Mises Daily Articles

Home | Mises Library | A Primer on the Never-Ending Bust

A Primer on the Never-Ending Bust

Tags Booms and BustsOther Schools of Thought

06/06/2011Robert P. Murphy

With Friday's dismal jobs report — showing a paltry 54,000 increase in nonfarm payroll employment in May — more and more analysts are realizing that the so-called economic "recovery" is stalling. As Jeffrey Tucker recently pointed out in an important article, Austrians realize that the recession never left. This has all been smoke and mirrors for the last two years.

As John Papola and Russ Roberts's latest video underscores, the classic confrontation is still between the Austrians and the Keynesians. These contrasting visions are still the primary choice when the average person tries to understand why the economy seems broken, and when policymakers try to fix things.

Why the Prolonged Slump?

I have noticed recently that there is some confusion in public discussions about the Austrian take on recessions, even from sympathetic observers. So let me clarify how most modern Austrians — certainly those of a Rothbardian persuasion — would interpret what has been happening in the last few years.

First, the Federal Reserve's easy-money policies after the dot-com crash, in conjunction with other government policies, fuelled the housing bubble (see here and here). Many economists (not just Austrians) have now come around to this explanation, but Austrians were saying it well before it was chic. In addition to Peter Schiff's famous showdowns, the Mises Institute's own Mark Thornton wrote incredibly prescient columns as early as 2004 on the issue.

Now in the standard Austrian theory of the business cycle, the question is not "How do we get out of a recession?" Rather, the question is "How do we avoid the boom?" According to the Mises-Hayek theory, the preceding boom makes the corrective bust inevitable. The goal, therefore, is not to keep the boom going, but to avoid it in the first place, rendering the bust unnecessary.

Therefore, given that there had been a massive housing bubble for years, by 2007 it was unavoidable that the US economy was in store for a massive bust. That's why in October 2007 (relying on a forecast I had performed for a bank client in July of 2007) I wrote a Mises Daily called, "The Worst Recession in 25 Years?" As anyone can see from looking at that piece, I wasn't merely relying on my gut; it was a quantitative exercise looking at what Austrian business-cycle theory blames recessions on.1

However, even though Austrians thought a recession was inevitable, the length of the recession and the strength of the ensuing recovery could definitely be influenced by policy. This is why Tom Woods and I spend so much time pointing to the depression of 1920–21 as an example of a severe but quick bust followed by a tremendous economic expansion.2 Far from providing a "soft landing" in that episode, the Fed jacked up the discount rate to a then-record high, and the government slashed spending an incredible 65 percent in one year! (This was following World War I, remember.) Prices fell half again as much during this depression as they did in any 12-month period during the Great Depression. And yet, as its name suggests, the Depression of 1920–21 was over pretty quickly.

In contrast, after the stock-market crash of 1929, Herbert Hoover began a series of then-unprecedented interventions into the economy. FDR of course upped the ante, coming the closest to full-blown socialism (outside of wartime) the country has ever experienced. As a result of these "cushioning" measures, the United States suffered the longest slump in its history.

In summary, the best thing for the Fed and government to do during a slump is get out of the way. Let interest rates signal the actual state of savings and investment demand, and let prices — including the price of labor — fall in order to clear markets. Malinvestments were made during the boom years, and they need to be liquidated. People who made entrepreneurial errors need to suffer the consequences of those decisions. If the politicians really want to "do something," they should cut spending and taxes, returning those resources back to the private sector, which is already on the ropes.

Why Should We Be Surprised That We're Stuck Now?

Given the Austrian views of history and the proper things policymakers should be doing during a recession, it's no surprise that our economy continues to sputter along. Again, this is not something Austrians have been saying after the fact: we've been predicting all along that the Bush and Obama "solutions" were only going to make things worse. With apologies for the narcissism, let me quote extensively from an article I wrote back in June 2009:

I am not going to be foolish and give annual rates of projected real GDP growth; let me simply summarize my view by saying that the economy will be in the toilet for a decade. (Consult another economics PhD for a precise translation of those terms.)

