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Austrian Business Cycle Theory

May 3rd, 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.

Update There’s a fascinating discussion linking to this post here. In French, but clear and simply written. Anyone with high school French and a familiarity with the issues should be able to follow the main points.

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.

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  1. Benjamin O’Donnell
    May 3rd, 2009 at 11:14 | #1

    I knew from Skidelski’s biography of JMK that he and Hayek were friends, but I hadn’t realised the way in which some of their ideas were actually so compatible. It does seem that Hayek let his political/ideological prejudices get in the way of his economics.

  2. Joseph Clark
    May 3rd, 2009 at 11:52 | #2

    It’s not fair to say that Austrians are running away from the interventionist implications of their theory. Non-neutrality of money leads to misallocation but trying to fix it usually makes things worse because it’s so difficult to pin down where the problem is.

    I found a nice model which makes this point:

    An Exploration of Neo-Austrian Theory Applied to Financial Markets: An Exploration of Neo-Austrian Theory Applied to Financial Markets. Harald Benink, Peter Bossaerts. The Journal of Finance, Vol. 56, No. 3 (Jun., 2001), pp. 1011-1027

    Anyway, very interesting post. Nice to see some positive engagement with Austrians!

  3. john c. halasz
    May 3rd, 2009 at 12:57 | #3

    “Both Marxism and classical economics were characterized by the assumption that money is neutral…”

    Actually, the long-run neutrality of money is a thesis of neo-classical economics, including “New Keynesians”, isn’t it? And could you cite some source for Marx adhering to the “neutrality of money” thesis? In my understanding, he insisted that any full-fledged system of commodity production presupposed the existence of money circulation driving it, such that money had a quasi-autonomous status. Though he operated within the then prevailing convention of hard “commodity money”, he was far from taking it as a fundamental store of value, Austrian-style, which would be a version of what he criticized as “fetishism”. (Needless to say, he had no use for “Say’s law”). And he held credit as endogenous to the production/business cycle, tracing out especially the tendency of financial “asset” prices to seriously gap out and diverge from underlying realizable costs/prices of production, thus forming accumulations of “fictitious capital”, as a key part of his theory of crises.

  4. Memory
    May 3rd, 2009 at 13:21 | #4

    I have always found the most useful implication of Austrian theory to be the concepts of systemic “malinvestment” and overinvestment in relatively unproductive sectors – investment overhang – as the (psychologically inevitable) results of credit availability in a boom period. These concepts are derivative primarily of Schumpeter in the forms that I have found interesting (though Hayek’s fundamental insight about the information function of the price mechanism underlies the concept), and they provide a very useful critique of theories of efficient capital markets.

    Taken to their logical conclusion, these concepts – perhaps interpreted through the lens of Galbraith’s description of the investment boom in “The Great Crash” provide a solid justification for relatively tight regulation of financial intermediation and credit markets.

  5. May 3rd, 2009 at 19:57 | #5

    JQ, I suspect from other similar coverage like Scott Sumner‘s that there is more to Austrian stuff than you describe. I certainly found his post and readers’ follow up illuminating, although I’m still digesting it.

    How long does stuff stay in moderation before getting through on Weekend reflections, by the way?

  6. Chris Warren
    May 3rd, 2009 at 20:05 | #6

    Orthodox Marxism – ossified dogma???!!!!

    Marx – money as a veil ????!!!!!!

    Gratuitous quips like that are meaningless, lack rigor, and damage reputations.

    Marx’s understanding of money was as ‘specie’ and he separately discussed credit. Today in the OECD we tend to conflate money and credit as the same – dollars. Money for Marx was not a veil.

    Quiggin’s ‘ossified dogma’ similarly has no basis, and he produced no evidence. He is just pandering to low grade academic staff room jokes and undergraduate giggling.

  7. jquiggin
    May 3rd, 2009 at 20:30 | #7

    PML, there’s nothing in the moderation queue.

    Chris, can you point to any interesting recent contributions to economics that fit within an orthodox Marxist viewpoint, and would contradict my judgement of ossification? If so, and if there’s any interest from other readers, I’d be happy to spell out my reactions in more detail.

  8. May 3rd, 2009 at 21:16 | #8

    That’s odd, JQ. I just went and tried posting there again, only to get “Duplicate comment detected; it looks as though you’ve already said that!”. Anyway, I added a new leading sentence to bypass that, so it should be in moderation now as it didn’t go straight up.

  9. Chris Warren
    May 3rd, 2009 at 22:45 | #9

    John

    I do not think that Marxism necessarily makes “interesting recent contributions to economics” – if by this you mean the economics essentially following Samuelson. It is not clear what you mean by recent?

    However, you can find interesting recent contributions to political economy. See for example David Schweickart and James Lawler in “Market Socialism: The Debate Among Socialists”, ed. Bertell Ollman (Routledge 1998). It has a useful and interesting Bibliography at p193f.

    The TSSI movement revisitation of value theory is interesting – summarised on Wikipedia.

    In Australia, Bruce McFarlane’s book, “Radical Economics” (Croom Helm 1982) is also interesting and easy to read.

    Most unbiased commentators may find the “The New Palgrave – Marxian Economics” ed. J Eatwell, M Milgate, P Newman (Macmillan 1990), of some interest. All contributors provide Bibliographies.

  10. May 4th, 2009 at 01:15 | #10

    Is (involuntary) unemployment in the recessionary aftermath of a deflationary (or disinflationary) episode “caused” by real wages that are too high?

  11. michaelego
    May 4th, 2009 at 02:01 | #11

    Thanks for this! I had always wondered why Austrian-influenced economists always display such a strange mix of insight and absolute stupidity.

  12. michaelego
    May 4th, 2009 at 02:08 | #12

    John Quiggin, I agree with Chris Warran that the TSSI work (particularly Kliman’s “Reclaiming Marx’s Capital”) is the first step in a non-ossified direction within Marxist economics. (Although I don’t think Kliman could be called “orthodox” and he is no fan of the bulk of Marxist economics.)

    Chris Warren you’re absolutely right that Marx did not regard money as a veil, but Quiggin did not say Marx’s economics, he said MarxIST economics, and he is correct that Marxist economics generally viewed money as a veil.

    I should point out that Marx was a follower of Thomas Tooke and John Fullarton, the main exponents of the so-called Banking School, whose views on credit money are quite similar to the enogenous-money theories of today’s Post Keynesians. Their theories ran directly contrary to the money-is-a-veil doctrines of Hume, Ricardo and the later Currency School.

  13. john c. halasz
    May 4th, 2009 at 04:49 | #13

    John Quiggin:

    As an example of a contemporary economic theorist drawing on Marxian/classical sources, you might look up Anwar Shaikh. And, yes, a similar assessment of Marx’ economics would be appreciated. Hopefully, you would do much better than that fatuous turd Brad DeLong recently emitted. (Yes, my comment there was deleted after remaining 2 days, probably because I suggested his scholarly ethics/competence on the matter were, um, less than stellar).

  14. Vangel
    May 4th, 2009 at 05:12 | #14

    The Austrian analysis is sound and has yet to be surpassed. Marxist analysis is poor and cannot be supported by either logic or real world observations.

    If the Austrians show that interventionism makes things worse it makes no sense for them to advocate interventionism just so that they can gain more political clout because they would undermine their own credibility.

  15. Kevin Cox
    May 4th, 2009 at 06:35 | #15

    The Austrians like most people make money too complicated. Money is a measure of value that facilitates the trading of goods and services. Money is also a means of allocating ownership of goods and services. Another feature of money is that it can be traded and is a commodity.

    Problems arise because each person measures value differently and because we argue over who should own what. However, the mechanics of how a money system operates is simple. It is the emergent properties resulting from using money that gives rise to complexity.

