The Austrian theory postulates that entrepreneurs
are tricked or fooled by government-engineered
increases in the money supply.
Here’s a simple example of how the scenario
runs: The central bank inflates the supply
of money.
The real interest rate falls because there
are more funds to be lent out.
As the real interest falls, entrepreneurs
borrow more.
They undertake longer and more ambitious projects,
and eventually, according to the Austrian
theory, those longer and more ambitious projects
cannot be sustained, they turn a loss rather
than a profit, and eventually the boom becomes
a bust.
[The Housing Bubble]
To consider a specific example, it’s been
argued by many Austrians that the housing
bubble was in fact an illustration of Austrian
business cycle theory.
In the years 2001 to 2004, the Fed really
was somewhat loose with credit, nominal interest
rates were quite low, there was a housing
bubble.
People borrowed a lot more money; they borrowed
more than they should have.
People thought the good conditions, the low
interest rates on mortgages, the easy availability
of credit, and the rising home prices would
continue forever.
That wasn’t the case.
Eventually the bubble burst, these trends
were reversed, and we had a lot of long-term
construction projects and housing and mortgage
decisions that turned out in retrospect to
have been big mistakes.
[Austrian Remedies]
Austrians propose some different remedies
for stopping the problem in the first place.
To stop the problem in the first place, Austrians
have argued we should either have a gold standard
or tighter money or some kind of monetary
rule.
The belief is it would then be harder to fool
entrepreneurs because, in terms of monetary
conditions, it is believed they would be more
stable or at least entrepreneurs would know
what to expect.
[Explaining the Great Recession]
Austrians and Keynesians give very different
readings of the 1920s and the subsequent Great
Depression.
According to a lot of Keynesians and also
monetarists, there’s some critical negative
period between 1929 and 1932, and if only
we had stopped aggregate demand from contracting
so radically, we would have had a much stronger
economy.
The Austrian view is different.
According to the Austrians there was a lot
of loose money and monetary expansion in the
1920s.
Entrepreneurs took on projects which were
too ambitious, and once those longer-term
projects are in place, Austrians often believe
there’s not any way you can back out of
the jam you’re in, that a lot of those investments
will turn bad.
Now on this question I’m not actually so
much of an Austrian when it comes to the Great
Depression, but that’s one way of thinking
about the difference between the two points
of view.
Austrians locate the problem more in a kind
of original sin of inflation, which once it
has been committed is very hard to get out
of.
Monetarists and Keynesians tend to think that
if you can boost aggregate demand or maintain
aggregate demand at the proverbial last minute
that you’ll actually succeed in making the
cycle a much less severe one.
[Strengths and Weaknesses]
Strengths and weaknesses of the Austrian theory:
What are they?
I think one strength is that we do see a lot
of credit bubbles in history, and on average
those credit bubbles are associated with periods
of loose monetary policy.
The Austrian theory picks up some important
part of this story.
There is too much credit put on the market,
entrepreneurs are fooled, and this is one
factor that contributes to making for a recession
or depression.
But the Austrian theory also has some weaknesses.
One is that for a theory which stresses the
virtues of the market, it assumes that entrepreneurs
are tricked rather easily.
So say there’s some inflation or an increase
in credit.
An entrepreneur doesn’t have to be genius
to say, “Hey wait a minute, there’s been
some inflation.
I saw this on Fox News; I read about it in
the Wall Street Journal.
Maybe I shouldn’t overexpand my business.
There’s some inflation.
Maybe now is time to just be a little more
cautious.”
It’s also the case that looking back in
history, a lot of business cycles are caused
by monetary contractions and not by the previous
expansion.
So there’s an awful lot of cases where the
Austrian theory wouldn’t even potentially
apply.