I really don't understand how even some free-market analysts on CNBC and the like can talk about the recession ending this year [in 2009], or who speculate that we've finally "hit rock bottom." If they really believe that, then I wonder why they spend so much of their careers praising free markets and blasting socialism? If all of Bush's and now Obama's enormous interventions only yield a few quarters of a moderately bad recession, then what's all the fuss about?

We have all been desensitized to the federal power grabs, because they have been so sudden and so sweeping. The human mind is able to adapt to any new environment fairly quickly.

Let's think back just one year ago [to 2008]. Remember when plenty of people were worried about the "unjustified" intrusion of the Federal Reserve into the Bear Stearns takeover? Contrast that to today, when the federal government is literally acquiring outright common-stock ownership in major banks, where the precise accounting mechanism is a conversion of (TARP) "loans" that it forced some of these banks to take, and which the government (as of this writing) refuses to allow to be paid back.

Or how about this one: in the spring of 2008, the Bush administration pushed through a stimulus tax cut that cost a little more than $150 billion. Do you remember that at the time, this was considered a fantastic sum of money? Analysts on CNBC fretted about the impact on the deficit and interest rates.

"I think many free-market economists have forgotten just how big the government has grown."

Well President Obama's stimulus package was $787 billion; the expected federal deficit this fiscal year is $1.8 trillion. The CBO projects that the federal debt as a share of the economy will double over the next decade, from about 41 percent last year [i.e., 2008] to 82 percent by 2019.

Beyond the massive shift of resources to the government, though, are the massive intrusions of federal power into various sectors. The feds have already partially nationalized the banking sector (a process started under that "laissez-faire conservative" George Bush); they have taken over one of the biggest insurers in the world (AIG) and two of the Big Three car companies; and they have taken over Fannie and Freddie and now control more than half of US mortgages.

On top of that, they are pushing through a plan to cap carbon-dioxide emissions — which allows the government to control energy markets, and — oh why not? — they are trying to nationalize healthcare too. Just to make sure investors around the world stay clear of the American economy, the Obama administration has overturned secured-creditor rights in the Chrysler fiasco and has hired 800 new IRS employees to put the screws to wealthy filers with international business operations.

It is no exaggeration to say that the last time the government expanded this much, this quickly, was under FDR's New Deal. And we got a decade of misery during that particular experiment. Why would things be different this time?

The reason I bring these points up is that I think many free-market economists have forgotten just how big the government has grown recently. Before the financial crisis hit, it would have been inconceivable for the Treasury to be running such massive deficits, let alone to seize ownership claims in so many private corporations. Although the plan for an explicit cap-and-trade program failed (for now), the EPA is threatening to directly regulate carbon-dioxide emissions.

And yet, in spite of these incredible expansions of government power, we have free-market guys like David Beckworth laughing at people because their worldview would require the current economy to be much worse than the official statistics indicate. So my question to Beckworth and other free-market economists is this: If the economy really did just suffer a few bad quarters, even in the face of the biggest expansion of government power since the New Deal, then why are you bothering to spread the word on the benefits of economic liberty? Wouldn't your time be better spent educating people on the distinction between that and which?

The Formidable Keynesians

Thus far I've explained why I think the Austrians deserve serious attention in discussions for both the layperson's and the policymaker's understanding. Among free-market schools of thought, to my mind the Austrians have come out of this episode very well. (In contrast, some Chicago School guys are still denying that there even was a housing bubble. Their views are internally consistent and have a theoretical elegance, but I think most people can recognize that their conclusion is simply wrong.)

But I don't want eager Austrian fans to walk away shouting, "Aha! We were the only ones to predict this recession, and so everyone should listen to our policy advice." That's just not right, and it discredits the Austrian view when people say it.

For example, Nouriel Roubini was the Peter Schiff of left-leaning economists. He was making dire predictions — earning the nickname Dr. Doom — at conferences when few others thought there was a housing bubble or problem of debt overhang.

There is also the reigning Keynesian champ Paul Krugman. He too predicted the housing bubble, though it's an odd accomplishment since he called for its creation and then later confirmed (with caveats) that it had been necessary after the dot-com crash.

