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More on "Austrian School Flunks"

February 3, 2004

From Gael J. Campan

The Jerusalem Post published a response, entitled Austrian School Flunks, to an earlier article of mine on the subject of deflation. Here is my response, before it was edited:

Jonathan Lipow did not appreciate my editorial "Save us from the deflation doctors" published in the 12th of November issue of the Post, where I stated my opinion regarding the present state of deflation in Israel, which I consider to be an expectable and healthy phenomena as opposed to the ill-fated outcomes of inflationpolicies.

He expressed his discomfort in a very defensive piece "Austrian theory flunks" where he lead several charges and granted me the privilege of personal attack as if, in the realm of economic thinking and debate, authors could be more relevant than the rigor and logic of their positions.

To start with, he correctly identified my economic background as Austrian School of Economics. After acknowledging its originality, he lead a charge arguing that first, it is not a new theory and second, its macroeconomics has been "utterly rejected" by mainstream economics. This is an argument from intimidation: "do not reader dare considering Austrian School of Economics since it is already discarded by mainstream economists". I personally prefer to give credit to the readers ability to make their own mind on the basis of explicite arguments.

Regarding this specific matter, the mainstream of the 20th century happened to be successively Classic, Marxist, Keynesian, Monetarist, Neo-classic, Post-Keynesian, to name a few; i.e. one thing and its opposite. So even if Austrian free-market economics was not considered mainstream, with regard to the historical volatility of paradigms within the academy, it might as well underline its robustness and its impermeability to intellectual fashions.

Now, it is true that Austrian economists, such as Ludwig Von Mises and Murray Rothbard, provide an alternative approach to what Mr. Lipow calls mainstream macroeconomics. Specially as far as the business cycle issue is concerned, they provide a complete explanation of how government-controlled central banks do trigger booms and busts by inflating the money supply. At the center of this explanation lies the axiom of time preference or preference for the present (that Mr. Lipow mistakenly calls time discount rate). It is the simple fact that individuals always prefer to enjoy economic goods earlier instead of later.

Applied to savings, this preference determines the amount of money available for investment : I am willing to lend NIS 100 now (that is, to sacrifice current consumption) against the promise of NIS 100 + X in one year from now. This supply of savings from customers confronts with a demand for financing from entrepreneurs. From this confrontation results the natural interest rate which is the price entrepreneurs pay on a given market for borrowing money. Then, if suddenly the authorities pump money into the economy, more credit become available for investment and the interest rate drops. Note that this is an artificial process, since there was no increase in real savings, no change of time preference.

With the new interest rate, ventures that were not profitable at the previous interest rate become profitable, at least apparently : sales projections are great and stock-market ramps up. Meanwhile these new projects look for capital and labor, thereby putting pressure on prices of non-specific production factors, ultimately spreading prices increase through the economy. At this stage, all the elements of what is commonly described as a boom are set. It is brought to a halt when, the new products and services coming to fruition, demand does not materialize. Hence inventories skyrocket, stock-market plummets, companies go bankrupt and massive unemployment follows.

If the government renounce to its inflating power, the economy can recover from its hangover and refocus on profitable ventures backed by sound savings. This is why I keep thinking that transitory deflation — which is the present state of Israel economy — is healthy : it is a sign of recovery in process, of cleaning up of the economy. This is why I keep denouncing calls for easing credit or cutting interest rate : they are precisely the cause of business cycles and of the current recession. Incidentally, it does not make any sense to target a normal or "expectable" interest rate as Mr. Lipow wishes he had (he said between 2 and 4%) since interest rate is a price and as such should be subjected to supply and demand.

Consider now Mr. Lipow's charge that, according to the Austrian theory, investors are ­ I quote him ­ "a bunch of idiots" who make wrong expectations regarding the market and are repeatedly mislead by wrong monetary policies, never learning from past mistakes. He even diagnoses ­ I quote him again ­ "split of personality" and "mass psychotic episodes" for investors who, as customers, should know very well that their time preference did not really change. Beyond the tentative humor, I am stunned by the oversimplification and falsehood of such arguments.

In real life, as in Austrian theory, investors and entrepreneurs are not one thinking abstract category but a group of different individuals with specific situations and different time preferences. If as a car manufacturer you decide to give up driving and take a bicycle, will you infer that since you are a representative customer your business is over ? As far as the "learning from mistakes" charge is concerned, there is no evidence that correct expectations regarding the outcome of loose monetary policy would prevent the boom and bust cycle. Even if they know business cycle theory and anticipate a bust, entrepreneurs in place before money pumping have no choice but to endure the pressure from new entrants who funded their projects with cheaper money. They must fight to keep their resources from being hired and therefore are powerless against the increase of their costs of production and the shrinking of their margins.

Bottom line, the only beneficiaries of inflation are the early receivers who see their relative purchasing power increase, out of thin air and at the expense of later or no receivers since they enjoy it before prices increase spreads through the economy.

In a desperate attempt to prove his point favoring inflation Mr. Lipow introduced a comparison between the deflationary 19th century and the inflationary 20th century based on some unquoted empirical study covering US, Canada and Europe. He bluntly affirmed that GDP per capita grew 1% in the former and 2% in the later century. You don't have to be an economist ­ — mainstream or not — ­ to see that this affirmation, which Mr. Lipow presents as an evidence, is ridiculous. How can he expect us to believe the GDP per capita has grown 3 % in the last two centuries that taken together, saw the realization of the agricultural, industrial and financial revolutions, just to name some key historical events !?

If this is being mainstream, although I know few economists that would recognize themselves in such a clumsy intellectual endeavor, then I definitely keep the challenger position. Still, if of any consolation for Mr. Lipow, the one good thing about being mainstream is that when you are wrong, you are not alone.

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