The Mises-Hayek theory of the business cycle — and of our recent housing bubble in particular — is gaining more and more adherents in the "real world." To give anecdotal evidence: Five years ago, when I'd write a Mises Daily article, the fan mail would pour in from college students. But now, I get questions from hedge-fund managers and others working in the financial sector. Austrian economics is no longer a hobby; this is serious stuff.
Because of the popularity of the Austrian message — where Exhibit A is the Ron Paul campaign — mainstream economists are taking the time to explain why (in their opinion of course) the Mises-Hayek theory is nonsense. In the past I've answered Tyler Cowen and Paul Krugman's objections, but today's focus will be the recent critique penned by Australian economist John Quiggin.
Quiggin's piece deserves careful scrutiny. In the interest of brevity, I am going to dive right into his objections. If you need a more introductory exposition of Austrian business-cycle theory (ABCT), try this collection or, if you prefer a PowerPoint presentation, check out Roger Garrison's amazing creations.
Business Cycles Predate the Fed
Quiggin's first objection is understandable:
The data Mises and Hayek had to work on was 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.
Quiggin is right, in that many casual expositions of ABCT say things like, "The Austrians believe the business cycle is not a feature of the free market, but instead is caused by the manipulations of the central bank." Since there were boom-bust cycles in countries and time periods that did not have a central bank, this strong statement is obviously wrong.
However, the problem here is one of loose language, not a flaw in the underlying theory. It is far more accurate to say that ABCT blames the boom-bust cycle on fractional-reserve banking. Specifically, when banks are allowed to issue paper money (or increase customers' electronic bank deposits) without an actual act of saving by somebody in the economy, then the resulting drop in interest rates is artificial. The false interest rate sets in motion an unsustainable boom period, which leads people to erroneously consume capital and which sows the seeds of the inevitable bust.
Government intervention is still very much involved in this sordid enterprise. Were it not for favored legal privileges granted to banks, the practice of fractional-reserve banking would be "regulated" by market competition. Even if banks were legally allowed to extend more loans than they had cash (or gold) in the vaults, they would be very cautious with their overissue so long as a bank run would spell ruin. Yet time and again, even before the establishment of central banks, governments would allow the banks to "suspend specie payment" during panics. In other words, when customers had contractual claims on big bankers who had behaved recklessly and gotten caught with their pants down, the government officials told the little guys, "Tough."
This practice of absolving privileged bankers of their legal obligations was simply institutionalized (in the United States) with the creation of the Federal Reserve. It is no coincidence that the worst boom-bust in US history occurred sixteen years after the formation of the modern American central bank.
Rational Expectations?
Quiggin then moves on to the most typical mainstream objection to ABCT:
There's an obvious implication about the (sub)optimality of market outcomes here… 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 [applies], there's no reason to think that market outcomes will be optimal in general.
Let's deal with the last sentence first: Quiggin is saying that if people in markets screw up, then markets aren't perfect. Well, yes, that's certainly true. But from this it does not follow that Austrians are wrong for preferring a voluntary, competitive market process to a coerced, monopolistic government process. It is not the Austrians but rather certain members of the Chicago School who actually theorize as if people on Wall Street were supercomputers.
The Austrians know that free individuals often make mistakes — even systematic mistakes — but the Austrians also know that government bureaucrats lack the one true criterion for successful entrepreneurship, namely the profit-and-loss test. Quiggin's (implicit) argument is akin to pointing out a case of scientists pursuing an erroneous theory, and then calling for government commissions to oversee the refereeing process in scientific journals to avoid such mistakes in the future.
Specifically, Austrians have offered two types of defense against this typical "rational expectations" objection. First, Austrians point out that individual entrepreneurs who know a boom is underway are powerless to prevent their more reckless competitors from taking cheap (or now free) government loans and bidding away scarce resources. Workers don't care whether their paychecks come from genuine saving or from the Fed's printing press, and every few years there is always a fresh crop of naïve employers willing to borrow money and start new projects.
Second, Austrians emphasize that interest rates communicate information to entrepreneurs. The way some critics describe it, you would think "everybody knows" that the true interest rate ought to be 5 percent, and so the Fed's efforts to push it down to 3 percent should be easily corrected. Yet nobody knows what the truly free-market interest rate is. That's why market prices are important in the first place, and why government distortions of these prices lead to real imbalances in the economy.note
Consumption and Unemployment
Let us return to Quiggin:
[U]nless 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.
