reflects an a priori commitment to laissez-faire

TO BE NOTED: From John Quiggan:

"Austrian Business Cycle Theory

By jquiggin | May 3, 2009

I’ve long promised a post on Austrian Business Cycle Theory, and here it is. For those who would rather get straight to the conclusion, it’s one I share in broad terms with most of the mainstream economists who’ve looked at the theory, from Tyler Cowen, Bryan Caplan and Gordon Tullock at the libertarian/Chicago end of the spectrum to Keynesians like Paul Krugman and Brad DeLong.

To sum up, although the Austrian School was at the forefront of business cycle theory in the 1920s, it hasn’t developed in any positive way since then. The central idea of the credit cycle is an important one, particularly as it applies to the business cycle in the presence of a largely unregulated financial system. But the Austrians balked at the interventionist implications of their own position, and failed to engage seriously with Keynesian ideas.

The result (like orthodox Marxism) is a research program that was active and progressive a century or so ago but has now become an ossified dogma. Like all such dogmatic orthodoxies, it provides believers with the illusion of a complete explanation but cease to respond in a progressive way to empirical violations of its predictions or to theoretical objections. To the extent that anything positive remains, it is likely to be developed by non-Austrians such as the post-Keynesian followers of Hyman Minsky.

First, some history and data. Austrian Business Cycle Theory was developed in the first quarter of the 20th century, mostly by Mises and Hayek, with some later contributions by Schumpeter. The data Mises and Hayek had to work on was that of that of the business cycle that emerged with industrial capitalism at the beginning of the 19th century and continued with varying amplitude throughout that century. In particular, it’s important to note that the business cycle they tried to explain predated both central banking in the modern sense of the term and the 20th century growth of the state. The case of the US is of particular interest since the business cycle coincided with a wide range of monetary and banking systems: from national bank to free banking, and including a gold standard, bimetallism and non-convertible paper money.

This NBER data goes back to 1857, but there was nothing new about the business cycle then (Marx, for example, had been writing about it for a decade or more). The US experienced serious “panics”, as they were then called in 1796-97, 1819 and 1837 [1] as well as milder fluctuations associated with the British crises of the 1820s and 1840s.

The typical crisis of the 19th century, like the current crisis, began with bank failures caused by the sudden burst of a speculative boom and then spread to the real economy, with the contraction phase typically lasting from one to five years. By contrast, recessions since 1945 have generally lasted less than a year, and have mostly been produced by real shocks or by contractionary monetary and fiscal policy.

According to the theory, the business cycle unfolds in the following way. The money supply expands either because of an inflow of gold, printing of fiat money or financial innovations that increase the ratio of the effective money supply to the monetary base. The result is lower interest rates. Low interest rates tend to stimulate borrowing from the banking system. This in turn leads to an unsustainable boom during which the artificially stimulated borrowing seeks out diminishing investment opportunities. This boom results in widespread malinvestments, causing capital resources to be misallocated into areas that would not attract investment if price signals were not distorted. A correction or credit crunch occurs when credit creation cannot be sustained. Markets finally clear, causing resources to be reallocated back towards more efficient uses.

At the time it was put forward, the Mises-Hayek business cycle theory was actually a pretty big theoretical advance. The main competitors were the orthodox defenders of Says Law, who denied that a business cycle was possible (unemployment being attributed to unions or government-imposed minumum wages), and the Marxists who offered a model of catastrophic crisis driven by the declining rate of profit.

Both Marxism and classical economics were characterized by the assumption that money is neutral, a ‘veil’ over real transactions. On the classical theory, if the quantity of money suddenly doubled, with no change in the real productive capacity of the economy, prices and wages would rise rapidly. Once the price level had doubled the previous equilibrium would be restored. Says Law (every offer to supply a good service implies a demand to buy some other good or service) which is obviously true in a barter economy, was assumed to hold also for a money economy, and therefore to ensure that equilibrium involved full employment

The Austrians were the first to offer a good reason for the non-neutrality of money. Expansion of the money supply will lower (short-term) interest rates and therefore make investments more attractive.

There’s an obvious implication about the (sub)optimality of market outcomes here, though more obvious to a generation of economists for whom arguments about rational expectations are second nature than it was 100 years ago. If investors correctly anticipate that a decline in interest rates will be temporary, they won’t evaluate long-term investments on the basis of current rates. So, the Austrian story requires either a failure of rational expectations, or a capital market failure that means that individuals rationally choose to make ‘bad’ investments on the assumption that someone else will bear the cost. And if either of these conditions apply, there’s no reason to think that market outcomes will be optimal in general.

