This rap song - perhaps the only one ever
to address
economic theory - has gone viral. It was the
idea of
John Papola, a creative in the New York ad
industry:
How I came to be interested in the economics
of Hayek
definitely stems from the crisis sort of beginning
to
unfold and that raising a lot of questions
about what's
underneath our system of money and credit
and the economy,
and Fear The Boom And Bust was the result.
We wanted to try to provide a way to lift
Hayek up,
so that he has his rightful place - at the
very least alongside Keynes.
Friedrich Hayek's ideas are no longer the
preserve of
economic wonks. Even teenagers are hearing
about them.
We've had over two million views and we've
heard from
teachers all around the world that they're
using it. It is participating in
this larger movement, which is a re-examination
of some of our assumptions.
What most people assume is that the recent
financial
crisis was caused by deregulation and free-market
zealotry. Not
everyone agrees.
FA Hayek and other followers of the so-called
Austrian school of
Economics - people like me - believe such
crises are caused not by
too little regulation, but by too much.
I'm Jamie Whyte, a banking consultant and
economic
commentator. In this programme, I'll be exploring
this radical
free-market critique of our financial system.
Next week,
Newsnight's Economics Editor Paul Mason will
explain another
radical critique, but one that comes from
a collectivist point of
view.
You won't learn anything about the Austrian
school of economics
by looking at the Austrian economy. It gets
its name from the fact
that its founders lived in that country's
capital city, Vienna, in the
early twentieth century.
Professor Steven Horwitz, of St Lawrence University
in New York,
believes the times that these economists lived
through played a
crucial role in forming their ideas.
The early Austrians were you know liberals
in the
European sense. And then when you put on top
of that the sort of
destruction they saw happen in World War I,
followed by the sort of
you know hyperinflation in Germany, followed
by the rise of the Nazis
and sort of the attempts across the board
to sort of interfere with how
markets and prices operated, you can see why
they were so concerned
about the sort of undermining of markets and
the liberal order given
what they'd witnessed in Europe. And with
the rise of Hitler and the
Nazis, many of those folks - well let's just
say they had to leave.
Hayek moved to an academic job in London and
found
the economic scene dominated by the Cambridge
economist John
Maynard Keynes, a defender of a large governmental
role in the
economy. Lord Skidelsky is an economic historian
and Keynes'
biographer. How did the two great economic
thinkers of their day
get along?
Hayek was brought in to the LSE in order to
challenge the dominance of Keynes, and so
he thought that he would
take up the challenge of explaining the Great
Depression. You took
your life in your hands if you started a controversy
with Keynes.
Keynes was a charismatic character and Hayek
said his voice was
ìbewitchingî. And Hayek was solid, reserved,
German, bourgeois, very
formal, and so it was an edgy relationship.
And in 1931 Keynes
published a book called A Treatise on Money,
and Hayek published a
book the same year called Prices and Production.
And Hayek reviewed
A Treatise on Money, and it was a very, very
scathing review. And it
stung him, that review. But then he had an
opportunity to comment on
Prices and Production, and he wrote that Hayek's
book is ëan
extraordinary example of how a remorseless
logician starting with a
mistake can end in bedlam'. And Keynes said,
ìYou know, I get on
with Hayek very well personally, but I find
his ideas completely mad.î
In fact, a simple and un-contentious premise
provides the
foundation of the Austrian objection to government
involvement in
the economy. It is based on the crucial importance
of market
prices.
Professor Larry White is an Austrian economist
and an expert on
the history of banking. He explains the importance
of market prices
for answering the most basic economic question
- namely, what is
the best use to make of the limited amount
of stuff the world makes
available to us?
We can't produce everything we want. We have
to choose
what it is we want to produce; and beyond
that, we have to choose how
to produce anything we decide we do want.
There are many ways to
grow wheat: you can use more or less fertiliser,
you can use more or
less mechanised equipment. So to produce things
efficiently, we need to
know which is the most cost-effective way
of producing; and to do that,
we need to assign prices to the inputs into
the productive process. So
we need to know how valuable a tractor is
in growing wheat as
compared to using it in some other way, and
we need to know how
valuable fertiliser is and so on. So we need
prices for the factors of
production. And to get informative prices,
you need a competitive
market.
Market prices are signals that guide our economic
behaviour. When they are set by voluntary
market transactions,
they carry information about scarcity and
demand. When prices
are set by the government, they tell us not
about this underlying
economic reality, but about the preferences
of politicians. In other
words, they're likely to be false signals.
