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Return of the Dead Hand

Tags Booms and BustsThe FedInterventionismOther Schools of Thought

06/24/2009John P. Cochran
For much of the world, the period from the 1960s through the early 1980s was an era of ever-greater government intervention into the economy. The period, an expansion of policy built on an intellectual foundation of Marxism, socialism, corporatism, and progressivism culminated in economic stagnation and inflation in the market-oriented mercantilist-interventionist countries such as the "Great Society" in the United States and economic collapse in the Marxist dominated Soviet block.1

Policy was changed and reoriented successfully in country after country toward a framework more consistent with the ideals of capitalism, with outstanding results. The long period of stagnation and, in many cases, decline were, within several years and to the surprise of many critics, turned into a sustained period of growth and development accompanied by new or renewed prosperity and increasing economic liberty.

Per Brink Lindsey this return to markets was not something forced on policy makers but was a deliberate response to the "wide failures of central planning and top down control."2 Lindsey went on to caution against undue optimism about the continuation of this trend toward greater prosperity:

The world is just beginning to overcome a century-long infatuation with state-dominated economic development; market competition continues to be hindered by a wretched excess of top-down controls, and at the same time undermined by a lack of supporting institutional infrastructure. The invisible hand of the market may be on the rise, but the dead hand of the old collectivist dream still exerts a powerful influence.

A major significant failure of the resurgence of market-oriented policies was a failure to reform the monetary system. This failure left significant control and direction of all aspects of money, credit, and financial flows under central-bank planning and control. The resulting monetary and financial crisis is not a market failure, but a central-planning failure — an artificial boom is a centrally controlled misdirection of production.

The resulting crisis is a "mini" calculation failure. This failure to build economic success and freedom on a solid foundation — a market determined money, a sound money3 — has resulted in two Fed-originated boom-bust cycles in the last ten years. The most recent and most severe was a direct result of the Fed's overstimulating the economy in 2002–2004 in an attempt to postpone a necessary correction. By keeping the federal-funds rate too low (as viewed ex post even by mainstream critics4) policy successfully masked the misdirections of production from the previous boom, prevented or postponed the needed corrections, and, predictably, misdirected production in other channels — housing and commercial real estate relative to the earlier dot-com boom — making the necessary redirections more severe.

The most recent crisis has been used by opponents of capitalism to undermine the intellectual foundations of the reforms of the 1980s and '90s. Critics incorrectly blame the end of the latest boom and current collapse — which is frequently labeled the worst financial crisis since the Great Depression5 — on laissez-faire capitalism and greed run amok. The response of voters and policy makers to this crisis, has in the United States, accelerated a return of the dead-hand philosophy, with the result that the proven-failed policies of the past have returned, masked as hope and change.6

Some in the press have begun to recognize the correctness of the Austrian arguments on the ultimate cause of the current crisis, credit creation, and monetary expansion made possible by a central bank.7 Some may even accept the notion that, once the recession is over, we might discuss monetary reforms to prevent the next boom and bust. But most continue to labor under the false impression that Austrian policy is too harsh.

Why is what works effectively and efficiently in normal times, too harsh in the times of a bust?

Ultimately, any good policy, whether for good times or "bad" times, should be based on the same sound principles. Policy that promotes growth also promotes recovery, since both growth and recovery are really one and the same thing: entrepreneurs hiring resources for new or expanded ventures as they seek profits by providing valuable goods and services to consumers or other business using economic calculation.

Keep in mind that in the dynamic US economy, even in good years, 15% of the jobs disappear each year. But their places are quickly taken, and in a growing economy augmented, by new jobs created by startups and expansions.8 Entrepreneurial planning based on economic calculation corrects errors in good times and, if allowed, would correct errors in bad.

The essentials for prosperity are everywhere and always the same: economic calculation and entrepreneurial planning augmented by a sound monetary institutional framework, a predictable legal framework that supports property rights and contract enforcement, and highly competitive resource markets.

If we are to better understand why the same policy that generates wealth to begin with is the best policy to follow in a crisis, one should begin with an understanding of the boom-bust process and more sound normative interpretation of the boom and bust.

The standard normative judgment about the phases of the cycle is that a period of booming economic activity is typically considered "good" while the downturn/recession/bust is "bad." But it is the boom times that play host to the plague of malinvestments, overconsumption, and misdirected production. The bust brings readjustment and reestablishes the potential for sustainable growth. The standard normative judgment is backwards: it is the boom that is "bad," and thus should be prevented or halted before it proceeds too far. It is the bust that, from a long-run perspective, is "good." Past errors and misallocations of resources are discovered and, if markets are allowed to work, corrected.

