The recent financial crisis has called into question several basic tenets of mainstream macroeconomics. In the words of William White, former chief economist of the Bank for International Settlements (BIS), “the prevailing paradigm of macroeconomics allows no room for crises of the sort we are experiencing.”
White and his BIS colleagues were among the few economists within the mainstream institutional orbit who warned of the unsustainable financial imbalances building up in the United States and elsewhere in the global economy during the 2000s. Among the leading indicators of these imbalances were rapid credit growth, unsustainable debt levels, and asset prices diverging strongly from historical trends.
In addressing the shortcomings of mainstream macro, White advocates drawing upon “Austrian” insights in order to change the way economists think about real and financial imbalances in the economy.
“Austrian” economics refers to the school of thought established by the Austrian economist Carl Menger in the 1870s, and further developed by his intellectual successors Eugen von Böhm-Bawerk, Ludwig von Mises and Friedrich Hayek.
In the postwar era, this school of thought has mainly been located in the United States, centered on economists such as Murray Rothbard and Israel Kirzner. The two main centers of Austrian economics today are the economics department at George Mason University in Fairfax, Virginia (where the Austrian research program is led by economist Peter J. Boettke), and the Mises Institute in Auburn, Alabama (led by Lew Rockwell). The Foundation for Economic Education, in Irvington, New York (soon to move to Atlanta, Georgia) is another organization dedicated to disseminating Austrian economic thought.
Austrian and mainstream economics differ greatly in explaining booms and busts in the economy. Austrians emphasize monetary disequilibrium in the boom phase–a central bank keeping interest rates lower than the “natural” rate of interest that would prevail in a free financial system without central bank tinkering with money. Mainstream macroeconomists tend to focus instead on what the government should do in response to crises after they occurr. They also typically don’t see any role for monetary policy in curbing asset booms, as their models lead them to believe that the economy is on a sustainable path as long as prices are “stable”– i.e. as long as there is moderate and constant year-on-year consumer price inflation (typically 2 percent per year)–and output grows at the assumed optimal rate (a highly hypothetical construct that according to this view also implies that unemployment is at its optimal level).
An informative description and discussion of the mainstream approach can be found in a recent paper by the chief economist of the International Monetary Fund, Olivier Blanchard. Here he writes:
“[W]e thought of monetary policy as having one target, inflation, and one instrument, the policy rate. So long as inflation was stable, the output gap was likely to be small and stable and monetary policy did its job.” (Emphasis added.)
Thus, “Stable and low inflation was presented as the primary, if not exclusive, mandate of central banks.” I have previously commented upon the short-comings of this line of thought, as represented by Blanchard, one of our times leading macroeconomics textbook authors and New Keynesian economists.
Mainstream macroeconomics stands in stark contrast to the Austrian approach. As explained by White:
“In contrast to the Keynesian framework, Austrian theory assigns critical importance to how the creation of money and credit by the financial system can often lead to cumulative imbalances over time. These imbalances, which ultimately come down to investments that do not end up profitable, eventually implode in the context of an economic crisis of some sort. In today’s terms, unusually rapid monetary and credit growth over the past decade or so led to asset price increases that seemed to have little to do with fundamentals. It also led to spending much higher than historical norms.”
Austrians accuse mainstream economists of what could be called aggregate myopia, namely that they do not pay close enough attention to what is really going on in the economy at the micro level. The Austrians find that low interest rates lead to economy-wide distortions and the misallocation of resources, led on by false price signals.
Whereas mainstream economists treat financial crises as something external, shocking the otherwise assumed healthy state of the economy, Austrians look upon how monetary disequilibrium leads to real (and financial) imbalances that eventually need to be unwound in a bust phase. Thus White criticizes the mainstream for not understanding the true importance of economic imbalances:
“One tendency that must be resisted is to see this work on imbalances as related solely to ‘financial stability.’ In part, this tendency is related to the misconception that our current problems are limited to those of a financial crisis. Rather, an important aspect of the issue is how excessive credit and monetary creation can lead to imbalances outside the financial system, with significant macroeconomic implications.”
Mainstream economists, in other words, treat financial crises as some unfortunate incident that hurts the “real” economy, and that must be addressed through “counter-cyclical” policies. However, if the true problems are economy-wide imbalances built up in the boom phase, these Keynesian remedies simply won’t work. What is needed is a significant restructuring and rebalancing of the economy. Thus the Austrians also have a strongly divergent view of the bust phase, i.e. the downturn, of the business cycle.
Since resources were misplaced during the boom phase, they need to shift during the bust phase and the recession that follows. Any attempts at stopping this process from taking place by helping sectors in distress would only prolong the necessary restructuring of the economy, thus dragging out the economic woes of the country. Also, the imbalances of too high consumption, too little saving, too much debt, malinvestment, and unsustainably high asset prices need to rebalance for the economy to return to a healthy state. Government programs to prop up asset prices, such as the current Fed purchase of $1.25 trillion in mortgage-backed securities, and the administration’s mortgage-relief programs, could at best be a temporary relief, but in the end only push the necessary corrections forward in time, thus preventing the imbalances from unwinding in the short run.
The policy implications of the Austrian understanding of the boom-bust cycle has led to accusations of “liquidationism,” i.e. that Austrians think it is a good thing that many companies and investments are liquidated in an economic downturn, a view of the Austrian position popularized by economist J. Bradford DeLong (1991).
This critique, however, is based upon a wrongful understanding of what the Austrians are saying. They lament the bankruptcy of firms during the economic hard times that follow an unsustainable boom, but if a company is insolvent it should be allowed to go under (including financial firms), thus freeing up resources which can be utilized somewhere else in the economy. As explained by Austrian business cycle theorist Roger W. Garrison:
“For the Austrians, the liquidation that is essential to the economy’s recovery is the liquidation of the malinvestments. Resources need to be reallocated. Hence, any government spending program that serves to rekindle the housing boom or even to keep resources from leaving the housing industry is counterproductive. It locks in the misallocated resources.”