Austrians apply this basic free market insight
not only to goods like
wheat and tractors, but to money itself. Interest
rates are simply
prices for borrowing. In a free market, that
price - the rate of
interest - would be determined by the demand
for borrowing and
by the supply of money that is available to
be borrowed - that is, by
the amount that has been saved.
But we do not have such a free market. Interest
rates are set by
central banks - such as the Federal Reserve
in the United States,
the Bank of England and the European Central
Bank. Interest
rates are therefore very likely to be false
signals, either artificially
high or artificially low.
This is the prism through which Austrian economists
interpret the
past. Professor Robert Higgs of the Independent
Institute in
America is an expert on the Great Depression.
He claims that by
holding down US interest rates during the
1920s, in an attempt to
manipulate exchange rates, the Federal Reserve
sent a false signal.
The Fed was taking actions which made interest
rates lower
than they otherwise would have been, which
is to say they were
distorting financial markets. And the result
of that distortion was to
encourage particularly certain types of investments
at the expense of
others, and the most important of those were
investments in real estate
development - both residential housing developments
and commercial.
So the United States witnessed during the
1920s an enormous boom in
house building, in office building, factory
building, which was caused
in some part at least by the Fed's distortion
of interest rates. And that
mal-investment that was taking place during
the 1920s was
unsustainable because it was the product of
an artificial interest rate, a
false signal that was being sent to investors
about where profits could
be made.
Of course, this analysis is contentious. The
causes of the
Great Depression, the reasons it was so deep
and so prolonged,
remain topics of fierce debate among economists.
Lord Skidelsky
explains that Keynesians do not blame the
depression on interest
rates. They blame it on an excess, and then
a deficiency of
confidence among consumers and business people.
He believed that people only have a very,
very
precarious knowledge of future events. They
don't know very much
about them, so they're very, very subject
to swings of sentiment. He
called it animal spirits. And when animal
spirits were buoyant, because
there were just a whole lot of pleasing circumstances
which lifted them,
then you tended to get into an over-optimistic
frame of mind. The
entrepreneurs had over-estimated the rate
of return that these
investments would yield, and once this became
clear - that they weren't
going to pay for themselves - then they withdrew
from investment. And
then that produced the slump.
Austrians agree that during booms that precede
busts,
over-optimism is rife. But for Austrians,
this over-optimism is
precisely what needs to be explained. How
come so many people
made the same mistakes at the same time? And
Austrians have an
answer; it is the false signals sent by interest
rates set by central
banks.
Because the boom and bust cycle reflects the
ebb and
flow of our collective mood, Keynesians say,
governments can
improve the performance of the market economy.
They can do
things that offset the ups and downs caused
by our mass mood
swings. And one thing they can do is spend.
When the animal
spirits of private citizens are flagging,
when they prefer saving to
spending or investing, governments should
step in and take up the
slack.
Austrian economists think this is a big mistake.
Professor Larry White:
When the crash comes, the important thing
is to move the
resources back out of the housing sector,
say, into areas of the economy
where there really is the demand for them.
So an effort to prevent that
from happening is just going to keep the economy
depressed for longer.
You have to remember that when government
spends in an attempt to
stimulate the economy, it has to get the financing
from somewhere. It
either has to levy taxes, which has an offsetting
effect on the economy -
it moves resources from Peter to Paul, it
doesn't create new spending in
the economy in total - or, what's often thought
to be a free lunch, they
can borrow the money. But we now recognise
that piling up
government debt is not free either. That taps
into the supply of funds
available for investors - there's crowding
out, as the famous expression
goes - and either present taxes or future
taxes discourage economic
activity. So when you put those things together,
the multiplier I think
you really ought to expect from government
spending is zero.
President Franklin Roosevelt certainly didn't
share this
Austrian perspective. During the Great Depression,
he spent vast
sums on industrial subsidies and public works
projects. The
consensus is probably still that FDR's economic
activism pulled
America and the world out of depression. And
there can be no
doubt that back in the 1930s, Keynes won the
debate with Hayek.
Politicians adopted the Keynesian approach.
Lord Skidelsky again.
Keynes had something to offer in terms of
policy, whereas Hayek had nothing. His idea
was if you have a Great
Depression or a big depression, you just do
nothing if you're the
government. You have to go through the whole
process, liquidate all
the wrong things that have led to the depression,
and government
intervention would only make things worse.