A closely related point is that, unless Say’s Law is violated, the Austrian model implies that consumption should be negatively correlated with investment over the business cycle, whereas in fact the opposite is true. To the extent that booms are driven by mistaken beliefs that investments have become more profitable, they are typically characterized by high, not low, consumption.

Finally, the Austrian theory didn’t say much about labour markets, but for most people, unemployment is what makes the business cycle such a problem. It was left to Keynes to produce a theory of how the non-neutrality of money could produce sustained unemployment.

The credit cycle idea can easily be combined with a Keynesian account of under-employment equilibrium, and even more easily with the Keynesian idea of ‘animal spirits’. This was done most prominently by Minsky, and the animsal spirits idea has recently revived by Akerlof and Shiller. I suspect that the macroeconomic model that emerges from the current crisis will have a recognisably Austrian flavour..

Unfortunately, having put taken the first steps in the direction of a serious theory of the business cycle, Hayek and Mises spent the rest of their lives running hard in the opposite direction. As Laidler observes, they took a nihilistic ‘liquidationist’ view in the Great Depression, a position that is not entailed by the theory, but reflects an a priori commitment to laissez-faire. The result was that Hayek lost support even from initial sympathisers like Dennis Robertson. And this mistake has hardened into dogma in the hands of their successors.

The modern Austrian school has tried to argue that the business cycle they describe is caused in some way by government policy, though the choice of policy varies from Austrian to Austrian - some blame paper money and want a gold standard, others blame central banks, some want a strict prohibition on fractional reserve banking while others favour a laissez-faire policy of free banking, where anyone who wants can print money and others still (Hayek for example) a system of competing currencies.

Rothbard (who seems to be the most popular exponent these days) blames central banking for the existence of the business cycle, which is somewhat problematic, since the business cycle predates central banking. In fact, central banking in its modern form was introduced in an attempt to stabilise the business cycle. The US Federal Reserve was only established in 1913, after Mises had published his analysis.

Rothbard gets around this by defining central banking to cover almost any kind of bank that has some sort of government endorsement, such as the (private) Bank of England in the 19th century, and arguing for a system of free banking that would avoid, he asserts, these problems. But, on any plausible definition of the term, the US had free banking from the Jackson Administration to the Civil War and that didn’t stop the business cycle (Rothbard offers some historical revisionism to argue that the Panic of 1837 didn’t really happen, but that wasn’t what US voters thought when they threw the Jacksonians out in 1840). And free banking in late 19th century Australia (our first quasi-central bank was the Commonwealth Bank established in 1915) didn’t prevent a huge boom and subsequent long depression around 1890. Overall, the US was much closer to free banking throughout the 19th century than in the period from 1945 until the development of the largely unregulated ’shadow banking’ system in the 1990s, but the business cycle was worse then (how much worse is a matter of some controversy, but no serious economist claims it was better).

To sum up, the version of the Austrian Business Cycle Theory originally developed by Hayek and Mises gives strong reasons to think that an unregulated financial system will be prone to booms and busts and that this will be true for a wide range of monetary systems, particularly including gold standard systems. But that is only part of what is needed for a complete account of the business cycle, and the theory can only be made coherent with a broadly Keynesian model of equilibrium unemployment. Trying to tie Austrian Business Cycle Theory to Austrian prejudices against government intervention has been a recipe for intellectual and policy disaster and theoretical stagnation."

"For Schumpeter, there was something both noble and tragic about the spirit of capitalism."

Robert Skidelsky in the Guardian:

"Testifying recently before a United States congressional committee, former Federal Reserve chairman Alan Greenspan said that the recent financial meltdown had shattered his "intellectual structure". I am keen to understand what he meant.

Since I have had no opportunity to ask him, I have to rely on his memoirs, The Age of Turbulence, for clues. But that book was published in 2007 – before, presumably, his intellectual structure fell apart.

In his memoirs, Greenspan revealed that his favorite economist was Joseph Schumpeter, inventor of the concept of "creative destruction"( ALL THIS MEANS IS THAT BUSINESSES COME AND GO. IT IS NOT PROFOUND. ). In Greenspan's summary of Schumpeter's thinking, a "market economy will incessantly revitalise itself from within by scrapping old and failing businesses and then reallocating resources to newer, more productive ones". Greenspan had seen "this pattern of progress and obsolescence repeat over and over again".