Krugman also correctly predicted that there would not be large rises in the consumer price index (CPI) in 2009 and 2010, even though many free-market economists (myself included) thought there would be. This situation is still playing out, and it may simply be a matter of timing. The huge injections of monetary base — more in the last two-and-a-half years than in the entire history of the Fed up till that time — went hand in hand with enormous increases in gold, silver, oil, and other commodity prices. Because the injections are largely bottled up as excess reserves parked at the Fed, their impact thus far has been primarily through expectations. I am still very skeptical that Bernanke is going to drain those reserves before they fuel undeniable CPI increases, and without crashing the financial sector.

But even though some Austrians gave premature warnings about the imminent collapse of the dollar — a warning that may yet come to fruition — they unambiguously did better at predicting the impacts of the "stimulus" package. Daniel Mitchell of the Cato Institute recently put out an updated graphic showing the Obama Team's projections of unemployment with the implementation of his stimulus package, compared with actual history:

Figure 1

Let me address one obvious objection from the Keynesian camp: They might say, "Yes yes, Obama's team (headed up by Christina Romer) came up with rosy predictions. But hey, Krugman and a few others were saying all along that the stimulus wasn't big enough! So you Austrians weren't the only ones saying we were in store for years of misery."

In the first place, the rumors of Krugman's predictive accuracy during this recession have been greatly exaggerated. Here he is on November 14, 2008:

All indications are that the new administration will offer a major stimulus package. My own back-of-the-envelope calculations say that the package should be huge, on the order of $600 billion.

So the question becomes, will the Obama people dare to propose something on that scale?

Let’s hope that the answer to that question is yes, that the new administration will indeed be that daring.

Of course, as things turned out, a mere two months later the Obama Administration was proposing a stimulus package that was $787 billion, so quite daring indeed. Now, it is true that Krugman (and Mark Thoma) were warning by this point that such an amount wouldn't be big enough. But go look at Krugman's analysis at the time. His point was not so much that the Romer team's numbers were wrong (though he did think their projections of what would happen without the stimulus were very optimistic). Rather, he was saying that on their own projections, they weren't anywhere near to closing the "output gap." In other words, in terms of the above graph, Krugman wasn't warning, "Guys, I think actual unemployment with the stimulus package will look like the red dotted line, so you need to spend a lot more." Rather, he was saying, "Guys, that blue line is still pretty miserable, and the Republicans might classify the stimulus as a failure. So you'd better spend more."

Therefore, when it comes to the effects of the "stimulus" package, the free-market economists (including the Austrians) were right, and the Keynesians were wrong: The economy suddenly got "a lot worse than we realized" after the stimulus kicked in. Now maybe it was a coincidence, but the episode is definitely a point in favor of the Austrians and against the Keynesians.


The Austrian School provides a coherent and realistic framework with which to understand the general operation of a market economy, as well as violent boom-bust disturbances. For those versed in the writings of Mises, Hayek, and Rothbard, the continuing economic slump has been no surprise.

  • 1. In the interest of full disclosure, I want to point readers to the worst blunder of my professional career — I've done worse things in my private life — when I criticized Peter Schiff in January 2007, and went so far as to fire off some predictions at the end of the article that were woefully wrong. Although I personally botched that episode, I want to explain why I am still so confident in Austrian business-cycle theory: In that January piece, I didn't look at Fed policy. I was hastily responding to Schiff's warnings about the trade deficit, so I contented myself with explaining why a trade deficit per se wasn't a good reason to predict a big recession. It was only after I left the investment firm where I was working at the time, and began private consultation in July 2007, that I returned to Austrian business-cycle theory with fresh eyes and realized I had been horribly mistaken in my earlier optimism.
  • 2. See Daniel Kuehn's RAE article for a Keynesian response to Tom's and my analysis.

Contact Robert P. Murphy

Robert P. Murphy is a Senior Fellow with the Mises Institute. He is the author of numerous books: Contra Krugman: Smashing the Errors of America's Most Famous Keynesian; Chaos Theory; Lessons for the Young Economist; Choice: Cooperation, Enterprise, and Human Action; The Politically Incorrect Guide to Capitalism; Understanding Bitcoin (with Silas Barta), among others. He is also host of The Bob Murphy Show.