Well when there were
thirty million unemployed in America and three
million unemployed in
Britain and six million unemployed in Germany,
that's not a message
that anyone wanted to hear.
Hayek you know disappears to some degree,
and winds up
later in the 50s at the University of Chicago.
But not in the Economics
Department. They would not hire him. He's
hired by the Committee on
Social Thought. Not a bad place to be, but
reflective of his standing in
economics. You know, now looking back, he's
rehabilitated those
ideas; but at the time, he is perceived to
have lost the debate with
Keynes in the eyes of the profession.
Professor Steven Horwitz.
Things did improve for Hayek. In 1974 he was
awarded the Nobel
Prize for economics, for the work he had done
during the 1930s -
the work Keynes had described as intellectual
Bedlam. This
success, combined with the economic malaise
of the Keynesian
1970s, helped make Hayek's free market ideas
fashionable again.
Legend has it that, at her first cabinet meeting
as Prime Minister in
1979, Margaret Thatcher thumped a copy of
Hayek's Constitution
of Liberty on the table and declared ìThis
is what we believeî.
But the distinctively Austrian ideas about
boom and bust and the
role of interest rates set by central banks
were not part of the
free-market ideological revival under Thatcher
and President
Reagan. For that, we needed another major
financial crisis, and
one that appears to conform perfectly to the
Austrian model of how
they occur. Professor Horwitz again.
During the first decade of the 21st century,
the Federal
funds rate, which is the rate that banks borrow
and lend from each
other, was about 1% for a long time. And that
was the nominal rate
when you consider that we were running a small
amount of inflation.
The real Federal funds rate was negative - that
is banks were being paid
to borrow basically. You sort of channel all
this money into the housing
industry, you get rising house prices, people
think they're never coming
down. You build all these other financial
instruments on top of this
and you've kind of pyramided this whole financial
super structure on
this inflationary base, this credit expansion
base that has to give at some
point.
You're listening to Analysis with me, Jamie
Whyte. On
tonight's programme we're looking at the
so-called Austrian school
of free market economics and why its followers
argue that the
financial crisis was caused not by too little
regulation but by too
much.
Austrian economists believe that, details
aside, the financial crisis
of 2008 is a rerun of the Great Depression.
It has the same
structural causes and the correct governmental
response is the
same: Don't get involved!
Keynesians also see parallels with the 1930s.
They think the
spending stimulus in 2008 was the right response
- lessons were
correctly learned from the Great Depression.
Lord Skidelsky
again:
The Great Depression showed negative growth
for 12 quarters. That is three years - just
went down and down and
down and down. Then it bottomed out and then
a recovery started.
Whereas in recent events, the downward decline
was only for 5
quarters. And people would say the reason
is that all the governments
of the world stepped in in the autumn of 2008
and the spring of 2009
with big rescue packages, which stabilised
the situation much earlier
than had been the case between 1929 and 1932.
When there is government led stimulus of the
economy to
replace the spending that isn't being done
by the private sector, the
market mechanism for allocating resources
is at least suspended; and
Austrians argue that resources that are allocated
by central planners or
governments rather than by the market are
sure to be wasted. What's
the Keynesian response to that objection?
Well it's a short-run/long-run thing, isn't
it? The
fact is that the efficiency of allocation
is the long-run engine of growth.
In the short-run when you have lots of unemployed
resources, it doesn't
matter whether they're allocated that efficiently.
You've just got to get
the level of activity up. That is the most
important thing. And I'm afraid
it's what the government believes today.
They say oh no, we can't have
government spending because it misallocates
resources. I mean it
makes growth less fast than it would be. But
that's a very, very
unimportant question in the short-run because
actually what you need in
the short-run is all the resources to be used.
The Great Depression was the first time a
policy of
stimulus spending was used. Before the 1930s,
governments had
played a small role in the economy - at least
during peacetime. But,
in the 70 years since the Great Depression
ended, there have been
many attempts at economic stimulation.
The Institute of Economic Affairs is a free-market
think tank in
London. Hayek helped to found it and his framed
photograph takes
pride of place in one of the meeting rooms.
Philip Booth is the
institute's director of research. He believes
recent history supports
the Austrian scepticism about stimulus spending.
