The chief economics commentator of the Financial Times, Martin Wolf, recently created a new forum to discuss economic issues--the Wolf Exchange. Interestingly, he chose as his first subject Austrian economics. The timing of this discussion is related to recent events, namely "Does Austrian economics understand financial crises better than other schools of thought?"Several have commented upon the failure of mainstream macroeconomics in identifying the underlying financial imbalances that led to the global financial crisis of the late 2000s, as discussed in a recent post. Wolf makes a similar observation, pointing to some of the strengths of the Austrian approach:
"some would argue that economists working in the Austrian tradition were more nearly right than anybody else. In particular, they have argued that: inflation-targeting is inherently destabilising; that fractional reserve banking creates unmanageable credit booms; and that the resulting global 'malinvestment' explains the subsequent financial crash. I have sympathy with this point of view."The Austrian theory of the business cycle is, as pointed out by Austrian "macroeconomist" Roger Garrison, primarily a theory of the turning point in the cycle, and not a theory of the duration or severity of the downturn that follows. However, the latter is what mainstream economists tend to focus upon. During the depression of the 1930s, the views of British economist John Maynard Keynes were saluted largely because he seemed to present a recipe for how the government could stimulate the economy out of the downturn, whereas Austrian economist Friedrich Hayek was primarily known for his ability to both predict and immediately explain the initial downturn. Martin Wolf acknowledges this insight into the original causes of economic busts, but is less sympathetic to what he perceives as the Austrian policy prescription during a severe economic crisis:
"But Austrians also say - as their predecessors said in the 1930s - that the right response is to let everything rotten be liquidated, while continuing to balance the budget as the economy implodes. I find this unconvincing. Mass bankruptcy is extremely costly. Moreover, it is impossible to separate what is healthy from what is unhealthy during a general economic collapse triggered by an implosion of the financial system."This, however, is a somewhat misguided assessment of the Austrian position. The Austrian theory of the business cycle (ATBC) doesn't specify how the government should respond to a severe crisis like the one witnessed in the 1930s or the one witnessed during the last couple of years. ATBC is, as mentioned, primarily an explanation of the original causes of the economic bust. However, the theory has some implications for the efficacy of "counter-cyclical" measures. Furthermore, strong policy implications can be extracted from Austrian monetary theory. It should also be noted that most financial historians today think that the micro-interventions of the Roosevelt administration and its New Deal had catastrophic effects on the economy, and that the wave of protectionist measures following in the trail of the misguided Smoot-Hawley tariff of 1930 only led to a severe contraction in global output as international trade shrank by around 2/3. As to macroeconomic policy, both the Hoover and Roosevelt administration at times conducted contractionary fiscal policy, and the Federal Reserve managed to conduct contractionary monetary policy both in the early 1930s and again in 1936-37. When it comes to the belief in contercyclical policy, in contrast to Keynesian or New Keynesian theory, the Austrian view does imply that the economic crisis following a financial bust necessarily contains a significant structural component in that resources were misallocated during the boom phase. Thus the economic crisis we are now witnessing is, according to this view, in large part a structural crisis. Such a crisis could very well lead to a significant upward shift in the structural unemployment rate, so that attempts at driving down the unemployment rate through Keynesian counter-cyclical policies (monetary and/or fiscal stimulus) would prove elusive in achieving the government's goal of alleviating the unemployment problem. The current unemployment rate in the United States stands around 10 percent, and according to the most wide definition (adding in people who involuntarily work part time and others who seem to have "dropped out" of the labor market), the unemployment rate could be as high as 17 percent. The administration's diagnosis of the situation, as laid out by its top economic advisor Christina Romer, is that the unemployment problem is cyclical, resulting from too little demand:
"The overwhelming weight of the evidence is that the current very high—and very disturbing—levels of overall and long-term unemployment are not a separate, structural problem, but largely a cyclical one."George Mason economist Tyler Cowen has commented upon recent developments and points to several factors that would seem to contradict Romer's view:
"I would start with the fact that output has bounced back more robustly than employment has. [Keynesian aggregate demand] theories per se do not explain that differential."He adds:
"I also see that wages, and the job market, are more flexible today than in a long time, with so much service sector employment, so much flex-time and part-time, and such a low rate of unionization. In most AD theories that implies the job market bounces back relatively quickly yet that is not what we observe."Paul Krugman responded to Wolf's debate by writing a short piece on Austrian economics in the New York Times, making the question of unemployment the center-piece of his critical stance towards the Austrian perspective. Unfortuntaely, and not for the first time, Krugman seem to express strong views on something which he has hardly spent any time researching:
"My view is that the fatal flaw in Austrian economics is that it can’t explain unemployment — or, worse, that it thinks that it can explain unemployment, but is deluding itself. The Austrian view is that unemployment in a slump results from the difficulty of “adaptation of the structure of production” — workers are unemployed as resources are painfully transferred out of an overblown investment-goods sector back into production of consumption goods. [...] But this immediately raises the question, why isn’t there similar unemployment during the boom, as workers are transferred into investment goods production?"Posing this very question suggests that Krugman is somewhat unaware of the significance of structural crises. Keynesians tend to see crises as a result of cyclical forces, i.e., resulting from a fall in aggregate demand. However, structural crises arise as a result of misallocation of resources in the years preceding the turning point of the business cycle. This misallocation could take place over a long span of time, as, for instance, the resources that went into housing and the financial services industry during the last two decades. It should be obvious that these resources can't be shifted back into other lines of production overnight. Workers acquire skills that are specific to certain kinds of work. Some skills are more flexible than others. For instance, someone who is laid off from the financial services industry most likely will find some other sector to work in. But that would require some job-searching as well as a willingness to work for less pay. An auto factory worker or a construction worker, on the other hand, could find it hard to readjust when the auto or construction industry no longer can employ him or her. Also, in contrast to mainstream macroeconomic theory, Austrians emphasize the heterogeneous nature of capital once it has been invested into physical capital goods. Some of the capital that was misplaced during the boom will simply be wasted, whereas other capital has to find new uses. This could take time. Third, businesses will be reluctant to borrow, invest and expand by taking on more workers when times are uncertain. Thus, there is of course also a cyclical component to the crisis. However, it still does not follow that counter-cyclical measures would work. In the aftermath of a serious financial crisis banks need to strengthen their balance sheets and solidify. Overleveraged businesses and households need to strengthen their financial positions as well. In fact, these are very real economic problems, stemming from real economic imbalances during the boom years. So here too, we see that a financial boom and bust involves more than just a cyclical component. The real imbalances of savings, investment and consumption need to be unwound. This can only happen through a painful rebalancing of the economy, in which the growth rate is much weaker than during the "good times" in the period before the crisis, i.e. the 1990s and 2000s. We should therefore expect recovery to be slow and the growth potential to be less during the coming decade. Still, Austrians acknowledge the existence of cyclical problems stemming from both the expansion and contraction phase of the business cycle. The contraction of money during the bust phase creates a coordination problem throughout the economy, as all relative prices need to shift. This will create temporal cyclical unemployment in addition to the structural unemployment caused by the former misallocation of resources. Krugman is thus incorrect in his description of the Austrian position on unemployment, and is in addition unable to see the need to broaden the story, as the Austrian business cycle theory would imply, to include rising structural unemployment as well. Martin Wolf, on the other hand, seem to be better informed on the Austrian positions, and even more so in the wake of his online debate, which he concludes as follows:
"I have found this first debate encouraging and thought-provoking: encouraging because it was courteous and thought-provoking because points were made that I had not considered. [...] I am encouraged by this to try to work out for myself what the 'Austrian model' of the business cycle looks like and present it to my readers. I think there are important aspects of this way of thinking with which I agree: first, credit and debt are hugely important; second, money is decidedly non-neutral; and, third, among the important distortions created by these first two facts is mistaken investment plans. What is not clear, however, is how far this set of ideas diverges usefully from those of Minsky (to which I am even more sympathetic)."(The perspective on financial crises developed by Post-Keynesian economist Hyman Minsky, and how his "financial instability hypothesis" differs from the Austrian theory of the business cycle, as developed by Austrian economists Ludwig von Mises and Friedrich Hayek, will be discussed in a later post.) Wolf rounds it off with more critique of what he perceives as the Austrian policy prescriptions during a severe crisis. However, as mentioned, this is not clear from the Austrian business cycle theory, and Austrians differ in their views. There is however a strong policy prescription implied in the Austrian monetary theory, namely to stabilize the annual flow of money--what in modern parlance would be referred to as nominal spending, or money (M) times the velocity of money (V). As discussed in a commentary on Austrian economics and the current crisis, Hayek did in fact prescribe a stabilization of nominal spending in the 1930s, something which, most likely, would have prevented the economic downturn from turning into a Great Depression (given that the manifold other policy mistakes made by the Hoover and Roosevelt administrations had not taken place). There is every reason to believe there would still have been a Great Recession (as the recent economic downturn has been dubbed by economists) and most likely a painful structural crisis, given the magnitude of real and financial imbalances that emerged during and after World War I.Marius Gustavson is a Sound Money Fellow at the Atlas Economic Research Foundation and an Economic Policy Research Fellow at the Reason Foundation.