The Broader Market

By Jordan Eizenga

I have recently had (intelligent) commentators disagree with me on such economic facts as “deflation is bad for economic growth.”  Rather than support their position with empirical evidence, they refer to a theory that I thought had been put to rest long ago – the Austrian theory of economics.  This is one of those theories in which its supporters claim its opponents have been proselytized by economics professors on well-to-do liberal campuses. 

Rather than muddle an explanation of the theory myself, I thought it would be best to have an economist describe its problems.  Accordingly, I’ll refer to Paul Krugman who crudely assesses the Austrian theory (which he refers to as the hangover theory):

[Hangover theory] is the idea that slumps are the price we pay for booms, that the suffering the economy experiences during a recession is a necessary punishment for the excesses of the previous expansion…

The many variants of the hangover theory all go something like this: In the beginning, an investment boom gets out of hand. Maybe excessive money creation or reckless bank lending drives it, maybe it is simply a matter of irrational exuberance on the part of entrepreneurs. Whatever the reason, all that investment leads to the creation of too much capacity—of factories that cannot find markets, of office buildings that cannot find tenants. Since construction projects take time to complete, however, the boom can proceed for a while before its unsoundness becomes apparent. Eventually, however, reality strikes—investors go bust and investment spending collapses. The result is a slump whose depth is in proportion to the previous excesses. Moreover, that slump is part of the necessary healing process: The excess capacity gets worked off, prices and wages fall from their excessive boom levels, and only then is the economy ready to recover…

Here’s the problem: As a matter of simple arithmetic, total spending in the economy is necessarily equal to total income (every sale is also a purchase, and vice versa). So if people decide to spend less on investment goods, doesn’t that mean that they must be deciding to spend more on consumption goods—implying that an investment slump should always be accompanied by a corresponding consumption boom? And if so why should there be a rise in unemployment?

An Austrian theorist would likely respond to this question by saying that unemployment is necessary because it allows for the transfer of workers from the swollen investment sector to the consumer goods sector.  This is why, in their minds, mass unemployment is part of the process of restoring the economy.  However, as Krugman continues:

Why doesn’t the investment boom—which presumably requires a transfer of workers in the opposite direction—also generate mass unemployment? And anyway, this story bears little resemblance to what actually happens in a recession, when every industry—not just the investment sector—normally contracts.

The truth is that recessions involve a net reduction in spending, as households and businesses begin to demand money and hoard cash.  It is this excess demand for cash that causes recessions, which is why policymakers increase the money supply.  However, as Krugman explains, this too generates criticism from the Austrians:

You [Austrians] may tell me that it’s not that simple, that during the previous boom businessmen made bad investments and banks made bad loans. Well, fine. Junk the bad investments and write off the bad loans. Why should this require that perfectly good productive capacity be left idle?

Krugman’s point is that the Austrian theory does not explain why bad investments of prior years necessitate a period of unemployment of able bodied workers now.  It does not explain why a recession is a central and necessary feature of restoring the economy.

Yet the theory has powerful emotional appeal. Usually that appeal is strongest for conservatives, who can’t stand the thought that positive action by governments (let alone—horrors!—printing money) can ever be a good idea. Some libertarians extol the Austrian theory, not because they have really thought that theory through, but because they feel the need for some prestigious alternative to the perceived statist implications of Keynesianism. And some people probably are attracted to Austrianism because they imagine that it devalues the intellectual pretensions of economics professors.

The Great Depression happened largely because policy-makers imagined that austerity was the way to fight a recession; the not-so-great depression that has enveloped much of Asia has been worsened by the same instinct. Keynes had it right: Often, if not always, “it is ideas, not vested interests, that are dangerous for good or evil.”

Have a great weekend everyone!