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This editorial, which ran in Investor's Business Daily, deals with the Austrian theory of economic downturns.

Investor's Business Daily
Tuesday, October 13, 1998

Austrian Advice

Everyone agrees that U.S. economic growth will slow greatly next year. It's becoming more likely each day that the U.S. will go into a recession. So what should the Federal Reserve and the government do about it?

Well, this question has been asked each time any country enters a recession. But at no point in history was it asked with more urgency than during the Great Depression.

John Maynard Keynes offered one answer. His friend and intellectual foe, F.A. Hayek, offered a very different one.

At heart, Keynesianism is a theory of underconsumption. Economies fall into recession, Keynes argued, when consumers don't spend enough and aggregate demand falls. So the proper cure is to boost demand through government spending.

Hayek stressed the role of monetary policy. Hayek, like his teacher Ludwig von Mises, argued the roots of a bust lie in the preceding boom.

Credit expansion caused by excessive growth of the money supply lowers interest rates, he said. This causes business to borrow more, build more, and expand more.

But these artificial booms always come to an end, either when the central bank raises interest rates to stop inflation, or when resources get stretched too thin.

This "Austrian" theory says that recessions are a necessary healing process for an economy, sort of like the hangover after a night of drinking. It's when the bad investments of the artificial boom get worked out. The Austrian prescription is for government to step out of the way and let the readjustment take place.

This do-nothing approach didn't find many adherents. Keynes won that debate.

After the Depression, Keynes's followers argued that government spending and manipulation of the money supply could even outwit the business cycle and ease recessions.

But those ideas were successfully challenged by Milton Friedman, and Keynesianism foundered during the stagflation of the ‘70s.

Both Friedman and Hayek won Nobel prizes in the ‘70s for their work on monetary theory that challenged Keynes.

Meanwhile, Austrian-school economist Murray Rothbard looked back at the Great Depression. He found that far from doing nothing, the U.S. government pursued a policy of keeping wages and prices from falling.

That kept the economy from readjusting as needed. Rothbard argued that such controls helped turn what might have been a fairly short, mild recession into the Great Depression.

Now, once again U.S. policy-makers must ponder what to do in the face of a global economic crisis.

Once more, there are calls to cut interest rates to forestall any recession, and any day now, we may hear proposals to increase demand by raising federal spending.

And once again, economists of the Austrian School, the intellectual heirs of Hayek and Mises, are offering the same advice they offered in the ‘30s.

"The government should make sure that the banking system doesn't collapse, and that the money supply doesn't shrink greatly, but apart from that, there isn't much that it can do that would be of help," said George Reisman, author of "Capitalism: A Treatise."

"In fact, anything else that it might do would likely interfere with the working off of any malinvestments, and it could make matters worse," he said.

So can government do nothing? Can't it at least free up the economy and make it easier for it to readjust?

"Tax cuts and deregulation are always good ideas. But I'm not sure they can be used specifically to counter downturns in the business cycle," said Lawrence White, an economist at the University of Georgia.

The Austrians' approach would be tough to follow for politicians faced with widespread unemployment.

Once more, it seems that policy-makers will have to grapple with how they should respond to a global downturn.

The answer to that question depends upon how they view the nature of recessions.

Are downturns caused by failures of demand? By outside shocks that hit an economy randomly? Or are they rooted in past policy mistakes of central banks?

c Copyright Investors Business Daily 1998

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