    It is worthwhile looking at the operation of other systems like the communication of ants or bees to see how simple communications mechanisms gives rise to complex group behaviour. Change the underlying communications mechanisms in small ways and it can cause radically different outcomes. Money is about the communication of value. Change the way the communication happens and the system will have different outcomes.

    We do not have to theorise about money in terms such as neutrality or non neutrality of money. Such ideas are emergent properties of the way the money system operates given a particular set of rules.

    Here is another way to think about money. Instead of thinking about “meaning” think about the mechanics. If we change the mechanics of the money system then we will get different emergent properties. We observe that the mechanics of how the current money system works gives rise to business cycles, inflation, asset bubbles and recessions. Let us change the mechanics of how the money system works and see what happens.

    One of the things we can easily change about the money system is the way we increase the money supply.

    For trading purposes we only need enough money to handle the amount of trade we conduct at any particular time. In a society where there was very little exchange of goods then we would need very little unless everyone decided to trade at the same time. For ownership purposes we need more money because we allocate the ownership of the goods and services and we often want to rent out our goods and services through the creation of loans. But, there is a limit on the amount we need for rental purposes. This limit is the total value of all goods and services that can be rented out both now and for some period in the future. If we create too much money or if we do not have enough then the system will adjust itself with inflation or recessions.

    The way we currently increase the money supply is through the issuing of loans with money that does not yet exist. Most loans are issued with money that exists and is on deposit but some loans are issued without there being money on deposit. The way the system works we have no idea whether the money we used for a given loan was new money or whether it already existed.

    If we changed the system so that before a loan could be given the money already existed and was on deposit then we are likely to solve most of the problems with the current money system. The problem now becomes one of deciding how much new money to create and who gets ownership of it and how to move to a new system.

    At the moment new money is created through loans and the ownership of the money is given to those who already have assets.

    However, we can create money by printing it, not giving any interest on the new money until it is spent, and requiring the money to be spent on producing a new productive asset. We have an opportunity of experimenting with this approach with the formation of the New Broadband Network company.

    The government could finance this by notionally printing the money and giving it to the company. The money does not earn interest until it is spent by the company. The money is allocated by giving everyone in Australia shares in the company. If this was done there is no debt created. New money is produced and we know it will be spent creating a productive asset. It will not cause inflation because the shares in the company will initially be valued at less than the nominal value of the shares.

    If it works for the NBN then it will work for other infrastructure projects. The existing system can remain exactly as it is including the fractional reserve system. The only difference will be that the Reserve Bank will reduce the amount of money it creates to lend to the banks. If it works as expected then the Reserve Bank can get out of the business of creating new money through lending to the banks and get into the business of increasing the money supply through the creation of productive community infrastructure.

    We can move to this system incrementally, observe what happens and see if the change stabilises the money supply.

  16. Alice
    May 4th, 2009 at 07:15 | #16

    How did this post get so many links to “entrepreneurial investment sites” John? You must have mentioned the magic word – “Austrian.”

  17. Ikonoclast
    May 4th, 2009 at 07:47 | #17

    I have a few specific questions and then a short summing up. But first the questions to jquiggin.

    A. Business cycles – Do we not have enough potential instruments and strategems at our disposal to keep the business cycle well damped and avoid booms, busts and unemployment (other than frictional)? If there is resistance to the implementation and use of these is it not due to the “irrational” lobbying, pressure, sway and interests of ‘the cavaliers of credit’ who prefer a boom and bust system to a more stable system because they thrive on the movements of that instability?

    The instruments would be;

    1. Counter-cyclical government spending.
    2. Better control of the issue of credit.
    3. Reform of the fractional reserve system to achieve the above.
    4. Use of government employment as reserve employment and to set a minimum wage.
    5. Better regulation of the creation of financial instruments (onus of proof of need of a new instrument being on the creator)

    B. Is the declining rate of profit a real phenomenon or a Marxist dogma? I’m not asking a rhetorical question. I really want to hear views on this as I have no idea myself on this one.

    C. Am I right in thinking that Smith and Marx both developed / adhered to the labour theory of value? If economic value does not all come from labour or at all come from labour (including intellectual labour) where does it come from? I believe this question will be quite hard to answer.

    Overall.

    To me, that was a very clear essay on the Austrians. An obvious sign that a theory has become a dogma is indeed when empirical obsevations are rejected if they don’t fit the theory. In other words, proponents of such theories say in effect ‘reality is wrong’ rather than ‘my theory is wrong’.

    When we look, for example, at all the benefits that privatisation of government services were supposed to bring us – and see that the benefits did not arrive – we must say, if we are at all guided by empiricism, “the theory was wrong.”

  18. FERNANDO A. HADBA
    May 4th, 2009 at 07:50 | #18

    It is allways good when someone argue respectfully trough another school of thought. I respect you for that but my comment is that the Austrian Business Cycle takes are related to the use of fiduciary money as a panacea for economic cycles. The bubble creation by FED is the output to avoid the normal business cycle. The temptation to create stability generates a far worse instability.
    respectfully

  19. drscroogemcduck
    May 4th, 2009 at 07:56 | #19

    Kevin Cox: it will be very difficult to stop private persons from expanding the monetary supply.

  20. May 4th, 2009 at 08:24 | #20

    In his _Human Action_ (1949), Mises indicated that the credit-induced boom is characterized by “malinvestment and overconsumption,” a phrase he used repeatedly in his exposition of his business cycle theory. In other words, both C and (early-stage) I increase during the boom. Hayek used the phrase “forced saving” to mean “artificially induced capital accumulation”—making his “forced saving” equivalent to Mises’ malinvestment. Hayek ignored the overconsumption aspect of the boom but did recognize the upward pressure on consumer-good prices. I reconcile, to the extent possible, Mises’ and Hayek’s views in my “Forced Saving and Oversonsumption in the Austrian Theory of the Business Cycle” (2004): http://www.auburn.edu/~garriro/strigl.htm.

    The Austrians do reject rational expectations in this term’s common meaning. It flies in the face of Hayek’s 1945 article on the role of prices. Essentially, RE means knowing–or behaving as if you know–all the information that undistorted prices would convey. It’s one thing to know or suspect that price signals (expecially interest-rate signals) are being jammed. It’s quite something else to know what the unjammed signal would be. And it’s something else still to act on the basis of what you think prices would be instead of on the basis of what they actually are.

    R.W.Garrison

  21. Chris Warren
    May 4th, 2009 at 10:01 | #21

    Vangel

    Very strange statements. You may have misinterpreted Marxist analysis.

    I obviously agree with michaelego. There is a difference between Marx’s political economics and ‘Marxist’ political economics.

    Kliman’s excursion into “intrinsic value” is annoying (and useless). He is no orthodox.

  22. Chris Warren
    May 4th, 2009 at 10:09 | #22

    Ikonoclast #21

    Marx did not subscribe to the labour theory of value. Samuelson mis-subscribed Marx to this theory and wrote a peculiar paper about Marx’s supposed Labour Theory of value.

    Marx developed a ‘socially necessary labour theory of value’ with the emphasis on the social determination. Hence with Marx we get political economy – not ‘economics’.

    You can only understand Marxists analysis, if you want, provided you take note of the difference between the classical Labour Theory of value (lampooned by Samuelson) and Marx’s Socially Necessary Labour Theory of Value.

    Marx’s concepts (including Capital and Capitalist Profit) are all based on social relations.

  23. May 4th, 2009 at 10:21 | #23

    RWG: “It’s one thing to know or suspect that price signals (expecially interest-rate signals) are being jammed. It’s quite something else to know what the unjammed signal would be. And it’s something else still to act on the basis of what you think prices would be instead of on the basis of what they actually are.”

