examining yellowed copies of the New York Times. He was looking for stories from the final months of the war about the Austro-Hungarian army. Again and again, the blue eyes behind wire-rimmed spectacles widened in surprise. How surreal to come halfway around the world only to learn that everything you thought you knew about an episode in your own life was a fiction.
As cynical as all Viennese were about the Austrian press, Friedrich von Hayek, Ludwig Wittgenstein’s cousin and a former corporal in the k.u.k. army, was shocked. Until now he had believed, as the Austrian media had claimed, that the Piave offensive was a bold strategic gamble that failed because of various blunders. It was clear from the Times account, however, that American and British war correspondents had unanimously regarded the defeat of the Austro-Hungarian forces as absolutely certain weeks before the offensive. In other words, one hundred thousand lives, of which Hayek’s might easily have been one, had been squandered for a lie.
In August 1918, Hayek had been swept along by a disintegrating army in chaotic retreat from Italy across the Alps. When he finally reached Vienna, he had given up an earlier dream of becoming a diplomat and enrolled as a law student at the University of Vienna.
He later attributed his interest in social sciences to the war and especially to the experience of serving in a multinational army. How could a society harmonize competing desires and interests without relying on military-style coercion? How could individuals with different languages, cultures, and educations communicate and agree on common actions? The dysfunctional command of the Austro-Hungarian army obviously had not found the answers, but the conduct of trench warfare had left Hayek with time to read. Among the books he read and reread were two turgid volumes on political economy.
At the University of Vienna, which hardly functioned for lack of coal, light, or food, Hayek became best friends with another veteran, a law student named Herbert Furth, who had been gravely wounded at Piave. Furth was the son of a Vienna city councilman and Austria’s first suffragette. He introduced Hayek to a sophisticated crowd of left-wing students from assimilated, relatively affluent Jewish families. Furth and his friends hung out at the Café Landtmann across from the Rathaus park and argued about Marxism and psychoanalysis. The sons of lawyers, academics, and businessmen, they struck Hayek as considerably more self-confident and cosmopolitan than other young men of his age. He recalled that “what went on in the intellectual world of France and England was to them nearly as familiar as what happened in the German-speaking world.” Through them, he discovered Bertrand Russell and H. G. Wells, Proust and Croce, and imbibed “that genuine devotion to things of the spirit need not mean being impractical in the art of getting on in life.”28
After the war, student politics at the University of Vienna was dominated by virulent Catholic nationalism and violent Communism. Hayek and Furth, who considered themselves Fabian Socialists, found both repellant. Eager to create an alternative, they organized a mildly Socialist organization, the Democratic Students Association, in their first term.
Hayek attended lectures by Friedrich von Wieser, the economist who had served as the monarchy’s last finance minister and was Austria’s most effective international spokesman. He read the work of Austrian economic thinkers such as Carl Menger and Eugen von Böhm-Bawerk. But as one might expect in a city of ten thousand coffeehouses, a severe apartment shortage, and a surplus of underemployed intellectuals, Hayek’s most important education took place in cafés among his peers. In their third year, Hayek and Furth organized a fortnightly seminar that they called the Geist-Kreis in jest. Geist can refer to the Holy Ghost or to the secular, even demonic, spirits that are channeled at séances. The group’s twenty-odd members discussed cultural topics from plays to logical positivism and included the economists Oskar Morgenstern, Gottfried Haberler, and Fritz Machlup, the philosopher Erich Voegelin, and the mathematician Karl Menger (Carl’s son), as well as historians, art historians, musicologists, and literary critics.
Hayek completed his doctor of laws degree in the spring of 1922, at the height of the hyperinflation. He immediately took a day job as a minor civil servant in the war claims settlement bureau. Like Einstein’s sinecure at the Swiss patent office, Hayek’s job was sufficiently undemanding to allow him to earn a second doctorate in political science. A friend of his commented that having one’s salary rise from 5,000 kronen to 1 million kronen in the space of nine months, as Hayek’s did, was “apt to shape a person’s mind.”29 That is probably an exaggeration, but it is safe to say his exploding paycheck and its shrinking purchasing power drew Hayek’s attention to the role of money, just as falling asleep in his desk chair at the Bern patent office had drawn Einstein’s to the theory of special relativity. Although Hayek preferred collecting old books to investing in stock certificates, he began to daydream about someday becoming president of Austria’s central bank.
Another development caught Hayek’s attention. The Bolsheviks’ “lightning socialization”30 of 1919 and the Renner government’s threat to nationalize key industries had made the most urgent questions for left-wing Viennese intellectuals: Could Socialism work? Could it deliver the goods? Was planning feasible? The German sociologist Max Weber had already weighed in with a blistering “No.”31 Foreign Minister Otto Bauer and Joseph Schumpeter both said “Yes,” the affirmative in the latter case being limited to “the right circumstances.”32
At that point, Hayek’s employer and mentor, the liberal economist Ludwig von Mises, propelled the debate to a new intellectual level. In a provocative essay, “Die Gemeinwirtschaft,” or “The Collective Economy,” Mises essentially reframed the argument by shifting its focus to information. His premise was that an economy was like a computer, a machine for solving a mathematical problem. He argued that a centrally planned economy lacked the necessary data to reduce the number of unknowns to the number of equations and, therefore, lacked the means to calculate prices that brought supply and demand into balance.