Capitalism advanced the human condition, said Schumpeter, through a "perennial gale of creative destruction", which he likened to a Darwinian process of natural selection to secure the "survival of the fittest"( A VERY BAD ANALOGY. BUT COMMON. ). As Greenspan tells it, the "rougher edges" of creative destruction were legislated away by Franklin Roosevelt's New Deal, but after the wave of de-regulation of the 1970s, America recovered much of its entrepreneurial, risk-taking ethos. As Greenspan notes, it was the dot-com boom of the 1990s that "finally gave broad currency to Schumpeter's idea of creative destruction".

This was the same Greenspan who in 1996 warned of "irrational exuberance" and, then, as Fed chairman, did nothing to check it. Both the phrase and his lack of action make sense in the light of his (now shattered) intellectual system.

It is impossible to imagine a continuous gale of creative destruction taking place except in a context of boom and bust. Indeed, early theorists of business cycles understood this. (Schumpeter himself wrote a huge, largely unreadable, book with that title in 1939.)

In classic business-cycle theory, a boom is initiated by a clutch of inventions – power looms and spinning jennies in the 18th century, railways in the 19th century, automobiles in the 20th century. But competitive pressures and the long gestation period of fixed-capital outlays multiply optimism, leading to more investment being undertaken than is actually profitable. Such over-investment produces an inevitable collapse. Banks magnify the boom by making credit too easily available, and they exacerbate the bust by withdrawing it too abruptly. But the legacy is a more efficient stock of capital equipment.

Dennis Robertson, an early 20th-century "real" business-cycle theorist, wrote: "I do not feel confident that a policy which, in the pursuit of stability of prices, output, and employment, had nipped in the bud the English railway boom of the forties, or the American railway boom of 1869-71, or the German electrical boom of the nineties, would have been on balance beneficial to the populations concerned." Like his contemporary, Schumpeter, Robertson regarded these boom-bust cycles, which involved both the creation of new capital and the destruction of old capital, as inseparable from progress.

Contemporary "real" business-cycle theory builds a mountain of mathematics on top of these early models, the main effect being to minimise the "destructiveness" of the "creation". It manages to combine technology-driven cycles of booms and recessions with markets that always clear (ie there is no unemployment).

How is this trick accomplished? When a positive technological "shock" raises real wages, people will work more, causing output to surge. In the face of a negative "shock", workers will increase their leisure, causing output to fall.

These are efficient responses to changes in real wages. No intervention by government is needed. Bailing out inefficient automobile companies such as General Motors only slows down the rate of progress. In fact, whereas most schools of economic thought maintain that one of government's key responsibilities is to smooth the cycle, "real" business-cycle theory argues that reducing volatility reduces welfare!

It is hard to see how this type of theory either explains today's economic turbulence, or offers sound instruction about how to deal with it. First, in contrast to the dot-com boom, it is difficult to identify the technological "shock" that set off the boom. Of course, the upswing was marked by super-abundant credit. But this was not used to finance new inventions: it was the invention( ONE COULD ARGUE THIS ). It was called securitised mortgages. It left no monuments to human invention, only piles of financial ruin.

Second, this type of model strongly implies that governments should do nothing in the face of such "shocks". Indeed, "real" business-cycle economists typically argue that, but for Roosevelt's misguided New Deal policies, recovery from the Great Depression of 1929-1933 would have been much faster than it was.

Equivalent advice today would be that governments the world over are doing all the wrong things in bailing out top-heavy banks, subsidising inefficient businesses, and putting obstacles in the way of rational workers spending more time with their families or taking lower-paid jobs. It reminds me of the interviewer who went to see Robert Lucas, one of the high priests of the New Business Cycle school, at a time of high American unemployment in the 1980s.
"My driver is an unemployed PhD graduate," he said to Lucas. "Well, I'd say that if he is driving a taxi, he's a taxi-driver," replied the 1995 Nobel laureate.

Although Schumpeter brilliantly captured the inherent dynamism of entrepreneur-led capitalism, his modern "real" successors smothered his insights in their obsession with "equilibrium" and "instant adjustments". For Schumpeter, there was something both noble and tragic about the spirit of capitalism. But those sentiments are a world away from the pretty, polite techniques of his mathematical progeny."

I have to say that Schumpeter's world view was not close to mine. It was tragic, but more like the Eternal Return of Nietzsche. The current Mechanistic Economics is a melange of slightly useful theories and models. Nothing more.