    One thing I don’t quite understand is: if the price system is askew and producing “overconsumption” and “malinvestment” during the boom, and the price is askew, producing involuntary unemployment and underconsumption during the bust, what justification is there for laissez faire in either period? As Quiggan says above, “there’s no reason to think that market outcomes will be optimal in general.

    Do Austrians think that (involuntary) unemployment in a deflationary bust is “caused” by real wages that are too high, and have to come down?

    Bryan Caplan, cited above, seems to think he shares that view with the Austrian School.

    Would deflation, if there had only been more of it, have cured the Great Depression?

    Deflation — a price signal that holding cash is more valuable than investment — seems unlikely to be a clear and optimal “signal”.

  24. Bill Stepp
    May 4th, 2009 at 10:25 | #24

    Thanks for this! I had always wondered why Austrian-influenced economists always display such a strange mix of insight and absolute stupidity.

    What is the “absolute stupidity” displayed by Austrian-influenced economists?

  25. tehdude
    May 4th, 2009 at 10:27 | #25

    The post war recoveries you mention are by nominal GDP which is influenced by inflation. If you consider the value of equities adjusted for inflation the post war recoveries fair very poorly compared to the pre-fed era.

    Nominal GDP will recover with enough banknotes, but the real economy that produces things and pays wages accordingly will not. This is the essence of stagflation. The nominal stats will normalize while the labor force shrinks and the cost of living skyrockets.

    You can claim Carter stagflation was an anamoly, and perhaps it is. Only the coming years will tell whether it was a fluke, or as the Austrians claim, a systemic effect.

  26. May 4th, 2009 at 10:40 | #26

    John — this isn’t very good history of economic thought.

    Hayek’s first work was on the U.S. Federal Reserve System which he worked on in New York in the early 1920s — and his first proto version of the ABCT was written in the context of a paper on the U.S. Federal Reserve System.

    Your paper is full of all sorts of other errors.

    This paper might make it through peer review — but just because peer review on the topic of Hayek has been very, very bad in the professional journals. As Bruce Caldwell puts it, writing papers on false explications of Hayek in the peer reviewed journals is a gold mine for a serious historian of economic thought — errors and BS are everywhere.

    Things have gotten better since in the 1980s, but not so as not to be a continuing embarrassment for the “peer review” process.

  27. May 4th, 2009 at 11:11 | #27

    John — just got to ask. Have you read anything by Lawrence White or Georg Selgin or Steve Horwitz?

    Just asking.

    John writes:

    “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.”

  28. C.P.
    May 4th, 2009 at 12:27 | #28

    Greg Ransom,

    How do the Austrians address the fact that the boom-bust cycle pre-dates the establishment of central banks and pre-dates the establishment of fiat currencies?

  29. john c. halasz
    May 4th, 2009 at 14:09 | #29

    Just a couple brief comments about the Austrians,- who are want to claim we fail to understand them and the purity of their doctrine, even if we know their intellectual history rather well: 1) they seem to utterly fail to realize the severely deflationary and self-stultifying nature of their “hard money” and limited or “free” banking proposals. This is not a matter of mild deflation, and situations under which it might be argued beneficial, but deflation so severe it would take the capital out of “capitalism”. 2) The mal-investment thesis is actually an old argument between the “general glut” view of business cycles and the inter-sectoral mal-alignment view. In fact, both aspects can be true, though the Austrians labor to vigorously deny the over-production/under-consumption problems. The argument is always that free markets fail only because they are never “free” enough. And in the course of their tergiversations, they manage to remove essential components that make capitalism and “free” markets at all “work”. In the abeyance of Austrian theory, it lives on ideologically through an idolization of “free markets” as reactionary utopianism.

  30. jquiggin
    May 4th, 2009 at 14:45 | #30

    Greg Ransom,

    “John — this isn’t very good history of economic thought.

    Hayek’s first work was on the U.S. Federal Reserve System which he worked on in New York in the early 1920s — and his first proto version of the ABCT was written in the context of a paper on the U.S. Federal Reserve System.”

    I think it’s you who has the problem here. I said “Austrian Business Cycle Theory was developed in the first quarter of the 20th century, mostly by Mises and Hayek” and you accuse me of error on the basis that Hayek wrote in the early 1920s. More importantly the basics of the theory were already in Mises 1912, so writing as if it began with Hayek is a pretty big error.

    If you have a substantive comment to make, and particularly if you want to discuss some ideas you see as important new developments in ABCT, feel free, but I’m not going to respond further to silly pointscoring.

  31. Robert
    May 4th, 2009 at 14:56 | #31

    “How do the Austrians address the fact that the boom-bust cycle pre-dates the establishment of central banks and pre-dates the establishment of fiat currencies?”

    The Austrians see the culprit of the boom-bust cycle to be an expansion of credit not backed by savings. This can occur through fractional reserve banking. That is why Austrians support a 100% reserve requirement.

  32. Joseph Clark
    May 4th, 2009 at 15:17 | #32

    “That is why Austrians support a 100% reserve requirement.”

    Not the smart ones 😉

  33. Greg Ransom
    May 4th, 2009 at 15:23 | #33

    John — among other things, I’m pointing out the silliness of things like this, you wrote:

    “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.”

    You’re fooling yourself if you thing this is substantive criticism of “Austrian” work of money, banking and business cycles.

    It isn’t. It superficial stuff — mixed with a good bit of ad hominem bashing.

    Why don’t you work on something substantive, that an intelligent person can dig his teeth into?

    This is a pretty good example of the kind of comment that won’t get a response. JQ

  34. Robert
    May 4th, 2009 at 15:44 | #34

    Bruce
    “Would deflation, if there had only been more of it, have cured the Great Depression?”

    The Great Depression wouldn’t have been as bad had there not been bank credit deflation caused by fractional reserve banking leading to a loss of confidence in the banks resulting in bank runs. Austrians see fractional reserve banking as fraud. Also Austrians note that it is important to distinguish between types of deflation.

  35. jquiggin
    May 4th, 2009 at 16:09 | #35

    Robert, given that “Austrians see fractional reserve banking as fraud” and that historically, fractional reserve banking has always been central to capitalism, doesn’t that imply that capitalism (as it has actually existed) is inherently fraudulent?

    To put the point less tendentiously, can you point to any current or historical instances of capitalist systems with non-FR banking systems (that is, banks that lend money and fulfil the other standard functions of banking; I’m not counting people who just look after your gold for you), or any reason to suppose that capitalism could function under a 100 per cent reserve requirement?

  36. Kevin Cox
    May 4th, 2009 at 17:08 | #36

    #23 drscroogemcduck
    Using the scheme proposed it is the issuer of the currency who is in complete control of how much the money supply increases.

    The issuer of the currency determines how much extra currency is needed – by observing – not setting the interest rates on loans.

  37. May 4th, 2009 at 17:09 | #37

    My rational expectation is that a socialist would have little ability to criticize ABCT, and they have been adequately satisfied. I’m still looking for a worthwhile criticism.

    Again, this is the kind of comment that doesn’t help much. Commenters like Russell and Greg Ransom might like to consider, that, as advocates of a distinctly minority position, talking as if you had long since been proved right doesn’t help your cause. Rather, it illustrates my point about ossified dogma, and raises a suspicion that the reason you dismiss criticism is because you can’t respond to it – JQ

  38. Robert
    May 4th, 2009 at 17:36 | #38

    jquiggins

    Capitalism is among other things a system where capital is traded without force or fraud by private individuals. This implies that a fractional reserve banking system is not consistent with capitalism according to the Austrian view.

    The Bank of Amsterdam maintained a 100% reserve requirement during the 17th and 18th centuries It became the richest city in the world at that time as well as the financial capital of the world.