Mises allowed that planners could draw up a list of consumer goods and services. But, he asked, then what? How will the authorities assure themselves that the value of, say, an automobile to consumers will equal or exceed the value of the labor, steel, rubber, and other resources that must be sacrificed to produce it? How will they know that the car will be worth more to consumers than the bus that could have been made with those same resources?
To make such calculations in a market economy, Mises said, individual businesses and consumers use price data. Take the question of whether the cost of making the car is more or less than the amount consumers are willing to spend on it. To figure the cost, add up the hours of labor, pounds of steel and rubber, marketing, distribution, and other inputs, multiply by their prices, and add everything up. To figure the value the consumer places on it, take the selling price and multiply by one for one car. Does it make sense to produce cars? If your cost is less than your revenue, you can keep on making them. If it costs more to make them than people are willing to pay, you’ll have to reconsider.
The trouble with substituting planners for markets, Mises argued, is that without markets there are no longer market prices to use for making your calculation. Can’t you just make some up? Sure, but if no one was producing for, or buying in, markets, they wouldn’t be market prices. They wouldn’t reflect the subjective preferences of the consumers who are demanding a good or the calculations of the businesses deciding whether to supply the good—in real time too. They wouldn’t give you the information you need to make a rational decision. You’d have no way of knowing whether you were making the most of your resources or squandering them heedlessly.
The debate over socialization and von Mises’s notion of markets as calculators and transmitters of information made an enormous impression on Hayek. It inspired him to write a paper on government rent control. For many families, the severe shortage of housing, another residual of the war, was becoming as pressing a problem as the lack of food or jobs. In 1922, the Social Democrats decided to fix rents at four times the prewar level. Since the consumer price index had risen 110-fold since January 1921, the city council was unwittingly decreeing a virtual rent holiday. As a strategy for ending the housing shortage, it was bizarre. As soon as the controls took effect, new construction ceased, existing buildings became more dilapidated, and overcrowding and homelessness grew worse. Intended to protect the poor, the policy blunder kept people from moving, created more inequality, and reduced the savings available for investment.33
Hayek jumped at a chance to spend the academic year 1923–24 at New York University in Greenwich Village as a research assistant to Jeremiah Whipple Jenks, a currency expert on the Allied Reparation Commission whose manners and appearance had confirmed Beatrice Webb’s prejudices about Americans. When Hayek arrived in New York with only a few dollars in his pocket, he was aghast to learn that Jenks had gone off to Cornell, where he held a second professorship.
Jenks returned in the nick of time to save Hayek from having to work as a dishwasher at a Sixth Avenue diner. Apart from collecting data for Jenks, Hayek took classes at NYU, started writing a book on how capital goods such as machinery and factory buildings were priced, and finished a long article analyzing
the performance of the decade-old Federal Reserve. He met with Irving Fisher, for whom Schumpeter had supplied a letter of introduction. He also crashed the lectures by Wesley C. Mitchell and John Bates Clark at Columbia, the leading center of American research on business cycles.
Hayek’s main motive for coming to New York was to learn as much as he could about American thinking about booms and depressions. He was less interested in pursuing the abstract question of whether capitalism could work than in finding out whether economic forecasting could. Was it possible to predict how output or prices would behave six months or a year hence—that is, accurately enough to allow monetary authorities to head off incipient inflations or deflations ahead of time? They were not purely academic questions on Hayek’s part. Von Mises, who had recommended him to Jenks, had been talking to Hayek about starting a program of business cycle research and producing economic forecasts at the Vienna Chamber of Commerce.
Hayek would have welcomed the chance to stay in New York for a second year, but by the time the Rockefeller Foundation informed him that its trustees had renewed his grant, he was already sailing back to Europe. By the end of May 1924, he was back in Vienna at his dull job at the reparations office, unhappy and depressed. Before leaving, he had fallen in love with his cousin Helene Bitterlich, who worked in the office as a secretary. He had almost asked her to become engaged to him before he left for New York, but in the end had not. He was furious with himself. In his absence she had married another man.
His spirits were lifted by an invitation from Mises to join his private seminar, “the most important center of economic discussion in Vienna and perhaps in Continental Europe.” Along with a dozen or so former members of the Geist-Kreis, the group included the economist Steffi Braun, the philosophers Felix Kaufman, Alfred Schutz, and Fritz Schreier, and the historian Friedrich Engel-Janosi. The first paper Hayek delivered at the seminar was on his analysis of rent control in Vienna.