Hayek's Law and Rothbard's Wisdom
In a recent article in Forbes, titled "L is for Layoffs," Peter Brimelow and Edwin S. Rubenstein highlight Austrian business cycle theory in their explanation of the current economic crisis. The article favorably quotes Roger Garrison in correctly tracing the cause of the unsustainable boom back to the excessive creation of money and credit, which "probably dates to early 1996."
Brimelow and Rubenstein also use data and analysis provided by Frank E. Shostak to illustrate the nature of the current crisis as the malinvestment and potential for capital consumption that was created by a major increase in the ratio of capital spending to personal consumption that accompanied the credit expansion.
The article, however, contains a major misrepresentation of the Austrian business cycle theory. This misrepresentation leads the authors to ask the question, "Does ‘Hayek’s Law’ condemn the U.S. economy to a Japanese-like L-shaped recession?" The authors argue that Austrian business cycle theory implies that a long period of credit expansion will be followed by a long recession or period of stagnation.
What exactly is Hayek’s Law? Is it a correct interpretation of Austrian business cycle theory? Furthermore, does the Austrian business cycle theory really lead to the conclusion that the long boom of the 1990s condemns the U.S. economy to a long period of relative stagnation?
The authors’ source for Hayek’s Law is Mark Skousen, who is quoted as saying, "Hayek’s Law states that the economy takes a long time to recover after an unsustainable boom (1995-99). The excesses of the previous boom create an investment structure that cannot be easily dismantled and transferred to new uses." I must admit that if there is such a law, Fred Glahe and I definitely overlooked it in our research for The Hayek-Keynes Debate: Lessons for Current Business Cycle Research.
What exactly do Hayek and other Austrian business cycle theorists, particularly Murray Rothbard, have to say about the relationship between the boom and the length of the bust? Actually, correctly interpreted, nothing.
The chief conclusion I want to demonstrate is that the longer the inflation [the increase in the effective quantity of money] lasts, the larger will be the number of workers whose jobs depend on a continuation of the inflation, often even on a continuing acceleration of the rate of inflation—not because they would not have found employment without the inflation, but because they were drawn by the inflation into temporarily attractive jobs, which after a slowing down or cessation of the inflation will again disappear." (Hayek, Unemployment and Monetary Policy: Government as Generator of the "Business Cycle," p. 13)
Rothbard comes to a similar conclusion when he states, "The longer the inflationary distortions continue, the more severe the recession-adjustment must become." (See Rothbard’s America’s Great Depression, p. xxvii.) Notice that both of these are statements about the severity of the maladjustments, not statements about the length of the recession/depression. It is an inappropriate jump in logic to go from the conclusion that the greater the length of the period of artificial credit expansion the greater the degree of malinvestment and, thus, the greater the necessary reallocation of resources, to a prediction about the length of the adjustment period.
The restructuring of the economy requires a realignment of relative prices and wages. The crisis and the period of recession are the "necessary corrective process by which the market liquidates the unsound investments of the boom and redirects resources from capital goods to consumer goods industries," says Rothbard. How long this adjustment takes, however, is more a historical problem than a theoretical one.
As Rothbard explains, "Since factors must shift from the higher to the lower orders of production, there is inevitable ‘frictional’ unemployment in a depression, but it need not be greater than unemployment attending any other large shift in production" (emphasis mine). The adjustment can be quick and the unemployment temporary if markets are allowed to work during the necessary period of liquidation and restructuring.
What, then, causes or leads to a prolonged depression? Here again, Rothbard provides a clear answer:
Unemployment will progress beyond the "frictional" stage and become really severe and lasting only if wage rates are kept artificially high and are prevented from falling. If wages are kept above the free-market level that clears the demand for and supply of labor, laborers will remain permanently unemployed.
Furthermore, Rothbard’s answer is supported by the evidence provided in Vedder and Gallaway in Out of Work, as well as in Herbener’s "Japan Can’t Inflate Away Its Woes" and "The Rise and the Fall of the Japanese Miracle," wherein Herbener shows how the analysis applies to Japan.
The current crisis is unambiguously an "Austrian" crisis. Even if one wants to pretend, al la Paul Krugman in a recent New York Times op-ed, that the "U.S. economy’s problem is ‘self-defeating optimism,’" one should recognize that the "self-defeating optimism" is directly attributable to market responses to the excessive creation of money and credit initiated by the Federal Reserve System beginning in the mid-1990s. What can be done to keep the current crisis, while potentially severe, short, and how can future crises be avoided? The wisdom of Rothbard can triumph over Hayek’s Law.
As for avoiding depressions, the remedy is simple: avoid inflations by stopping the Fed’s power to inflate.
If we are in a depression, as we are now [this is as applicable now as it was when it was written], the only proper course of action is to avoid governmental interference with the depression, and thereby allow the depression-adjustment process to complete itself as rapidly as possible and thus restore a healthy and prosperous economic system.
Before the massive government interventions of the 1930s, all recessions were short-lived. The severe depression of 1921 was over so rapidly, for example, that Secretary of Commerce Hoover, despite his interventionist inclinations, was not able to convince President Harding to intervene rapidly enough. By the time Harding was persuaded to intervene, the depression was already over, and prosperity had arrived.
When the stock market crashed in October 1929, then-President Herbert Hoover intervened so rapidly and so massively that the market adjustment process was paralyzed. Following this, the Hoover-Roosevelt New Deal policies managed to bring about a permanent and massive depression, from which we were only rescued by the advent of World War II. Laissez-faire—a strict policy of nonintervention of government by the government—is the only course of action that can assure a rapid recovery in any depression crisis. (Ibid, pp. xxvii–xxix)