  39. Joseph Clark
    May 4th, 2009 at 17:47 | #39

    Robert,
    If you ban people from having voluntary arrangements with their banks isn’t that force?

  40. jquiggin
    May 4th, 2009 at 18:03 | #40

    It appears from this paper as if the Bank of Amsterdam ended convertibility in the late 17th century

    http://ideas.repec.org/p/fip/fedawp/2006-13.html

    Indeed, it’s described as the first central bank, which is about as damning as you can get for most of the Austrians I’ve read.

  41. Austrian but open-minded
    May 4th, 2009 at 18:44 | #41

    I agree that ABCT hasn’t progressed much but that may be due to lack of insitutional funding rather than the uselessness of the explanation. If you combine Minsky with Mises you get a very potent explanation of the dangers of unregulated financial markets.

    Two solutions appear possible: (1) Either regulate the financial industry heavily as a quasi-government institution (similar to 1950s Austrian with Nugget Coombs at the helm) or (2) Deregulate BOTH the financial sector and the monetary system and allow gold or silver to compete with domestic currencies (ie allow bank notes to be redeemable by a public or private mint/bank for value and do not tax capital gains on “real money”).

    What we’ve had is the WORST of all possible worlds: Austrian deregulation of banking AND Keynesian central banking supporting them when they screw up. The disaster was inevitable.

    It is not called moral hazard for nothing.

    And in answer to your question: Yes, the current version of capitalism is fraudulent and many Austrians would consider the US economy post-1913 as a fraudulent form of capitalism.

  42. Austrian but open-minded
    May 4th, 2009 at 18:46 | #42

    1950s Australian, not Austrian. 1950s Australia actually looks pretty good right now…capital controls and all…

  43. Austrian but open-minded
    May 4th, 2009 at 18:55 | #43

    Final point: I take issue with bizarre characterisation of the Austrians as taking an irrational a priori view on the beauty of markets.

    Austrians do not have a fixation on free markets, like the Lucas rational expectations academics or the perfect information dogmatists. Austrians are the only free marketeers who understand that people make irrational ill-informed decisions ALL THE TIME.

    The issue is that government (a collection of the same “irrational” idiots as those in the market, just paid on a stipend and therefore even dumber) is EVEN WORSE. And because they tax (ie steal) and because they can currently print money, the danger of the monopoly stupidity of government is far, far worse than the individual stupidity of a diversified collection of market-based idiots all making individual mistakes. The market will muddle through. Governments can kill all of us with their stupidity.

    That is the key free market insight of the Austrians. Not dogma. Realism. About markets. And especially about academics and governments.

  44. Robert
    May 4th, 2009 at 19:26 | #44

    jquiggin

    Adam Smith states in the Wealth of Nations written in 1776 that the Bank of Amsterdam “professes to lend out no part of what is deposited in it.”

    http://books.google.com/books?id=70759KjSs0sC&pg=PA198&lpg=PA198&dq=The+Bank+of+Amsterdam+professes+to+lend+out+no+part+of+what+is+deposited+with+it,+but,+for+every+guilder+for+which+it+gives+credit+in+its+books,+to+keep+in+its+repositories+the+value+of+a+guilder+either+in+money+or+bullion.+That+it+keeps+in+its+repositories+all+the+money+or+bullion+for+which+there+are+receipts+in+force,+for+which+it+is+at+all+times+liable+to+be+called+upon,+and+which,+in+reality,+is+continually+going+from+it+and+returning+to+it+again,+cannot+well+be+doubted.+.+.+.+At+Amsterdam+no+point+of+faith+is+better+established+than+that+for+every+guilder,+circulated+as+bank+money,+there+is+a+correspondant+guilder+in+gold+or+silver+to+be+found+in+the+treasure+of+the+bank&source=bl&ots=7SjUbeWbyE&sig=JmDjm7ZnTrlk7pnx6BBwro9SLt0&hl=en&ei=n6n-ScmFEZmEtgO0nvHJAQ&sa=X&oi=book_result&ct=result&resnum=1#PPA198,M1

    According to the article the Bank of Amsterdam “was the first public bank to offer accounts not directly convertible to coin. As such, it can be described as the first true central bank.” based on this it didn’t become a central bank until the late 17th century. It was the 17th century that was considered Amsterdam’s “Golden Age.” This was the period that accounts were still convertible and the the bank had yet to become a central bank.

    This seems to validate the Austrian view that a 100% reserve requirement could function.

  45. Robert
    May 4th, 2009 at 19:28 | #45

    Austrian

    “Yes, the current version of capitalism is fraudulent and many Austrians would consider the US economy post-1913 as a fraudulent form of capitalism.”

    fraudulent capitalism is a contradiction of terms.

  46. Alice
    May 4th, 2009 at 20:57 | #46

    Austrian but open minded says

    “The issue is that government (a collection of the same “irrational” idiots as those in the market, just paid on a stipend and therefore even dumber) is EVEN WORSE. And because they tax (ie steal) and because they can currently print money, the danger of the monopoly stupidity of government is far, far worse than the individual stupidity of a diversified collection of market-based idiots all making individual mistakes.

    I dont agree. The “unregulated” market is not only a bunch of idiots making mistakes. It is a bunch of very intellgent people comitting absolute fraud and they know it. To put it down to idiots making mistakes is to undestimate the imtelligence of free market profiteers. They will bankrupt the rest of us (and ultimately themselves before their own particular brand of idiocy is fully revealed and by that time they may have sufficient of everyone else’s savings under their control not to worru about the majority in an economy).

    This is not just “silly mistakes.”

    As clumsy as the government can be, it must be, and as many mistakes as they make, guided by underlying public common principles and checks and balances and accountability for the same (not private profiteering principles).

    The government acts as a countervailing balance to unrestrained greed. The purpose of government is not to STEAL but to prevent STEALING. We pay insurance (tax) for that purpose.

  47. Alice
    May 4th, 2009 at 21:04 | #47

    We should have learned thye lesson in then playground that unrestrained capitalism doesnt work. Some kids end up with a huge bag of marbles (or pokemon cards or whatever) and other kids end up crying that someone stole theirs. Eventually the headmaster steps in and bans the gambling.

    Come on guys. Lets get sensible about markets. The referee (provided it is a decent referee) is needed. Per Stiglitiz last night. Checks, balances and refereeing. It falls to government lest fistfights break out.

    Sorry the analogy is so simple but its needed for those who want to run away with everyone’s marbles – those marbles didnt trickle down – they were hoarded (and no I havent lost mine).

  48. Alice
    May 4th, 2009 at 21:05 | #48

    Hoarded for 40 years and passed on to my son!

  49. May 4th, 2009 at 21:10 | #49

    I know I will get my head bitten off, but…

    “The government acts as a countervailing balance to unrestrained greed”. That isn’t how the record looks to me.

    “The purpose of government is not to STEAL but to prevent STEALING. We pay insurance (tax) for that purpose.” That’s like saying jump or be pushed; even if that really were the purpose (but see above), the effect is much the same, involuntarily ending up with less. Of course, there is more to be said on the area, bringing in other criteria and relevant facts, but it wasn’t there in that formulation.

  50. Chris Warren
    May 4th, 2009 at 21:30 | #50

    Robert

    By definition, because of expropriation, capitalism is fraudulent.

    So to say “fraudulent capitalism” is not contradictory. More likely it is either redundant or overkill. The fraud is already implied in “capitalism”.

    Fraudulent capitalism boils down to;

    fraudulent, fraudulent political economy.

  51. May 4th, 2009 at 21:58 | #51

    BW (see comment 27): You ask why Austrians advocate laissez faire during booms and busts when markets seem to perform so poorly during such episodes.

