Thornton to Wanniski, re: Phelps

Dear Jude Wanniski:

Thanks for sending out the Wall Street Journal editorial by Professor Phelps. Some good points to be sure, but he presents an incorrect view of the Austrian school’s theory of the business cycle. The Austrian theory is not an overinvestment (i.e. “too much”) theory, it is a malinvestment (i.e.
“wrong ones”). Naturally, his analysis that follows is flawed.

Austrian economists rarely speak favorably in terms of aggregates, or like an accountant or historian might. They speak and write in terms of prices, economic decisions, and resource allocation--real life “price theory.” They are concerned about the structure of production (the economy from natural resources to consumer goods) and the structure of production was completely out-of-whack in 1999 despite rosy statistics and record breaking stock markets. You don’t need much “extra” investment to change the structure of production and entrepreneurs were doing just that--radically changing the structure of production--under the influence of Alan Greenspan’s monetary policy.

Many of these investments have now been shown to be bad investments (hence malinvestment theory). The recession need not be a long one, as Professor Phelps wrongly attributes to the Austrians, if the investments are allowed to liquidate quickly. So-called stimulus policy (monetary ease and loose budgets) only make things worse and drag out and worsen the correction-recession-recovery.

By the way, do you know of any mainstream economists who accurately predicted the “boom” and “bust” in the stock market and economy? For most orthodox economists, “science is prediction” and yet I don’t know of many who made accurate predictions in print. Shiller is one, but he doesn’t buy into the rational-scientific version of economics. Please let me know.

I have a paper that trys to illustrate the Austrian theory based on the construction of skyscrapers. You might find it an interesting read. It was mentioned briefly in today’s Bloomberg.