Wednesday, January 11, 2012

The Economist Magazine on Austrian Economics

Last Saturday, I wrote about an Economist magazine article discussing alternative--what they call heterodox--macroeconomic policy frameworks. I explained how its treatment of nominal GDP targeting was somewhat wanting.

The Economist writers are not much better when they turn to the efficacy of Austrian economics.
Austrians still struggle, however, to get published in the principal economics journals. Most economists do not share their admiration for the gold standard, which did not prevent severe booms and busts even in its heyday. And their theory of the business cycle has won few mainstream converts. According to Leland Yeager, a fellow-traveller of the Austrian school who once held the Mises chair at Auburn, it is “an embarrassing excrescence” that detracts from the Austrians’ other ideas. While it provides insights into booms and their ending, it fails to explain why things must end quite so badly, or how to escape when they do. Low interest rates no doubt helped to inflate America’s housing bubble. But this malinvestment cannot explain why 21.8m Americans remain unemployed or underemployed five years after the housing boom peaked. 

There is much in the above that needs response. In the first place, there a number of reasons why many economists do not admire the gold standard. One is that it places constraints on what monetary authorities and bankers can do and thereby refuses to nurse their hubris. Professional economists are a lot like politicians in this regard. They cannot abide being told that their monetary intervention is worse than useless.

Additionally, many are under the impression that the gold standard caused and/or prolonged the Great Depression. This fallacy has been ably responded to by Joseph Salerno in his essay, "The Role of Gold in the Great Depression: A Critique of Monetarists and Keynesians," Chapter 27 of his fantastic Money Sound and Unsound. On the question of the gold standard and the Great Depression, I also recommend Chapter 3 of Banking and the Business Cycle published in 1937 and written by C. A. Phillips, T. F. McManus, and R. W. Nelson.

Those economists who blame the gold standard misconstrue its true nature and consequences. It is more accurate to say that the Great Depression was made possible by leaving the classical gold standard during the First World War. The reason there were crises even under the gold standard is because either the monetary system was merely a pseudo-gold standard, or authorities allowed the issue of fiduciary money via fractional reserve banking.

I would also suggest that Austrian business cycle theory has won more converts than the Economist may think, but they may come more from financial practitioners than academic economists. Financial practitioners actually need to know the way things really work for them to avoid losing money. On the other hand if Krugman, Sumner, or J. Bradford DeLong make a wrong public pronouncement due to operating in a faulty economic framework, it does not cost them much personally. Additionally, academic economists have a lot invested in the economic framework they learned from their graduate school mother’s knee, so to speak. It takes much intellectual fortitude for someone to walk away from the framework in which they were trained.

Because Austrian business cycle theory is primarily a theory of just that--business cycles, it necessarily is primarily concerned with features that are common to all cycles. It should not surprise us that it neither exclusively nor chiefly explains why a particular downturn can be so bad. However, to say that Austrian theory does not concentrate on those issues is not to say that it is silent.

The answer to questions such as why some downturns are so bad and what should we do to get out of recessions after they have happened are implied by the theory itself. Once it is understood that recessions are due to malinvestment undertaken by artificially low monetary interest rates, and that a well-coordinated capital structure depends on free markets with flexible prices, the answers become apparent. Particular recessions can be very bad if there has been a tremendous amount of malinvestment resulting in a tremendous amount of capital consumption during the boom. They can be exacerbated if the government consumes even more capital via fiscal stimulus or if its central bank intervenes in the market and seeks to keep interest rates artificially low.

Contrary to what the Economist implies, Austrian theorists have written much about the best policy to undertake to get out of recessions. In 1931 Mises explained what to do to get out of the Great Depression:
All attempts to emerge from the crisis by new interventionist measures are completely misguided. There is only one way out of the crisis: Forgo every attempt to prevent the impact of market prices on production. Give up the pursuit of policies which seek to establish interest rates, wage rates and commodity prices different from those the market indicates. This may contradict the prevailing view. It certainly is not popular. Today all governments and political parties have full confidence in interventionism and it is not likely that they will abandon their program. However, it is perhaps not too optimistic to assume that those governments and parties whose policies have led to this crisis will some day disappear from the stage and make way for men whose economic program leads, not to destruction and chaos, but to economic development and progress (The Causes of the Economic Crisis, pp. 180-81).
Although written in 1931, the above remains as timely as today's headlines.
In 1963 Rothbard likewise explained:

If government wishes to see a depression ended as quickly as possible, and the economy returned to normal prosperity, what course should it adopt? The first and clearest injunction is: don’t interfere with the market’s adjustment process. The more the government intervenes to delay the market’s adjustment, the longer and more grueling the depression will be, and the more difficult will be the road to complete recovery. Government hampering aggravates and perpetuates the depression (America's Great Depression, p. 19).