    The boom being discussed is an _artificial_ boom, i.e., one triggered by credit expansion by the (extra-market) central bank. The Austrians’ recommendation of laissez faire is simply the recommendation that the central bank not trigger an artificial boom–and, more fundamentally, that the business of banking be decentralized.

    Consider the proposition that markets do not perform well under condtions of price floors (minimum wage) or price ceilings (rent control or interest-rate caps). Would you ask why the Austrians would favor markets in these circumstances, given such poor performance?

    Think of credit expansion as an interest-rate cap with the central bank papering over the would-be credit shortage with newly created money. The “papering over” feature doesn’t keep the low interest rate from having perverse consequences. It simply lets the problem fester in the form of malinvestments and an inherently unsustainable boom–leading ultimately to a bust.

    RE deflation: Hayek argued against allowing deflationay pressures to play themselves out once the bust has occurred. More precicely, he argued that while liquidation of the malinvestments is essential to the restoration of economic health, further liquidation (during what he called the “secondary contraction”) is to be avoided. He suggested that the “ideal” monetary policy (given that a central bank was in play) would be to maintain a constant MV, which, of couse, would mean increasing the money supply to offset declines in money’s velocity of circulation.

  52. May 4th, 2009 at 22:03 | #52

    There’s much I could say here, but let me just make three points.

    1. John could use to read some of the numerous pages written on and extending and deepening the ABCT since World War II. Greg Ransom cited my work along with that of George Selgin and Larry White, and Roger Garrison has commented elsewhere in this thread. All good places to start. We have articles in professional journals (and not just “Austrian” ones) as well as books. If you want to write about ABCT critically, that’s fine, but you have an obligation to be at least conversational with what the ABCT actually says in the 21st century.

    2. Not all Austrians (not even most, I’d argue) think fractional reserve banking is a problem. All the names mentioned above are fine with it. The real problem is *central* banking, not fractional reserves. The Austrian criticism is that central banks are much less able to maintain macroeconomic order (think nominal GDP targeting if you want) than a competitive banking system would be. Those who are arguing 100% reserve banking is a bad idea will get no argument from the Austrian macro theorists noted above.

    3. Following from that, those same Austrians generally agree (as did Hayek in retrospect) that the right policy to have followed in the early 1930s was to have prevented the disastrous fall in the money supply. Again, Hayek’s own policy guide was to stabilize MV by changing M to offset changes in V. Austrian advocates of free banking argue it will do a better job of that than central banking, but given the existence of the Fed in 1930, it should have been consciously trying to follow such a rule (which also targets NGDP, it is worth noting).

    I’m very happy to see ABCT being discussed here, but it is not of antiquarian interest only. There is lively and progressive literature on it, including empirics, and I would encourage folks to engage with it, especially before making claims about it that are flatly false.

  53. D.W. MacKenzie
    May 4th, 2009 at 22:09 | #53

    Roger Garrison is correct, and I would add that Mr Quiggin made two more mistakes. First, he is thinking in terms of ‘representative agents’, and whether or not they are rational. In the real world there is a spectrum of people from highly rational and intelligent, to dense. Many entrepreneurs do avoid catastrophic errors during a credit induced boom. Others fall prey to the illusion of low interest rates. Quiggin (and Bryan Caplan) are setting up a false choice, between theory with rational agents and theory with irrational agents. What we need to do instead is to drop this nonsense about ‘representative agents’, as such persons do not exist outside of pure thought experiments.

    Second, the idea that any markets are ever ‘optimal’ is absurd. Austrian economics deals with real world phenomena by assuming that markets are never in perfectly competitive equilibrium. Since markets are never ‘optimal’ we should instead think in terms of improvement or deterioration of economic conditions. Government manipulation of interest rates makes conditions worse by increasing the distortion of prices, which were never optimal to begin with.

    One point where I would agree is that businesses cycles would exist, as a statistical phenommena, in a world without central banks. There is no reason to assume that the economy would assume a linear path without a central bank. Growth rates would vary, and there would still a bad year every now and then. However, it is quite clear that central banks have exacerbated business cycles. I find the current tendency in the press and among many economists to ignore the role of the Fed in this crisis absurd.

  54. Alice
    May 4th, 2009 at 22:29 | #54

    53# Whatever Pm – Im not biting your head off (nor anyone else – so dont be so pessimistic) but you and I have had these arguments before. Either Ive asked you for more info or you have asked me..

  55. Bill Woolsey
    May 4th, 2009 at 23:45 | #55

    Perhaps I missed this in the comments, but Rothbard believed that fractional reserve banking causes the business cycle. He died some years ago, but his followers promote the 100% reserve gold standard “policy norm” which they believe is essential to avoid business cycles. Rothbard understands traditional central banks (for example, under a gold standard) as another layer of fractional reserve banking. And the post-gold fiat money central bank, that operates on banking principles, has the same problems but without any anchor at all. While central banks exacerbate the problems, malinvestments exist with fractional reserve banking. (Oh, and that is necessarily criminal fraud and a private crime inconsistent with free market principles.) So, any business cycle that occurs after the goldsmiths started fraudulently lending the gold that was stored with them….

    Garrison and Horwitz have already posted in the comments. They are representatives of the “free banking” school of Austrian economics and they do blame various government interventions in banking for the business cycle. The statement that the U.S. had free banking during various periods would be constested by them. While there was nothing like a central bank during the Jacksonian period, “free banking,” really meant that there was no need for a special legislative act for a bank charter. It was like “free entry” banking. There was, however, a regulatory scheme that caused problems.

    On the free banking view, branching restrictions, reserve requirements, differential collateral requirements for currency and deposits, and, finally, the ban on the option clause (which allowed base money suspensions by contract) all created an unstable banking system.

    To some degree, the free banking group see central banks as an effort to ameliorate the problems created by these interventions, but at the expensive of allowing malinvestments to grow and fester.

    As for the pro-cyclical nature of consumption, I think it is important to distinguish between the ability to produce consumer goods in the recession with nominal expenditures on them. Because of the “secondary” depression, spending on consumer goods may fall more than the diminshed abilty to produce them that comes from after effects of the boom.

    The free banking school of Austrian economists would count any deflation of consumer expenditure beyond the decrease in productive capacity as disequilibrating. If a free banking system resulted in such a drop, that would be a bad thing.

    The Rothbardians believe that the secondary depression should end through a deflation in prices. Once real base money is large enough, real aggregate demand will match productive capacity. Consumption production may well be lower, but there will be adequate real demand to purchase what can be produced.

    The pro-cyclical nature of the production of consumer goods is a bit more difficult to undestand in the boom. I must admit that I am an Austrian Trade Cycle skeptic for this sort of reason. It is just this sort of effort to produce more of everthing that brings up the price level and returns the real quantity of money to equilibrium.

  56. Ubiquity
    May 5th, 2009 at 00:12 | #56

    The Rational Expectation concept, which argues that entrepreneurs are so rational that they won’t be fooled by lower interest rates into malinevestment is flawed in two ways:

    Entrepreneurs who are informed and accepting of the Austrian business cycle are likely to correctly anticipate the future downturn created by central bank policy. However those unaware of (the majority), and don’t accept the ABCT will not see investments based on artificially lowered interest rates will turn out to be malinvestments.

    However in the shoes of the entrepreneur / investor, it would still be attractive to take advantage of lower interest rates to maximise profits. The subsidised interest rates by the central bank mean the risk/losses are spread out across the economy so that the investor losses are smaller than losses for the whole economy.

    I think Stefan Karlsson argued along the above lines when defending the ABCT objections by Caplan.

    It is great to see some discussion on the ABCT by several Austrian economists. Thankyou JQ

  57. jquiggin
    May 5th, 2009 at 05:58 | #57

    Thanks to Steve Horwitz and other Austrian visitors for some useful comments.