On the first point, Quiggin seems to be saying that Austrians don't believe in "idle" resources, and so if investment goes up during the boom, then consumption must go down. After all, the government can't make the economy more physically productive simply by pushing down interest rates, so how could businesses possibly produce more investment and consumption goods during the boom?
The answer is that Quiggin needs to appreciate the Austrian approach to capital theory. This is one area where the "sophisticated" modern theorists are childishly simplistic, in comparison to the "obsolete" verbal analysis of 19th-century writers like Böhm-Bawerk. The low interest rates of the boom period mislead entrepreneurs into borrowing too much, but they also mislead consumers into borrowing too much and saving too little. This is physically possible because resources that otherwise would have gone into replenishing the capital structure are instead devoted to new projects or additional consumption goods. As I illustrate with a simple story here, this "eating of the seed corn" can take a while to manifest itself in a complex, modern economy.
Concerning labor markets, the ABCT explains why a brief period of high unemployment is necessary. Workers who were channeled into unsustainable occupations need to be laid off, and their wages need to fall so that they can be reintegrated into useful niches elsewhere in the economy.
The persistence of high unemployment throughout the 1930s is not a task for ABCT to explain. Rather, this was a consequence of the destructive high-wage policies of both Hoover and FDR, not to mention massive deficits and tax increases that further eroded worker productivity and made employers less likely to hire people. It's a bit odd to say that only Keynes could explain the persistence of unemployment in the 1930s, when after all Hoover and then FDR were among the best Keynesians in US presidential history.
Miscellaneous Cheap Shots
Having dealt with Quiggin's serious objections, in this final section I'll point out some of his contradictory rhetorical eye jabs. For example, Quiggin writes:
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.
But earlier in his piece he had written:
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 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.
I wish Quiggin would make up his mind. Are we Austrians a bunch of dogmatic zealots, worshipping at the altar of Mises? Or are we a bunch of illogical fools, who can't even reach the same conclusion from our shared assumptions? Quiggin is ridiculing us for (a) mindlessly parroting our dogma and (b) not agreeing with each other. What Quiggin sees as religion and confusion, the Austrian of course would describe as thinkers engaging in intellectual refinement of a great theory.
Ah, I've saved the best for last. Quiggin returns to his theme that the Austrians are silly for blaming business cycles on central banks, which after all weren't in existence for some big depressions:
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….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).
If you stop and analyze it, the portion I've emphasized above is absolutely hilarious. Note carefully the move Quiggin is pulling here. He wants to show that Rothbard is crazy for blaming the business cycle on central banking. So you might think a natural test of this thesis would be to look at business cycles in the United States pre-Fed (i.e., before 1913) and after the Fed was created (i.e., after 1913).
But that's not what Quiggin does. No, his approach compares US history before the Fed with the period of US history after the Fed has been established and in between the two worst financial crises in world history!
The Federal Reserve was founded in 1913, and so the Great Depression of the 1930s definitely occurred on the Fed's watch. But Quiggin throws out that particular "outlier" by starting his comparison after World War II. OK fair enough, maybe the Fed officials needed a few decades to get their hands dirty and learn the ropes. Yet surely the Fed should then be held responsible for what is easily the second worst global financial crisis in world history, occurring right now. Nope, that doesn't count as a strike against central banking either, because Quiggin stops his comparison in the 1990s. How convenient.
Conclusion
I am not here to tell you the Mises-Hayek theory of the business cycle is a work of art that has no flaws. If I said that, then I would be living up to Quiggin's caricature. What I will say is that the Austrian explanation of the boom-bust cycle makes more sense than any other explanation I've seen. In particular, most rival schools of thought say that the way to fix an economy plagued by overconsumption and reckless lending is to have the government borrow obscene amounts of money and to have politicians take over financial accounting. And it's the Austrians who allegedly cling to dogma in the face of overwhelming counterevidence?
- noteFor the purists, here is a formal model I wrote up a few years back, with all the mainstream bells and whistles, showing how the Fed can lead even rational agents into making more mistakes: "The Rational Expectations Objection to Austrian Business Cycle Theory: Prisoner’s Dilemma or Noisy Signal?"