The reversed traditional normative interpretation of the cycle phases supports the erroneous view that a central bank brings stability and promotes growth. The correct theory and normative ordering leads to the conclusion that placing the money supply under government control — control by a central bank — is not good, whether judged by the standard of efficiency or stability. A central bank is one of the economy's main destabilizing forces, and the growth that it promotes by money and credit creation is inefficient and unsustainable; a boom will eventually be followed by a bust.

Given that we have a central bank, and that said bank has created a crisis, what is the appropriate response?

A good response requires a proper understanding of the correction process — the recession and recovery. The process of recession and recovery are intricately intertwined. Recession is the process of discovering previous excessive errors in the allocation of resources — allocations of resources not consistent with underlying preferences and resource availability.

Recovery (and normal, sustainable growth) is the process of directing and redirecting resources more efficiently, i.e., more consistently in line with preferences and inherent scarcity. Now, if (as assumed in many economic models) all resources were perfectly homogenous, and all prices, wages, and interest rates perfectly flexible, then the recession and recovery would be a single, quick, and practically painless process. As resources were released from declining activities they would be immediately absorbed into expanding industries.

But in the real world, with nonhomogenous resources — including both capital goods and labor — and rigidities in adjustment processes (and, more importantly, state-induced impediments, both existing and new, to competitive markets), the second phase of the process — recovery, the redirection of available resources to more productive uses — significantly lags the first phase of the process, recession.

What then sets the stage for recovery, job creation, and ultimately growth? What is common knowledge to most business people, and should be evident to all students of Austrian capital theory, is that a significant portion of current activity is directed not to current, but to future consumption. Planning, which includes decisions on reinvestment to maintain current levels of production into the future, new investment for expansion, and investment in new enterprises is future oriented. What we do know from theory and history is that sound money, easy and predictable taxes, a stable legal environment built on a rule of law and contract enforcement, and broadly competitive markets encourage successful long-run planning.

What then is the Austrian answer to today's problems? First, per Hayek and supported by Rothbard, stop the credit creation and inflation. Second, per Hayek, prevent a secondary deflation, a deflation that may provide no steering function. Third, remove all government impediments to effective entrepreneurial planning: avoid protectionist measures internationally; allow prices and wages to adjust as needed to restore market equilibrium. Fourth, not only cut tax rates, as was done in the incomplete reforms of the 1980s and early in this century, but, per Rothbard, drastically reduce the government budget, both taxes and expenditures.9

Instead, we now — unlike the last major crisis period of the early 1980s, where a tighter monetary policy was accompanied by market liberalizations in other areas, including tax reform — see a policy response that is a combination of the earlier failed and discredited policies that brought on the calamities of the 1930s, the 1970s, and the collapse of the economies of the former Soviet states.

Instead of a monetary-policy response that seeks to end monetary expansion while preventing a contraction of the money-spending stream à la Hayek, we see a Fed balance sheet at $2 trillion and growing. There is pressure from some to target not price stability but a 5–6% inflation rate in the CPI and, since some economist believe the correct target for the federal-funds rate is significantly negative and the actual effective limit is zero, for the Fed to undertake operations over and beyond the traditional targeting of the federal-funds rate.10 Instead of fiscal constraint and tax decreases, we see massive expansion of government spending, a guaranteed massive tax increase when the 2001–2003 tax cuts expire automatically in 2010, threatened (and actual in some states already) tax increases on the rich (those making over $250,000), a proposed cap-and-trade policy to fight global warming, which is in fact a massive tax increase on production and on any consumption activity that uses fossil-fuel-based energy.

Instead of privatization, we see major government takeovers of private business in the automotive and financial sectors, which are often conducted in ways that violate contracts and supersede the rule of law. We see wasteful government misdirections of production through subsidies and directives such as an energy policy that promises "green jobs," but is an energy policy missing one key ingredient: delivery of affordable reliable energy. The jobs created would be created in the same way that substituting spoons for shovels would increase employment for grave diggers or, to paraphrase Frédéric Bastiat's "Petition of the Candlemakers," in the same way that mandatory restrictions on sunlight would enhance employment for candle makers and other producers of artificial light. What we have is a significant assault on freedom and the market, which should have predictable long-run negative impacts on the economy.

The period from 1980 to 2000 illustrates how well markets can perform when freed from even some of the collectivist constraints of the past. Those same twenty years illustrate the ultimate destructive power of money and credit creation to misdirect production and falsify calculation, even in a period of relatively stable prices.