    If we’re agreed that the liquidationist position taken by Hayek and the other Austrians in the Great Depression was a mistake, doesn’t that suggest that liquidationism might be similarly mistaken now? I admit that I’m not perfectly informed about the views being taken by more sophisticated Austrians about the appropriate response to the crisis, but the loudest voices appear to be repeating Hayek’s errors.

  58. jquiggin
    May 5th, 2009 at 06:06 | #58

    As regards the free banking school, any response to my observation on the 1880s bubble and 1890s Depression in Australia? Google produces a defence here, but it seems thoroughly non-Austrian, offering a Real Business Cycle story, and in any case looks to be special pleading comparable to Rothbard on 1837

    http://books.google.com.au/books?id=VfTSxZsKKCUC&pg=PA117&lpg=PA117&dq=1890s+free+banking+australia&source=bl&ots=c7a0PNz-_w&sig=YR_WLv9jKPUpXdjUICcNgtghRRE&hl=en&ei=hUn_SYqeNoyItAO7jfHYAQ&sa=X&oi=book_result&ct=result&resnum=1#PPA143,M1

  59. May 5th, 2009 at 09:28 | #59

    John,

    I think it depends on what one means by “liquidationist.” And let me note that even that term did not describe the position of Austrians during the depression. As Larry White demonstrated in a recent JMCB paper, neither Hoover nor Mellon were either.

    In any case, I think a good number of “sophisticated” Austrians would say that the Fed’s decision to pump funds in last fall was probably the right thing to do, but they might also say that it was overdone, leaving us with the threat of inflation on the horizon. In that sense, modern Austrians reject the “do nothing” view of the crisis. It also demonstrates Austrian criticisms of central banking in that it has hard time getting just this sort of thing right.

    However, if “liquidationist” refers to the idea that businesses should be allowed to fail (i.e., no bailouts etc), then those same Austrians would agree that letting them go through bankruptcy is the right policy.

    Maintaining the best shot at monetary equilibrium is good policy, artificially propping up failing firms is not. Part of the argument is that getting monetary policy right is the best way to prevent appropriate failures from spreading beyond where they should.

    So I think it’s consistent for Austrians to say “make sure the money supply is sufficient” and “let failing businesses fail.”

  60. May 5th, 2009 at 10:34 | #60

    Roger W. Garrison: “Consider the proposition that markets do not perform well under condtions of price floors (minimum wage) or price ceilings (rent control or interest-rate caps). Would you ask why the Austrians would favor markets in these circumstances, given such poor performance?”

    I actually favor minimum wage laws and usury ceilings, because, in my judgment, “markets” can “perform” better with rules of these kind than without. (I’m quite a bit more skeptical about rent control.) Now, what’s your point?

  61. May 5th, 2009 at 10:40 | #61

    Roger Garrison: “The boom being discussed is an _artificial_ boom . . . ”

    Ah, an _artificial_ boom. As opposed to . . . what?

    Really . . as opposed to what? What’s the ground of comparison, here? Whatever counterfactual you conjure. Is this a unnatural experiment, in which the control group is the alternative history fantasies of fanatic Austrians?

    Is it all going to be alright if it’s a “natural” boom and all the investments “good” — there are no “malinvestments”?

  62. May 5th, 2009 at 11:33 | #62

    Bruce,

    A “natural” boom hardly requires that there are no bad investments. Markets aren’t perfect, and no Austrian thinks they are. The artificiality of the boom in question is that it is fueled not by the savings of firms and households, but by the excessive credit created by the banking system. That makes it appear as though there are resources to finance longer-term processes of production, thereby generating the boom. However, excess supplies of credit cannot create resources out of thin air and said boom is, to use a popular phrase these days, “unsustainable.”

    Credit-induced booms cause distinct *patterns* of mal-investment, as Roger points out. Sustainable secular growth (a boom, if you wish) has winners and losers, but no pattern of mal-investment that must ultimately reverse itself.

    Now I gave you a good faith, serious, non-snarky answer. Do you think you can try to reciprocate, or will you continue to be dismissive of an opportunity to actually learn something about a theory that clearly do not understand but wish to reject anyway?

  63. Lord
    May 5th, 2009 at 11:51 | #63

    Markets good, government bad. That summarizes Austrian economics in all its tediousness and answers any question that arises. Now both markets and government are subject to human foibles and both can error. Even Adam Smith thought interest rate caps prudent to prevent bad lending. Certainly the Fed should have watched the burgeoning of credit and taken steps to limit bad lending which was what made this boom artificial, and it should probably be doing more rather than less now to prevent further damage, but those are errors of omission than commission.

  64. Austrian but open-minded
    May 5th, 2009 at 12:08 | #64

    Just a note for those interested in studying ABCT further: There are Austrians and there are Austrians. “Hard core” Austrians DO NOT approve of fractional reserve banking and want central banking killed off and replaced by gold and genuine free markets (look up Murray Rothbard and Ludwig von Mises). Many mainstreamers would consider these “extreme” views “barbarism” (Keynes) or “unsophisticated” (Steve Horwitz).

    The “soft Austrians” think government can play a POTENTIALLY useful role in money creation/monetary policy – they just have to do it “right” (Hayek, Buchanan, Horwitz (apparently)).

    Steve Horwitz appears to be pushing the Austrian view closer to the mainstream when he states the following:

    “2. Not all Austrians (not even most, I’d argue) think fractional reserve banking is a problem. All the names mentioned above are fine with it. The real problem is *central* banking, not fractional reserves. The Austrian criticism is that central banks are much less able to maintain macroeconomic order (think nominal GDP targeting if you want) than a competitive banking system would be. Those who are arguing 100% reserve banking is a bad idea will get no argument from the Austrian macro theorists noted above.

    3. Following from that, those same Austrians generally agree (as did Hayek in retrospect) that the right policy to have followed in the early 1930s was to have prevented the disastrous fall in the money supply. Again, Hayek’s own policy guide was to stabilize MV by changing M to offset changes in V. Austrian advocates of free banking argue it will do a better job of that than central banking, but given the existence of the Fed in 1930, it should have been consciously trying to follow such a rule (which also targets NGDP, it is worth noting).”

    Most “hard core” Austrians DO think FRB is the problem, but defining “Austrian School” advocates is so difficult they may be a minority under the “big tent”.

    Steve, show my the Austrians who thought the “disastrous” fall in the money supply was a mistake. Tom Woods in Meltdown points out that the do-nothing Harding allowed a fall in money supply in 1920 and the economy bounced back. So you’re pushing it if you think most Austrians supported the Roosevelt policies of (1) confiscating gold (2) inflating like mad (3) supporting the private banks through the Fed’s policies of shoving $$$s into the bankers’ pockets to keep them alive.

    Let’s be very clear: There are hard core Austrians and soft core Austrians. Let’s not dilute the message.

  65. May 5th, 2009 at 12:24 | #65

    Horwitz’s view, amply stated in reams of my published books and articles, is that government should be out of the money production business, period end of sentence. That is a different question from whether FRB is desirable or not, and I think it is. It’s also a different question from the world of the second-best problem of what central banks should do faced with problems. To say the Fed should try to maintain monetary equilibrium is NOT, repeat NOT, to say gov’t should have a role in money production. It’s answering a second-best problem. I do not think getting the state out of money is “unsophisticated.” I used that word because our host used it.

    I never said I supported FDR’s confiscation of gold nor shoving dollars into private banks to keep them alive, nor inflating like mad. I said I thought the Fed should have increased the money supply to match the rising demand (falling velocity) taking place. On Rothbardian grounds, that’s “inflation.” To most other economists it isn’t. Accusing me of supporting inflation is question-begging at its best without a stipulated definition of inflation.