Keynesians always respond by saying well the
stimulus just
wasn't big enough. And the problem is that
you then take examples
such as Japan where there's been a long fiscal
stimulus now over a
period of about twenty years and the economy
is still suffering from
sluggish growth. It's been pulled further
out of shape. We have public
sector infrastructure projects which are really
of very little value, and
we have a huge debt burden which is being
placed on the next
generation. And quite quickly, if that debt
burden mounts up, then it has
implications for private spending because
consumers want to spend less
because they worry about the burden of future
taxes. And you could
potentially have seen that happening in the
wake of the crash in Britain
in 2008 to 2010 when the British government
was borrowing one pound
in every four that it spent. So that the Keynesian
analysis really is very
static. It assumes that the government can
take one particular action and
it doesn't have any effect on the private
decisions of those operating in
the real economy, but unfortunately it does.
Indeed, some Austrians claim that stimulus
spending also
has the perverse effect of benefiting the
rich at the expense of the
poor. Steve Baker, a Conservative MP and believer
in Austrian
economics, explains how the stimulus policy
of ìquantitative
easingî - or printing money, as it is more
commonly known -
enriches bankers.
Whoever gets the money first starts spending
that money, and
whatever they spend money on goes up in value.
So when quantitative
easing started, there was a house price recovery
in Chiswick and in
Islington. New money was injected into the
economy, into the bond
market. Those people who trade the bond market
got the new money
first. Immediately of course they start spending
it on things and the
house prices go back up. And it's kind of
tragic that we spend so much
time, particularly on the Left, talking about
wealth inequality whilst
tolerating this system which generates these
huge economic problems
which everyone then has to bail out. So to
me, there's a huge amount to
be done here explaining to people that one
of the greatest sources of
injustice in our society is the system of
central planning and legal
privilege around banking. And what we need
in banking is actually not
more regulation. What we need is the concept
of bearing your own
risks.
This idea - that people who take risks should
bear them -
is essential to the proper functioning of
a market. If costs are
transferred from people who risked them to
people who did not, too
much risk will be taken. Austrians object
not only to central banks'
distortion of interest rates, but also to
the common government
practice of guaranteeing bank depositors and
bailing out the bond
holders of failed banks. They believe these
interventions in the
banking market create catastrophic moral hazard.
Philip Booth
again:
It no longer matters to consumers whether
or not the banks
they deal with are run in a prudent way. It
therefore no longer matters
to banks in terms of their business plans
and so on they are run in a
prudent way, and they don't feel the need
to signal to customers that
they are run in a prudent way. So banks used
to have much higher
margins of capital than they do today, despite
the fact that that capital
wasn't regulated, and much higher level of
liquidity. And banks used to
use many other mechanisms as well to signal
to consumers that they're
actually safe, sound, secure institutions.
All that has been lost as a result
of two generations of increasing state support
for the banking system.
Many people can hardly imagine a banking system
without government guarantees, a lender of
last resort, and without
a central bank setting interest rates. Yet
this arrangement is
relatively new. The United States Federal
Reserve was only created
in 1913. For long periods in the 19th century,
Canada, Scotland and
the United States all had what has come to
be known as a free
banking system. Austrians would like a return
to a banking system
with no central bank. Professor Higgs again:
I would argue that the most successful monetary
system that
ever existed in the United States was the
one that existed in the 1840s
and 50s. At that time there was no central
bank. It was simply a free
banking system in which banking was a business.
You went into it, you
succeeded or failed like any other business.
Banks issued their own
bank notes. There were about 1500 banks issuing
notes in 1860. These
notes circulated freely around the country.
This banking system worked
very successfully.
During this period of what we'll call free
banking, were there
not many runs on banks?
Runs did occur on occasion. Bank failures
and even a certain
amount of contagion was not a good thing,
but it was better than having
a central bank which can make a decision that
devastates a whole
country or indeed perhaps even an entire world
if that's the central bank
of the United States.
Prior to the crisis, such ideas would have
struck most
economists and bankers as crazy talk. Following
the conquest of
inflation in the early 1980s, western economies
enjoyed a long
period of low inflation, no bank runs and
no sovereign defaults.
Central banking looked like a safe and cost-efficient
way of keeping
the economy stable. And, even after the crisis,
most economists and
bankers still adhere to this orthodoxy. Tim
Congdon, founder of
the economic forecasting firm Lombard Street
Research, is among
them.