However, economic busts could also lead otherwise solvent companies into bankruptcy as happened in the 1930s, due to a major contraction in the circulating money supply. Hayek referred to this as a “secondary contraction.” Garrison describes such a detrimental development as “a selfreinforcing spiraling downward of economic activity that causes the recession to be deeper and/or longer-lasting than is implied by the needed liquidation of the malinvestment.”
In DeLong’s view, the Fed did nothing to stop the contraction during the early 1930s because it relied upon the “liquidationist” views of economists such as Hayek. However, this is hardly historically correct. There is no record of Fed officials referring to Hayek or any other Austrian during this period. In fact, Hayek’s first English publication on the business cycle (Prices and Production) came in 1931 and could hardly have influenced the actions of the administration or the Fed during the presidency of Herbert Hoover (who left office in early 1933) as DeLong claims. Rather, the Fed was informed by an antiquated monetary theory called the “real bills doctrine,” a current of monetary thought that the Austrians opposed.
Furthermore, Hayek, far from advocating a “do nothing” policy or “liquidation” in the face of such a contraction, actually called for the central bank to stabilize the circulating money supply, an important point discussed at length by George Mason University economist Lawrence H. White in a paper on Hayek and the Great Depression. (Unfortunately, this policy prescription was only clearly formulated later on in the 1930s, but is implied by the monetary theories of the Austrians preceding the depression.)
Though Hayek’s policy prescription would be for the Fed, or any other central bank, to stabilize the circulation of money in the face of a severe credit contraction, as the one witnessed in the 1930s and again in the late 2000s, the main message of the Austrians could be summed up in the phrase “the best way to stay out of trouble is not to get into it in the first place.” In other words, the best way to avoid a financial crisis and depression-like downturn, as the one we’re experiencing right now, is to avoid financial imbalances from building up in the boom phase. And the best way to address these imbalances is to stop manipulating interest rates below the market equilibrium rate.
This should be the main monetary lesson of the current economic calamity. There are of course other important lessons to be drawn as well, lessons to which Austrian insights turn out to be equally instructive.
The government should stop encouraging and stimulating investment in housing and housing-related securities through preferential tax treatment (interest rate deductions on mortgages and preferential treatment of capital gains from investment in housing), through government-mandated buyers of mortgages in the secondary market (Fannie Mae and Freddie Mac) and by preferential treatment of mortgage-backed securities in the regulatory standards for capital ratios (the Basel rules). The bipartisan political quest to drive up the U.S. homeownership rate only leads to misallocation of capital: too much credit flows into housing and housing-related investments.
The government, notably the central bank (Fed) and the fiscal authorities (Treasury), should stop bailing out the financial sector whenever it runs into trouble. This only creates moral hazard, systemic under-pricing of risk, and the build-up of financial fragility–eventually creating huge distortions and potential pitfalls that materialize in a credit crisis, thus amplifying the boom-bust cycle.
Austrian economists (and other free market economists) greatly emphasize the role of the market as a profit-loss system, not a “coins, we win; heads, the tax-payers lose”-system, as seems to be the characteristic of the U.S. financial sector. The economic signals of profit and loss are central to the market mechanism. Take out the loss part, and you create destructive distortions and perverse incentives.
The government should adopt a more realistic view on what can be achieved through regulation. Often regulation designed to be foolproof, turn out to create unintended consequences. The market works best if there is a certain degree of market discipline, i.e. market participants monitoring counterparties for risk and punishing imprudent players through higher risk premiums or denied access to credit. Centrally set and supervised regulation tends to replace this market discipline with a reliance on arbitrary standards (as succinctly pointed out by Jeffrey Friedman in the essay A Crisis of Politics not Economics: Complexity, Ignorance and Policy Failure, emphasizing a somewhat Hayekian theme).
A point in case is the above-mentioned international rules for capital ratios–the so-called Basel rules. These were risk-weighted in an attempt to establish a benchmark for how much capital was required for financial firms to keep different kinds of assets in their portfolios. The rules deemed that mortgage-backed securities (MBS), given an “investment-grade” by the three U.S. government mandated rating agencies, were much safer than holding the underlying mortgages. The amount of capital required for MBSs were half of the capital required to hold actual mortgages. Thus commercial banks filled their portfolios with MBSs. When the crisis hit, it turned out that risk was actually concentrated in the banking system (and not spread, as regulators and market participants originally believed). When housing prices flattened and then started to fall and foreclosure rates started to rise in 2006-2007, this led to a rapid deterioration of these banks balance sheets.
This is of course only one example of unintended consequences related to regulations and policies in the years leading up to the recent financial crisis. The story of unintended consequences should be familiar to anyone acquainted with Austrian economics. Austrians hold that society is complex, the future uncertain, and that knowledge is limited. There is thus ample room for mistakes, both amongst government regulators and policymakers as well as market participants.
There are however some pronounced differences between the political arena and the market place. The market, though never perfect, has a built-in mechanism for detecting and correcting mistakes over time, namely price signals and the signals of profit and loss. The political process lacks these signals and political actors face a different set of incentives, which means that politics often leads to outcomes which are not socially desirable.
The main strength of Austrian economics is that it adapts a more realistic understanding of how real markets work and the limitations of human knowledge. Such an understanding leads one to a more sober view of what can be achieved through politics and regulations. It also leads to a better understanding of the central importance of market signals and how they need to operate with as little distortion as possible.