    FWIW, I think Woods’ book is excellent and will say so in a review in the Freeman shortly. He’s wrong about fractional reserves, but so be it. As for the early 20s, allowing the money supply to fall will be far less damaging when prices and wages are free to fall as well. They were in the 20s but not in the early 30s. Given that, the fall in the money supply was devastating and should have been counteracted, again in the world of the second best.

    And that’s all I’m going to say as I’m not going to play “holier than thou” Austrian games on someone else’s blog. I’ll let the readers decide for themselves which sorts of Austrian arguments they find more or less persuasive and whether being “hard core” is what really matters.

  66. derrida derider
    May 5th, 2009 at 14:30 | #66

    “Maintaining the best shot at monetary equilibrium is good policy, artificially propping up failing firms is not.” – Steve horrwitz @65

    But how on earth can you maintain monetary equilibrium when the firms that are failing are the very ones that supply money? Surely Friedman and Schwarz’s insight that the liquidation of the banks collapsed the money supply in the 1930s is correct, and surely if we hadn’t bailed out those firms in late 2008 that’s exactly what would have happened again.

  67. Austrian but open-minded
    May 5th, 2009 at 14:31 | #67

    FWIW I agree Woods’ book is excellent. Clear. Persuasive. Well written. Remarkable given the tight deadline for publication. Hopefully it will trigger a revival in ABCT scholarship.

    One final point: “That is a different question from whether FRB is desirable or not, and I think it is.”

    Why is it “desirable”? And why is FRB not just a sub-species of embezzlement? Rothbard clearly states the “hardcore” Austrian view that FRB (1) creates volatility in financial markets and in the real economy (ABCT) (2) is fraudulent (3) is a form of embezzlement (4) distorts incentives by encouraging borrowing and speculation and punishing saving (5) victimizes those who save (6) is THE cause of “systemic risk”.

    I can see only two reasons why it is desirable: (1) It artificially creates more financing “capital creation” than “really” exists (I think that’s bad, not good in the long run) and (2) makes bankers very wealthy – until a bank run exposes them as Ponzi-like fraudsters.

    “Desirable”? I don’t think so. Not for “hardcore” Austrians. Perhaps for softies.

  68. jquiggin
    May 5th, 2009 at 14:43 | #68

    Just to clarify. I don’t think I used the word “unsophisticated”.

  69. Austrian but open-minded
    May 5th, 2009 at 14:56 | #69

    Agreed. Which is why I attributed it to Steve Horwitz.

  70. Austrian but open-minded
    May 5th, 2009 at 15:13 | #70

    Steve and I need a separate forum. There are so many compounding tiny errors I would take too long to correct them. I’m shocked an Austrian would make these kinds of statements and I can’t leave them alone.

    Just quickly (1) prices AND wages ARE falling (and would have fallen even more in the 1930s if govt let them fall). Ask any Mac Bank or Citigroup exec. There’s surprising flexibility in labor markets – if you allow them to adjust. There’s no clear modern evidence of the Keynesian sticky wage theory (that I find persuasive anyway) (2) increasing the money supply when narrow money demand goes up and velocity goes down: (a) legimitizes PREVIOUS excessive FRB activities (i.e. legalizes/hides fraud) (b) is impossible to reverse (c) encourages moral hazard in the long run (d) creates inflation in the medium term when velocity picks up again.

    There are no second best options. Let the market work. Or get sucked into government intervention forever until there’s monetary anarchy. That’s the stark bindary choice Mises and Rothbard believed existed.

    That what the Austrians believe.

  71. Austrian but open-minded
    May 5th, 2009 at 15:14 | #71

    That what? That’s all, folks!

  72. Alice
    May 5th, 2009 at 19:49 | #72

    73# This post and the comments have been very interesting actually. Im not well versed in Austrian Business Cycles but “Austrian but open minded” says that hardcore Austrianism oposes FRB as being a form of embezzlement and distorts and encourages moral hazard? Then what would hardcore Austrians think of the removal of the Glass Steagall act that permitted banks to be both banks and investment firms? Wouldnt that have acted to increase the degree of FRB in general or lower the fraction of funds retained that were not subject to excessive speculation and risk, and increase the moral hazard and distortions in the financial system and the fraud and embezzlement?

    Should banks have been granted this freedom (if you suggest they have less freedom to conduct FRB) What also do Rothbardian hardcore Austrians think should be done with super flows (or shouldnt there be any mandatory super?).

  73. May 5th, 2009 at 22:10 | #73

    I’ll just add to my Austrian interlocutor: if you think my views are mistake-ridden and not very Austrian, you are spending too much time drinking the Rothbardian kool-aid and not enough time reading what actual, practicing Austrian economists have to say. Your “shock” that an Austrian would say such things only reveals your ignorance of what those actual, practicing Austrian economists have to say.

    Austrian economics is not a liturgy to be recited, nor is it a set of doctrines one uses to judge the “hardcoreness” of others. It’s not “what Mises and Rothbard said,” but what dozens of scholars have to say. Try reading some of them.

    I find it amusing that most dogmatic, idea-policing contributor to a blog exchange critical of ABCT is a self-described Austrian.

  74. May 5th, 2009 at 22:10 | #74

    And my apologies to John Q. It must have been another commenter who used that term.

  75. May 5th, 2009 at 23:10 | #75

    From this article:

    “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).”

    Ummm, the “serious economists” that post at rgemonitor argue the exact opposite.

    From this paper:
    http://www.rgemonitor.com/blog/economonitor/212954/editor_pick_-_an_introduction_to_financial_crises

    “The Recent Period [1973-1997] does indeed appear more crisis-prone than any other period except for the Interwar Years. In particular, it seems more crisis-prone than the Gold Standard Era [1880-1913], the last time that capital markets were globalized as they are now.”

  76. Lawrence H. White
    May 6th, 2009 at 00:20 | #76

    jquiggan at #62 asks: “If we’re agreed that the liquidationist position taken by Hayek and the other Austrians in the Great Depression was a mistake, doesn’t that suggest that liquidationism might be similarly mistaken now?”

    Hayek was actually of two minds in the Great Depression. As Roger Garrison noted above, Hayek’s monetary policy norm, as enunciated in Prices and Production, called for stabilizing nominal income (MV in the equation of exchange). In newspaper pieces, however, he was overly sanguine about nominal income contraction and did not call for offsetting it as he should have. We’re agreed that the newspaper advice was a mistake. In a fiat money system the central bank should see to it that MV not shrink. The Fed is currently accomplishing that, measured on a year-over-year basis. Unfortunately the Fed is expanding M (to offset declining V) via cheap lending directly to chosen categories of financial firms, rather than via open-market operations.

    Derida derider at $72 asks: “But how on earth can you maintain monetary equilibrium when the firms that are failing are the very ones that supply money?” It’s simple: if bank failures cause the ratio of deposits per dollar of base money to shrink, then inject more base money. You don’t need to rescue failing banks to keep MV from shrinking.

  77. May 6th, 2009 at 00:46 | #77

    The fact that mainstream economists such as John Quiggin, et. al, are forced to address the ABCT (and defend their lack of foresight in the face of irrefutable evidence that the Austrians foresaw the boom and the bust), is a welcome sign.

    Prior to the establishment of the Federal Reserve, recessions in the United States lasted between 1-5 years. After the establishment of the Fed in 1913, America experienced the worst depression in its history. This is no coincidence. As the US has progressively moved away from “sound money” it has experienced inflationary depressions such as during the 1970s, whereas the gold standard at least resulted in deflation during the Great Depression. We are now on the verge of an inflationary depression II, with the present global economic crisis. This is the result of a system of fiat money, where politicians wield unchecked power over the monetary unit.

