Did The Economist Present Austrian Theory Accurately?

As krlatham pointed out yesterday, it is wonderful to see the Austrian school get a shout out in such a noted publication as The Economist. While it is true, in a sense, that all publicity is good publicity, there were some shortcomings in The Economist’s representation of Austrian theory.

The author writes that “Austrians see the bogeyman as deflation, the fear of which inflates bubbles.” The mistake here is to report that Austrians see deflation as a bogeyman. In reality, Austrians in no way see deflation as a “bogeyman.” On the contrary, deflation is a welcome consequence of sound money and economic growth. This is such an unfortunate mischaracterization of Austrians because it is the Bernankes and Krugmans of the world who see deflation as a bogeyman. Economists like Bernanke, whose views are far from Austrian, regard deflation as devastating to the economy. In their consumption-driven view of the economic theory, deflation would send the economy into a downward spiral of ever decreasing aggregate demand.

The idea the author must have meant to convey (giving him the benefit of the doubt) is that Austrians view the fear of deflation as a bogeyman, and not deflation itself. In this metaphor, the Austrians are the parents telling their children (Keynesians, monetarists, etc.) that it is massively unrealistic to fear of the bogeyman under the bed. If the metaphor holds true, we can all hope that as economists grow up they will also grow out of their unreasonable fear of deflation. They will realize that their aggregated models lead them to ignore the fundamental truth about deflation and its economic consequences. Deflation merely increases the purchasing power of each unit of money. As the purchasing power rises, people can buy more for less and become richer for it. Many non-Austrians would say that this is bad because it rewards savings. The only reason they say this, however, is because they fail to understand the key role saving plays in economic advancement. Since production takes time, the funds required to bring goods to market must be present before the actual goods can earn any returns. The higher the ratio of savings to consumption, the faster the economy will grow (other things equal). This is what Austrians mean when they talk about time preference. A higher ratio of savings to consumption is an example of low time preference. This leads to lower interest rates and greater capital investment. Greater investment in capital (when interest rates are decided by the free market and not central bankers) leads to a higher marginal productivity of labor, increased wages, and a higher standard of living. Conversely, entrepreneurs are misled when interest rates are manipulated by credit expansion. The result is malinvestment that must be reallocated. These malinvestments are the inflationary bubbles Austrians really do fear.

Another misleading statement from this article is calling Michelle Bachman and Paul Ryan Austrians. Even though Michelle Bachman claims to read Ludwig von Mises on the beach, her expressed political views do not exhibit an understanding of Austrian economics. Likewise, Paul Ryan is much more a Reagan, supply-sider than Austrian. He even voted for TARP, something no Austrian has ever recommended.

In an attempt at encapsulating the Austrian theory of the business cycle (ABCT), the author makes another subtle, but quite misleading folly. He writes, “The Austrian School’s thinking centres on the way ‘malinvestment’ orchestrated by central banks distorts the business cycle.” The error here is that the malinvestment doesn’t distort the business cycle, it creates it. The author’s statement implies that the business cycle is inherent to the economy just as life cycles are inherent to ecosystems in the biological  world. This fallacy is further examined and rebutted by the venerable Murray Rothbard in his article, “The Mantle of Science.”

The author also writes that the gold standard “did not prevent severe booms and busts even in its heyday.” It is true that booms and busts permeated nearly every chapter of American and world history, but this problem is easily answerable from the Austrian perspective. The gold standard in the days ofr yore was not a true gold standard. Governments were always quick to corrupt and abuse the banking industry for politically expedient funding. The bankers were always quick to go along with the interventions because it always meant a lower reserve ratio and thus increased profits.  One example of this was in 1814 when banks were allowed to suspend specie payments to their clients. This meant a blatant contract violation on the part of the banks fully backed by the government (Rothbard, History of Money and Banking, P. 74). The gold standard recommended by Austrians today would indeed eliminate the boom bust cycle. The simple act of eliminating credit expansion would eliminate the boom and its necessary corollary, the bust.

The author writes of the Austrian theory of the business cycle that:

“While it provides insights into booms and their ending, it fails to explain why things must end quite so badly, or how to escape when they do. Low interest rates no doubt helped to inflate America’s housing bubble. But this malinvestment cannot explain why 21.8m Americans remain unemployed or underemployed five years after the housing boom peaked.”

First, Austrian theory does explain why things must end so badly. The malinvestment induced by artificially low interest rates is misallocated capital. The capital is misallocated during the boom and bid into uses not in line with social time preference or consumer spending patterns. Entrepreneurs are misled into doing so because of the central bank’s manipulation of interest rates through credit expansion. The bust hits when they start to realize that they made some mistakes with their investments. The reallocation of capital that follows is a painful, but necessary process. The initial process of capital misallocation and necessary reallocation during the bust explains why things must end so badly. The adjustments necessary after a boom involve unemployment. Labor must be shifted from industries more distorted by the boom, for example the housing industry, to other more highly preferred uses.

The author highlights the fact that the unemployment has persisted for five years since the crisis and presents this as if it is a fatal blow to the Austrians. In reality, the government is taking actions which prevent the reallocation process and prolong the negative effects of the business cycle. These activities include interventions such as minimum wage laws. These price controls on the labor market prevent wages from adjusting freely to market conditions. They prevent otherwise profitable production processes from operating with the most profitable labor to capital ratio. They also price many individuals out of the labor market completely. Perhaps more importantly is the Federal Reserve’s inflationary policy of propping up bad loans. This prevents the reallocation of resources to their most profitable and thus most highly preferred uses. It does so by preventing the liquidation of malinvestments that characterizes the bust and recovery phases of the business cycle. They encourage banks to hold onto bad loans and sometimes even guarantee them.

All told, it is great to see the Austrians given some publicity in The Economist. It is especially great to see that the author took time to learn the ABCT better than most critics (he gives a nearly accurate and quite eloquent summary of the ABCT). But that does not exempt his analysis from scrutiny.

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4 Responses to Did The Economist Present Austrian Theory Accurately?

  1. faisalmahboob February 13, 2012 at 9:55 am #

    Very well written! I would like you to know your opinions on Neo-Chartalism. Maybe a future article on that…hmmm

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