In his article What is Austrian Economics, Matt Yglesias recognizes the growing strength of Austrian economics on the political environment as exemplified by Ron Paul’s recent 2nd place finish in New Hampshire. After providing a brief history of Austrian economics and recounting some feuds between libertarian economists, he criticizes aspects of Austrian economic theory, condemning it as extreme, outlandish, and mistaken. Although generally accurate in his portrayal of the views held by Austrian economists, he mistakenly asserts that Austrians believe tax cuts do not promote economic activity and implies falsely that Austrians do not want any governmental changes during recessions. More significantly, he provides two thoughtful and important criticisms of the Austrian theory of the business cycle that fail to refute it under closer examination. He concludes his piece by remarking that the Great Depression discredited Austrian economics, ignoring that it actually conforms extremely well with Austrian theory. With the exception of one of his criticisms of the Austrian theory of the business cycle, all of his criticisms are answered and his mistakes corrected in Murray Rothbard’s book America’s Great Depression, which Yglesias would benefit greatly from reading.
Austrians and Taxes
Mistaken regarding the Austrian view on taxes, Yglesias remarks “Austrians also believe that cutting taxes to boost economic activity doesn’t work either.” In reality, Austrian economists agree that tax cuts combined with spending cuts promote economic growth, though for different reasons than Keynesians and other economists. As explained by the Austrian theory of the business cycle, the boom represents a period of overconsumption and insufficient savings due to artificially lowered interest rates. As a consequence, reducing consumption and increasing savings helps coordinate production in line with the time preferences of society, providing the best way of mitigating recessions. As Murray Rothbard remarks in America’s Great Depression,
“There is one thing the government can do positively, however:it can drastically lower its relative role in the economy, slashing its own expenditures and taxes, particularly taxes that interfere with saving and investment. Reducing its tax-spending level will automatically shift the societal saving-investment–consumption ratio in favor of saving and investment, thus greatly lowering the time required for returning to a prosperous economy. Reducing taxes that bear most heavily on savings and investment will further lower social time preferences.”
Since all government spending represents consumption, cutting taxes and spending necessarily increases savings and reduces consumption compared to the 100% consumption by the government. More generally, Rothbard’s advice shows the comments by Yglesis that “Austrians reject the idea that there is anything at all the government can do to stabilize macroeconomic fluctuations” and that Austrians “demand no action” to be misleading. Rather than advocating for no changes, Austrians believe that government acts as a drag on the economy, making both tax and spending cuts one of the best means of responding to economic downturns.
Austrians and Rational Expectation
After briefly explaining the Austrian theory of the business cycle, Yglesis criticizes it for failing to consider rational expectations theory. In the view of Yglesis, “it’s hard to understand why businesspeople would be so easily duped” by artificially lower interest, explaining that Austrians do “not consider the role of expectations feedback in macroeconomic policy.” In fact, Austrians have considered and responded to this critique in a variety of ways. In the most convincing response, Austrians assert that the artificially lower interest rates create a disastrous Nash equilibrium. As Gene Callahan remarks in his book Economics for Real People
“Let us, for simplicity, divide entrepreneurs into classes A and B…Class A entrepreneurs are those who are currently profitable, i.e.,those most able to interpret the current market conditions and predict their future. Class B’s are struggling, money-losing, or, indeed, unfunded “want-to-be” entrepreneurs, less capable at anticipating the future conditions of the market. Now, let us go to the start of the boom. It is 1996, and the Fed begins to expand credit. To where does this new supply flow? The ‘As are not necessarily in need of much credit. If they wish to expand, they have available their cash flow…The situation for the B’s is quite different, however. Their businesses are marginal, or perhaps nonexistent…Even if they could tell that they are witnessing an artificial boom, it might make sense for them to “take a flier” anyway…As the B’s create and expand businesses, the boom begins to take shape…Although the most skilled entrepreneurs [class A] suspect that the expansion is artificial, most can’t afford to shut down their business for the duration of the boom. But if they can’t, they must increasingly compete with Bs for access to the factors of production…However, in order to do so, [class A] must take advantage of the same easy credit that [class B] is using to back its bids…So the A entrepreneurs, willy-nilly, are forced to participate in the boom as well. Their hope is that, in the downturn, the basic soundness of their business and the fact that they have expanded less enthusiastically than the Bs will see them through, perhaps with only a few layoffs.”
As explained by Callahan, the artificially lower interest rates create a situation in which society would benefit if no entrepreneurs responded. However, some entrepreneurs responding to the lower interest rates force other entrepreneurs to respond in order to remain competitive, making a disastrous Nash equilibrium. For this reason and others,[i] the critiques from rational expectations theory fail to disprove the Austrian theory of the business cycle.