    Depressions will continue to get progressively worse, because economists such as Paul Krugman, Quiggin, etc. won’t allow prices to fall and adjust to the changed situation.

    When it comes to monetary economics, I’d rather take my advice from Anna Schwartz. The vulgar Keynesians who dominate policy debate these days appear to think that wealth can be produced by the printing press.

  78. May 6th, 2009 at 01:10 | #78

    So why is it again that we should take seriously a school of thought that can’t get its story straight, that even its adherents describe as dogmatic, doesn’t make testable hypotheses and advocates extreme utopian idealism despite offering no evidence that it works?

  79. May 6th, 2009 at 01:12 | #79

    sukrit,
    your comment is quite funny. I’m still about confused about why the great depression was better than the 1970s because “at least it was deflationary”! Wow! Nice for people with money, lousy for people with debt – but who is more important and why?

  80. May 6th, 2009 at 01:16 | #80

    And Sukrit,
    I just love this
    “The vulgar Keynesians who dominate policy debate these days appear to think that wealth can be produced by the printing press.”

    Let me give you a tip. They don’t. They just think that wealth can be destroyed by people and machines not working for no good reason, and that increasing the supply might help.

  81. May 6th, 2009 at 01:17 | #81

    Oops
    That should read .
    .. increasing the supply of money might help.
    Look and read “babysitting the economy” from Paul Krugman if you want to know why they think that.

  82. May 6th, 2009 at 01:22 | #82

    Sukrit,
    by the way, I really wonder whose side you are on. Your comment makes great satire, seriously!

  83. Eric
    May 6th, 2009 at 02:04 | #83

    Reason- thanks for bringing down the conversation to a level that discourages substantive debate. Seriously, how are comments such as “your comment is quite funny”, “Let me give you a tip”, and “Your comment makes great satire” in any way conducive to a healthy and constructive debate? Everyone gets it, you disagree with the Austrian point of view but your arrogant comments only turn people off and create an incentive to leave. Is that your purpose? Are you that insecure with your on point of views that you feel compelled to be obnoxious in order to avoid a meaningful and mature discussion? If not, then lose the attitude and I’m sure I speak for everyone who has enjoyed this thread.

  84. Sean Cooksey
    May 6th, 2009 at 03:39 | #84

    First, you are neglecting the important work of Swedish economist Knut Wicksell in the development of the Austrian business cycle theory, looking especially at his ideas of the natural rate of interest. I also think you are neglecting the psychological factor of malinvestment. It is not that the Austrians are ignoring rational expectations or saying that people are choosing to make bad investments. The general mindset during this period of unnaturally low interest rates is one of “I know that interest rates are too low and that this would normally be a bad idea, but I’m smart enough to get out before the change.” It’s the hubris of investors that creates to many unprofitable ventures with people thinking they can jump out of the plane with the last parachute.

  85. jquiggin
    May 6th, 2009 at 05:46 | #85

    Bobby, you somehow seem to have skipped over

    In retrospect, the Bretton Woods Period (1945-1971) appears to be quite special.
    Countries either regulated bank balance sheets to prevent them from taking on much risk or achieved the same aim through direct ownership of banks. These measures were successful in suppressing banking crises and there was only one twin crisis during this period.

  86. michael
    May 6th, 2009 at 05:53 | #86

    Lawrence H. White and #83 says:

    “In a fiat money system the central bank should see to it that MV not shrink. The Fed is currently accomplishing that, measured on a year-over-year basis. Unfortunately the Fed is expanding M (to offset declining V) via cheap lending directly to chosen categories of financial firms, rather than via open-market operations.”

    Why does it matter whether this is done via open-market operations or via direct lending? I don’t see it.

  87. Alice
    May 6th, 2009 at 06:17 | #87

    re the comment
    “Unfortunately the Fed is expanding M (to offset declining V) via cheap lending directly to chosen categories of financial firms, rather than via open-market operations.”

    I agree with this comment. The lending concentrates in the firms who were most active in the “speculative malinvestment” and it entrenches lack of competition, maintains the “status quo” and establishes a pattern for future speculative investment (more of the same from the same firms – it props them up and their practices will not be subject to that much change. It seems a pick and choose style of managing M.

  88. Healthy Markup
    May 6th, 2009 at 07:16 | #88

    The non-depression of 1921 after a drop-off in the real economy of 21% of production is a strong argument for the Austrian prescription for government in a bust: do nothing. Well, not exactly nothing. Harding lowered taxes a little and gov spending a lot and the result is that nobody knows about this period because there were no heroic interventions by government coupled with a speedy turnaround.

  89. Lord
    May 6th, 2009 at 07:37 | #89

    Hardly. The Fed moved to a price stability standard which rapidly ended that recession.

    Reason #84 is substantive. There is some truth in credit induced booms and busts. The problem is there is little offered in the way of addressing them than ideology. Wishful daydreams of an ancient golden age market utopias. A kingdom for ‘the right monetary policy’. Ossified is charitable; petrified is closer to the truth.

  90. Austrian but open-minded
    May 6th, 2009 at 09:29 | #90

    Alice: Yes, I suggest the repeal of the Glass-Steagall Act would not have been supported by “hardcore” Austrians UNLESS monetary reform (allowing gold and silver to circulate as money) occurred AT THE SAME TIME. Allowing even more fraud/embezzlement with the Fed to back up the fraudsters (sorry, bankers) was a recipe for disaster from the beginning.

    Steve – It’s not dogma. It’s right and wrong. Simple. Hardcore Austrians retain the spirit of Rothbard/Mises. Softies don’t. And I notice you did not get around to explaining why FRB was “desirable”. Funny how that was never addressed….

  91. May 6th, 2009 at 11:17 | #91

    Austrian but open-minded, I have yet to hear any evidence that Gramm-Leach-Bliley did more contributing than mitigating of the crash. Canada never had anything like Glass-Steagall, and so merged their commercial and investment banks way back.

  92. May 6th, 2009 at 11:19 | #92

    @97:

    I did not address it because I’ve addressed it ad nauseum over the last 20 plus years in a variety of published work and public lectures and, frankly, I’m bored with the topic. Plus, you are the one who suggested we need a separate forum, so I decided not to dig up that old chestnut debate here.

    If you want to know my views on that topic and why, please feel free to read my book on Austrian macroeconomics or check out my lecture on monetary equilibrium at fee.org. I’m pretty sure it came up in the Q&A there. I also address it in a recent internet radio interview here: http://www.modavox.com/voiceamerica/vepisode.aspx?aid=37747 . Or you could read any of the numerous articles by Selgin and/or White that address this topic as well.

    Bottom line: FRB is not fraudulent nor is it inflationary and there is nothing in FRB that is in contradiction with ABCT. Mises understood this, btw, as you can read in Theory of Money and Credit. The 100% reserve position is only “Austrian” since Rothbard.

    Austrians before Rothbard’s work in the early 60s and since White’s 1984 book have hardly been of one mind on this issue, which undermines your case for claiming that 100% reserves is somehow “purely” Austrian. You’re just wrong on the facts about what Austrians have and do believe.

    And this will be my last word on this aspect of this conversation. I’m happy to go back to ABCT proper. If you want to continue this, come by the AustrianEconomists blog or email me.

  93. May 6th, 2009 at 11:25 | #93

    One more thing. I’m very interested in what’s right and wrong. I’m totally uninterested in things like “hardcore” and “softcore,” both of which are bits of dogma which have the effect of making Austrians look like a cult. You’re the one equating “hardcoreness” with “right”. I’m much more interested in what economic theory and history have to say than being “hardcore.”

    You probably wonder why people think Austrian economics is dogmatic and cultish while doing everything in your power to demonstrate exactly those characteristics.

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