I'm in favour of freedom - freedom for consumers
and
customers, but also for the banks. Now the
banks want to compete, and
one thing they want to do is to offer low
cost services. Now the more
cash they've got, the higher the price of
services they offer. So they
want a reserve bank to help them with the
management of their cash.
And again in history check the evolution,
check what actually
happened. What happened was that the central
bank evolved because
the banks wanted that - because that was a
matter of choice by the
banks, because the banks freely wanted low
reserve banking.
Of course, Austrians believe that banks'
ability to avoid
the expense of holding large cash reserves
- something made
possible by central banks - is one of the
reasons we have just
experienced a financial crisis. But can Austrians
point to any
modern day banking system that operates successfully
without a
central bank? Professor White again.
The closest approximation to it we have today
is in offshore
banking centres in places like the Cayman
Islands, Jersey and
Guernsey. There you have banks that operate
with very thin margins
between the rate they pay on deposits (they
pay high rates on deposits)
and the rates they charge on loans (they charge
low rates on loans). And
they're able to operate very competitively
because they donët carry all
the burden of regulation that onshore banks
carry. There hasn't been
any financial crisis in offshore banking centres.
Why? Because they're
managed much more conservatively than banks
in New York or
London. And why is that? Because they don't
have the guarantees that
banks in New York and London have. They have
to operate very
conservatively to attract clients.
Austrian economists are now being heard. Even
Keynesians, like Lord Skidelsky, accept that
Austrians do have
something important to say.
There should be a revival of Hayekian analysis
or Austrian analysis of why economies go wrong.
Where you have
financial crises and crises that involve banking,
I think a Hayekian
approach can alert you to that kind of thing.
Hayekians may have more
to say than Keynesians, but they had nothing
to say at all about what
you should do about it.
This is an important point that should worry
us
Austrians. Our recommended policies take little
account of what is
politically possible. Removing the power of
central banks to set
interest rates, refusing to guarantee bank
creditors or doing
nothing to ease the immediate pain of a recession:
is any
democratically elected government likely to
find such ideas
appealing? Professor Horwitz of St. Lawrence
University again.
When the lesson of Austrian economics is the
sort of
lesson of humility and that you can't yourself
save the world by passing
all these policies, I think it's not a message
that politicians want to hear.
That said, you know I think there are more
folks in the political world
who are being influenced by those Austrian
ideas and in the Tea Party
Movement who, if they're elected, as putting
a stop to a lot of things
that are happening. So there's a little bit
of growth there. But again if
you're someone who's inclined to go into
politics, unless you're going
in you know to play defence as it were and
sort of you know stop bad
policy - if you're going in to create good
policy Austrian ideas aren't
going to be of much interest to you because
it basically says you're not
going to be helpful.
Steve Baker was elected to parliament in May
2010. He
has already tabled a bill to reform Britain's
banking system. It did
not get through parliament. Nevertheless,
he hasn't lost faith.
I want to be contributing an Austrian explanation
in the public
sphere, in the hope that in five or ten years
time people will be
demanding those commonsense solutions that
put them in charge of
their own lives. I think we're in a time
now where we could have
historic change, but I have to accept that
my role is really to move the
debate, not to have some grand victory. I
don't think it's likely
immediately.
No country is now governed according to the
principles
of Austrian economics or anything close to
them. But several are
close approximations of the Keynesian model.
The political
prospects of Austrian economics may depend
on which economies
end up doing better, those that follow the
Keynesians prescriptions
closely or those that do not. Lord Skidelsky.
China and the United States have kept quite
big
stimulus programmes going; whereas Britain
and Europe have gone in
for austerity. And I think we'll just see
how this plays out. I think that
the recovery will be very mediocre in Britain
and Europe, and I think
the American programmes will get a better
recovery going in the
United States. But I can't be sure, and anyone
who tells you they can be
is either a fool or a liar.
Even if Keynesian prescriptions fail over
the next few
years, I suspect the prospects for an Austrian
approach remain
poor. The financial crisis has made people
aware that the banking
system can be extremely hazardous. And the
natural response to
danger is to seek to control it. Market mechanisms
do, in fact,
regulate things. But leaving things to the
market is a hard idea to
sell to voters who expect governments to protect
them. I suspect
that Steve Baker and the rest of us trying
to bring free markets to
banking are wasting our time. But, given what
is at stake -
prosperity and justice - it's hard to quit.