Rothbard concluded that,
In sum, the proper governmental policy in a depression is strict laissez-faire, including stringent budget slashing, and coupled perhaps with positive encouragement for credit contraction. For decades such a program has been labelled “ignorant,” “reactionary,” or “Neanderthal” by conventional economists. On the contrary, it is the policy clearly dictated by economic science to those who wish to end the depression as quickly and as cleanly as possible (America's Great Depression, p. 22-23)
More recently Jesus Heurta de Soto, when discussing what to do after an economic downturn to avoid a secondary depression also advocates freeing the market.
[T]he only effective policy for avoiding a “secondary depression,” or for preventing the severity of one, is to broadly liberalize markets and resist the temptation of credit expansion policies. Any policy which tends to keep wages high and make markets rigid should be abandoned. These policies would only make the readjustment process longer and more painful, even to the point of making it politically unbearable (Money, Bank Credit, and Economic Cycles, p. 453).
Writing just last June, Frank Shostak gave the following advice about what is the best fiscal policy to deal with our recession:
We suggest that the focus should be, not the fiscal deficit as such, but curbing government outlays. Cutting government is the best policy for normalizing the economy, and it must be implemented as soon as possible.
Commenting in November on the troubles in the Eurozone, Shostak had this to say:
Again, we maintain that the present crisis is due to past and present loose monetary and fiscal policies. We also suggest that, given the severity of the crisis, this raises the likelihood that the pool of real savings is badly damaged. This means that to fix the eurozone problem what is needed is to address the factors that undermine this pool.
So, any policy that endorses a tighter monetary and fiscal stance will lay the necessary foundation for a buildup of capital and will set in motion a solid economic expansion. Obviously a tighter stance will wipe out various bubble activities that have emerged on the back of loose policies.
The bottom line is that Austrian economics has much to say about what policies are best for recovering from a recession. Sustainable recovery requires the capital structure to be realigned according to the wishes of people in society. Unprofitable investments must be allowed to be liquidated. Unwise entrepreneurs must be allowed to go bankrupt, so that what productive assets are in the economy will be obtained by more productive entrepreneurs who can then direct those resources toward more productive uses. Relatively smooth readjustments require markets to be a free and flexible as possible. Impediments to such adjustments, such as minimum wage laws and unemployment insurance and uncertainty regarding future levels of regulation regarding things like health care, help explain why the current rate of unemployment is still quite high.

Sadly, the Economist also cannot help itself from citing Austrian economics' to most unhelpful critics.
As for the Austrians, Brad DeLong, a Keynesian Berkeley professor who also blogs, has called an acquaintance with their ideas a useful part of a diversified intellectual portfolio. But his frequent comrade in arms, Mr Krugman, does not seem to have revised his view that their business-cycle theory is “as worthy of serious study as the phlogiston theory of fire”.
If Austrian business cycle theory is the intellectual equivalent of the phlogiston theory of fire, perhaps its is time to revisit theory of pyrotechnics. In point of fact, Austrian Business Cycle Theorists are the only academic tradition of economists who actually identified the housing bubble and correctly predicted the Great Recession.

Soundness of ideas is not established by popular opinion. Truth is not determined by majority vote. If a theory is right, it is right regardless of whether Krugman or DeLong (or anyone else for that matter) pay it any heed. Krugman’s and  DeLong’s criticisms of Austrian Business Cycle continue to be weak because they continue to demonstrate that they are not well-enough acquainted with the theory. Sometimes their writing suggest that they are willfully ignorant. 

Some people think that internal logical consistency is an important test for economic theory. Others identify the ability to predict well as the criteria for good economic science. Still others require a theory that is realistic and relevant for the world in which we actually live. Austrian economics meets all of these criteria. Precisely because it is derived from the premise that humans engage in purposeful behavior, it is realistic, internally consistent, and has demonstrated better predictive power than its alternatives.

Austrian economics, in the Misesian causal-realist tradition, is the economic framework that is most compatible with the nature of man and the created order. It is, therefore, the economic framework best suited for analyzing economic problems such as what caused and what can get us out of our economic mess.


  1. Re: "On the other hand if Krugman, Sumner, or J. Bradford DeLong make a wrong public pronouncement due to operating in a faulty economic framework, it does not cost them much personally."

    It doesn't? Yes it does. It costs me an immense amount. The costs are in other things rather than money, true--but if I were playing this game for money I would not be here, now, looking out at the Golden Gate Bridge; I would be at 57th and Park running Euro breakup scenarios...


    Brad DeLong

  2. @ brad,

    Well it is true that costs are subjective, however, I think it highly unlikely that your personal career would be much different if you suddenly embraced, say, real business cycle theory by converting to strong rational expectations. I don't think you would lose your job or be harmed in situation in life. You would still teach your classes, get published, and maintain your social positions.