Without a foundation of sound money, cycles are inevitable and destructive. If the crisis is used as an excuse to bring back the dead hand of collectivist policies, it is not only destructive of short-term economic well-being but also of long-term freedom and prosperity.

Rothbard saw the alternatives for the American economy in the 1980s, without liberal reforms, as a choice between 1929-type depression or an inflationary depression of massive proportions.

There are other current likely alternatives, the most likely of which is a return of a 1970s-style decade-long period of increasing unemployment and inflation. Other alternatives resemble the decade-long stagnation of the Japanese economy, or a permanent Eurosclerosis.

There is however still time to turn course and follow the Austrian prescription for future sustainable prosperity. We can end government intervention in the economy. Such a policy has been dubbed as draconian, but the pain of a short, severe recession followed by renewed, sustained growth and prosperity may actually be "comfortable and moderate compared to the economic hell of permanent inflation, stagnation, high unemployment, and inflationary depression"11 that is the likely outcome of a continuation of our current policy path.

  • 1. See Gerald Stone's Core Macroeconomics (2008, pp. 338) for an excellent summary of the upward spiral of increasing inflation, accompanied by increasing unemployment experienced in the US economy during this period. Data on p. 340 clearly illustrates the significant improvement in US data in the 1980s and 1990s in response to the rolling back of the dead hand and the resurgence of the invisible hand due to market-based reform begun in the late 1970s and early 1980s. Rothbard, writing in 1982, during the height of the 1981–1983 depression, was, like most economists, quite pessimistic about prospects for a return to prosperity. Since Friedmanite gradualism will not permit a sharp enough recession to clear out the debt, this means the American economy will be increasingly faced with two alternatives: either a massive deflationary 1929-type depression to clear out the debt, or a massive inflationary bailout by the Federal Reserve. … We can look forward therefore, not precisely to a 1929-type depression, but to an inflationary depression of massive proportions. (America's Great Depression, 5th ed., p. xxiii)
  • 2. Lindsey, Brink. 2002. Against the Dead Hand: The Uncertain Struggle for Global Capitalism (New York: John Wiley and Sons, Inc.).
  • 3. Joe Salerno, writing in 2002, clearly articulated this shortcoming in many of the market reformers thinking: while there is a basic recognition by economists that rational allocation of resources necessitates institutional reforms that return resources to private hands and restore genuine markets for productive resources, there is no such comprehension of the importance of sound money to the process of economic calculation. (Quoted in John P. Cochran's "Capital, Monetary Calculation, and the Trade Cycle: The Importance of Sound Money," Quarterly Journal of Austrian Economics 7, no. 4 (Spring 2004): p. 21.)
  • 4. John Taylor recently argued that monetary excess triggered by central-bank actions "lead to a boom and an inevitable bust." See Taylor, John B. 2008. "The Financial Crisis and the Policy Response: An Empirical Analysis of What Went Wrong." For another example see Steve Hanke's "The Credit Triangle" in GlobeAsia (January 2009), p. 164–65.
  • 5. For an excellent discussion of how the current crisis is dead-hand and not market caused (i.e., easy monetary policy combined with perverse political pressure and accompanying incentives and regulations, particularly in the financial and mortgage markets created the current crisis) see Thomas E. Woods, Jr.'s Meltdown.
  • 6. For two excellent summaries of failed and inappropriate policy responses in a historical and a current perspective, see Robert Murphy's Politically Incorrect Guide to the Great Depression and the New Deal.
  • 7. For an example see Randall W. Forsyth, "Ignoring the Austrians Got Us in this Mess," Barron's (March 12, 2009).
  • 8. "Piling On." The Economist (May 30–June 5, 2009), p. 13.
  • 9. Rothbard, America's Great Depression, pp. 185-86; Hayek, Friedrich A. 1979. Unemployment and Monetary Policy: Government as Generator of the Business Cycle, pp. 15-19.
  • 10. See Ducca, DiMartino, and Reneir (2009), "Fed Confronts Crisis by Expanding Role as Lender of Last Resort," Economic Letter: Insights from the Federal Reserve Bank of Dallas 4, no. 2, for a well-presented overview of the extraordinary activities of the Fed.
  • 11. Rothbard, America's Great Depression, p. xxiii.

Contact John P. Cochran

John P. Cochran (1949-2015) was emeritus dean of the Business School and emeritus professor of economics at Metropolitan State University of Denver and coauthor with Fred R. Glahe of The Hayek-Keynes Debate: Lessons for Current Business Cycle Research. He was also a senior fellow of the Mises Institute and served on the editorial board of the Quarterly Journal of Austrian Economics.