Austrian Business Cycles
In a second critique of the Austrian Theory of the Business Cycle, Yglesias notes that prices fluctuate constantly without economic catastrophes. As he argues, “the Austrian story of investment booms and busts doesn’t actually explain recessions and unemployment” because“[s]pending patterns shift all the time without sparking a recession.” To clarify his critique, he remarks that “If investment spending in general declines, you would expect spending on consumer goods to rise to offset it. In practice, this doesn’t always happen and you get a recession. It’s this anomalous collapse in overall spending that needs explaining, and describing some of the past spending as “malinvestment” doesn’t help you understand it.” This criticism ensues from Yglesisias only noting half of the important features of a business cycle described by Austrians: an unjustified lowering of the interest rate. In doing so, he neglects the emphasis on money by Austrians. Summarizing and then responding to the criticism explained by Yglesias, Murray Rothbard remarks in America’s Great Depression,
“It is important, first, to distinguish between business cycles and ordinary business fluctuations…Changes…take place continually in all spheres of the economy…We may, therefore, expect specificbusiness fluctuations all the time. There is no need for any special “cycle theory” to account for them. They are simply the results of changes in economic data and are fully explained by economic theory…Many economists, however, attribute general business depression to “weaknesses” caused by a “depression in building” or a “farm depression.” But declines in specific industries can never ignite a general depression. Shifts in data will cause increases in activity in one field, declines in another. There is nothing here to account for a general business depression—a phenomenon of the true “business cycle.”… In considering general movements in business, then, it is immediately evident that such movements must be transmitted through the general medium of exchange—money…If one price goes up and another down, we may conclude that demand has shifted from one industry to another; but if all prices move up or down together, some change must have occurred in the monetary sphere… Yet, fluctuations in general business, in the “money relation,”do not by themselves provide the clue to the mysterious business cycle…The explanation of depressions, then, will not be found by referring to specific or even general business fluctuationsper se. The main problem that a theory of depression must explain is: why is there a sudden general cluster of business errors?”
Whereas specific prices rise and fall simply by changes in consumer preference for different things, general price increases and decreases result from changes in the supply of and the demand for money. During the boom, the increasing supply of money leads to a general rise in prices, with a disproportionate rise in prices among the more capital-intensive goods most affected by the lower interest rate, resulting in malinvestments among these capital intensive goods. After interest rates increase and the economy re-adjusts to the new supply of money, everyone realizes that entrepreneurs were engaged in a collection of errors, leading to a recession. As Rothbard explains in the pages after the above passage, the recession often entails a general drop in prices due to a contracting supply of money and especially due to an increasing demand for money from individuals. The demand for money increases by people largely due to uncertainty surrounding the collection of errors. As a consequence, malinvestments explain “the anomalous collapse in overall spending” as the uncertainty created by the collection of errors results in an increased demand for money. After the liquidation of debt and the reorganization of production in line with consumer preference, consumer demand for money drops once again, leading to a general rise in prices. By differentiating between business fluctuations and business cycles and focusing on the role of money, Austrians explain both the boom and the bust.[ii]
Austrians and the Great Depression
After two important but incorrect criticisms of the Austrian theory of the business cycle, Yglesias writes that the Great Depression effectively discredited Austrian economics. In emphasizing the Great Depression, he correctly remarks that “[m]any of the original Austrians found their business cycle ideas discredited by the Great Depression.” Indeed, even Lionel Robbins, one of the leading Austrian economists of the 1930s, disavowed himself from Austrian economics and repudiated his very good 1934 book The Great Depression, which provided a good early Austrian account of the Great Depression. In hindsight, though, the disrepute of the Austrians following the Great Depression was very ironic. Leading up to the beginning of the Great Depression, Ludwig von Mises and F. A. Hayek applied their knowledge of the Austrian theory of the business cycle to warn of an impending crash. As shown in detail in Murray Rothbard’s America’s Great Depression, the Federal Reserve artificially lowering interest rates and the overall supply of money increasing by over 50% in the 1920s, meaning the data follows the Austrian explanation perfectly.[iii]Additionally, Rothbard has replied in detail to Yglesias’s criticism that “the bust was clearly not self-correcting.” In particular, Rothbard notes that President Hoover increased spending by over 40% and artificially held up wages during his term to try to restore economic growth, resulting in the massive unemployment under his term.[iv] Rather than disconfirming the Austrian account, the high unemployment resulting from unprecedented government interventions to stimulate demand and intervene in the market bolster the merits of Austrian economics.[v]
Although making important critiques of Austrian economics, Yglesias fails to make any major critiques that survive scrutiny, and they have all been answered by Austrians. In particular, Murray Rothbard responded to almost all of the criticisms of Yglesias in his book America’s Great Depression. As a consequence, Yglesias should consider reading the book, perhaps convincing him that he too can be an Austrian.
By Sean Rosenthal
[i]For a more detailed account of the Nash equilibrium and other shortcomings in the rational expectations theory critiques of the Austrian theory of the business cycle, see chapter 13 ofEconomics for Real People, particularly under the sub-heading “But What About Expectations.”
[ii]For a more detailed account, see chapter 1 of Murray Rothbard’s America’s Great Depression, particularly from the beginning of the chapter through the end of the section “Secondary Features of Depression: Deflationary Credit Contraction.”
[iii]See Part II of America’s Great Depression.
[iv]See Part III of America’s Great Depression.
[v]Although Yglesias made a critique of the gold standard in relation to the Austrians, it has no bearing on the merits of Austrian economics and its theory of the business cycle, so I chose not to respond to it.