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A Central Banker with Austrian Instincts


Raghu Rajan is a very good neoclassical economist who has made important contributions to banking, finance, the theory of the firm, corporate governance, economic development, and other fields. He is also taking over as head of India’s central bank. Rajan is no Austrian, but he has a quasi-Austrian take on the financial crisis, and far greater appreciation for free markets in general than any of the key US or European policymakers. As I tweeted this morning, Rajan is about 1,000,000 times better than either Summers or Yellen. I’d gladly trade him for any US central banker.

Consider, for example, Rajan’s take on the financial crisis:

The key then to understanding the recent crisis is to see why markets offered inordinate rewards for poor and risky decisions. Irrational exuberance played a part, but perhaps more important were the political forces distorting the markets. The tsunami of money directed by a US Congress, worried about growing income inequality, towards expanding low income housing, joined with the flood of foreign capital inflows to remove any discipline on home loans. And the willingness of the Fed to stay on hold until jobs came back, and indeed to infuse plentiful liquidity if ever the system got into trouble, eliminated any perceived cost to having an illiquid balance sheet.

As I wrote before, I’d reverse the order of emphasis — credit expansion first, housing policy second — but Rajan is right that government intervention gets the blame all around.

Rajan also wrote an interesting theoretical paper with Peter Diamond that echoes the Austrian theory of the business cycle: “[W]hen household needs for funds are high, interest rates will rise sharply, debtors will have to shut down illiquid projects, and in extremis, will face more damaging [bank] runs. Authorities may want to push down interest rates to maintain economic activity in the face of such illiquidity, but intervention may not always be feasible, and when feasible, could encourage banks to increase leverage or fund even more illiquid projects up front. This could make all parties worse off.” Add Diamond and Rajan:

We are certainly not the first to place the emphasis for contraction and crises on the mismatch between the long duration before investment produces consumption goods, and the temporal pattern of consumption in an expansion. This dates back at least to Von Mises (1949) and the Austrian School. Von Mises placed the emphasis, though, on an artificially low initial rate of interest, induced by bank credit expansion, which makes the process of creating new goods excessively long compared with the tolerance of consumers to postpone consumption. While it is difficult to map his theory precisely to a rational expectations general equilibrium model, it would appear that Von Mises (1949) places the blame for crises squarely on the heads of overly optimistic, excessively aggressive, bankers (and on central bankers who encourage aggressive credit expansion). . . .

Summarizing our analysis, a central bank that promises to cut interest rates conditional on stress, or that is biased towards low interest rates favoring entrepreneurs, will induce banks to promise higher payouts or take more illiquid projects. This in turn can make the illiquidity crisis more severe and require a greater degree of intervention, a view reminiscent of the Austrian theory of cycles. . . .

Our model suggests that the crisis of 2007-2009 may not be unrelated to the actions of the Federal Reserve earlier in the decade, not only in convincing the market that interest rates would remain low for a sustained period following the dot-com bust because of its fears of deflation, but also in promising to intervene to pick up the pieces in case of an asset price collapse — the so-called Greenspan put.

I’d prefer not to have a central bank but, if we have one, I’d rather have a central banker who grasps the rudiments of Austrian business-cycle theory.

Peter G. Klein is Carl Menger Research Fellow of the Mises Institute and W. W. Caruth Chair and Professor of Entrepreneurship at Baylor University's Hankamer School of Business.

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