More on "Austrian School Flunks"
From Gael J. Campan
The Jerusalem Post published a response, entitled Austrian School Flunks, to an earlier article of mine on the subject of deflation.
Here is my response, before it was edited:
Jonathan Lipow did not appreciate my editorial "Save us from the deflation doctors" published in the 12th of November issue of the Post, where I stated my opinion regarding the present state of deflation in Israel, which I consider to be an expectable and healthy phenomena as opposed to the ill-fated outcomes of inflationpolicies.
He expressed his discomfort in a very defensive piece "Austrian theory flunks" where he lead several charges and granted me the privilege of personal attack as if, in the realm of economic thinking and debate, authors could be more relevant than the rigor and logic of their positions.
To start with, he correctly identified my economic background as Austrian School of Economics. After acknowledging its originality, he lead a charge arguing that first, it is not a new theory and second, its macroeconomics has been "utterly rejected" by mainstream economics.
This is an argument from intimidation: "do not reader dare considering Austrian School of Economics since it is already discarded by mainstream economists". I personally prefer to give credit to the readers ability to make their own mind on the basis of explicite arguments.
Regarding this specific matter, the mainstream of the 20th century happened to be successively Classic, Marxist, Keynesian, Monetarist, Neo-classic, Post-Keynesian, to name a few; i.e. one thing and its opposite. So even if Austrian free-market economics was not considered mainstream, with regard to the historical volatility of paradigms within the academy, it might as well underline its robustness and its impermeability to intellectual fashions.
Now, it is true that Austrian economists, such as Ludwig Von Mises and Murray Rothbard, provide an alternative approach to what Mr. Lipow calls mainstream macroeconomics.
Specially as far as the business cycle issue is concerned, they provide a complete explanation of how government-controlled central banks do trigger booms and busts by inflating the money supply.
At the center of this explanation lies the axiom of time preference or preference for the present (that Mr. Lipow mistakenly calls time discount rate). It is the simple fact that individuals always prefer to enjoy economic goods earlier instead of later. Applied to savings, this preference determines the amount of money available for investment : I am willing to lend NIS 100 now (that is, to sacrifice current consumption) against the promise of NIS 100 + X in one year from now.
This supply of savings from customers confronts with a demand for financing from entrepreneurs. From this confrontation results the natural interest rate which is the price entrepreneurs pay on a given market for borrowing money.
Then, if suddenly the authorities pump money into the economy, more credit become available for investment and the interest rate drops. Note that this is an artificial process, since there was no increase in real savings, no change of time preference.
With the new interest rate, ventures that were not profitable at the previous interest rate become profitable, at least apparently : sales projections are great and stock-market ramps up. Meanwhile these new projects look for capital and labor, thereby putting pressure on prices of non-specific production factors, ultimately spreading prices increase through the economy. At this stage, all the elements of what is commonly described as a boom are set.
It is brought to a halt when, the new products and services coming to fruition, demand does not materialize. Hence inventories skyrocket, stock-market plummets, companies go bankrupt and massive unemployment follows.
If the government renounce to its inflating power, the economy can recover from its hangover and refocus on profitable ventures backed by sound savings.
This is why I keep thinking that transitory deflation - which is the present state of Israel economy - is healthy : it is a sign of recovery in process, of cleaning up of the economy.
This is why I keep denouncing calls for easing credit or cutting interest rate : they are precisely the cause of business cycles and of the current recession. Incidentally, it does not make any sense to target a normal or "expectable" interest rate as Mr. Lipow wishes he had (he said between 2 and 4%) since interest rate is a price and as such should be subjected to supply and demand.
Consider now Mr. Lipow's charge that, according to the Austrian theory, investors are I quote him "a bunch of idiots" who make wrong expectations regarding the market and are repeatedly mislead by wrong monetary policies, never learning from past mistakes. He even diagnoses I quote him again "split of personality" and "mass psychotic episodes" for investors who, as customers, should know very well that their time preference did not really change.
Beyond the tentative humor, I am stunned by the oversimplification and falsehood of such arguments. In real life, as in Austrian theory, investors and entrepreneurs are not one thinking abstract category but a group of different individuals with specific situations and different time preferences. If as a car manufacturer you decide to give up driving and take a bicycle, will you infer that since you are a representative customer your business is over ?
As far as the "learning from mistakes" charge is concerned, there is no evidence that correct expectations regarding the outcome of loose monetary policy would prevent the boom and bust cycle. Even if they know business cycle theory and anticipate a bust, entrepreneurs in place before money pumping have no choice but to endure the pressure from new entrants who funded their projects with cheaper money. They must fight to keep their resources from being hired and therefore are powerless against the increase of their costs of production and the shrinking of their margins.
Bottom line, the only beneficiaries of inflation are the early receivers who see their relative purchasing power increase, out of thin air and at the expense of later or no receivers since they enjoy it before prices increase spreads through the economy.
In a desperate attempt to prove his point favoring inflation Mr. Lipow introduced a comparison between the deflationary 19th century and the inflationary 20th century based on some unquoted empirical study covering US, Canada and Europe.
He bluntly affirmed that GDP per capita grew 1% in the former and 2% in the later century.
You don't have to be an economist - mainstream or not - to see that this affirmation, which Mr. Lipow presents as an evidence, is ridiculous. How can he expect us to believe the GDP per capita has grown 3 % in the last two centuries that taken together, saw the realization of the agricultural, industrial and financial revolutions, just to name some key historical events !?
If this is being mainstream, although I know few economists that would recognize themselves in such a clumsy intellectual endeavor, then I definitely keep the challenger position.
Still, if of any consolation for Mr. Lipow, the one good thing about being mainstream is that when you are wrong, you are not alone.
Comments (5)
I also posted a response to Austrian School Flunks in the Mises Yahoo! Groups, which I'm posting here. Some of the points I made are exactly the same or very similar to your points.
Quote:
"The Austrian argument is that when governments pursue easy monetary policies, short-term interest rates are artificially pushed below the time discount rate. This supposedly leads investors to mistakenly believe that the discount rate itself has declined, which implies that the public will be increasing its consumption in the future.
Investors build new factories based on this belief. The result is over-capacity and an inevitable bust, since the true discount rate has not declined and the consumption increase doesn't materialize.
THE FIRST problem with this is that investors supposedly make this mistake again and again and never learn that easy monetary policies lower the rate of interest below the time discount rate.
The second problem is that investors are also consumers. As such, they must know that the rate of interest is below their own private time discount rate for consumption, yet choose to ignore that fact."
This is a flawed critique of the Austrian theory on a macroeconomic scale. Firstly, most investors don't know why the business cycle occurs. All one need do is look at the writings of some of the greatest investors to realize that many investors haven't got a clue as to what causes depressions. Benjamin Graham proposed buffer stocks to guard against deflation and the "irrationalities of the Gold Standard" See http://cepa.newschool.edu/het/profiles/bgraham.htm. Graham was treated very sympathetically by Keynes, who followed Graham's investing advice and profitted greatly from it (despite being his economics, Keynes was an exceptional investor, who outperformed the market 18 out of 24 years). See http://www.tilsonfunds.com/superinvestors.html. Thus, Keyne's favorable treatment of Graham is understandable on account of his poor economics (perhaps Graham's economic advice was based on Keynesianism) and loyalty to Graham. What is not understandable is why Hayek also endorsed Graham's "buffer stock" plan.
Secondly, even if investors do understand the Austrian theory of the business cycle, that doesn't mean that they can avoid malinvestment. They may know that low interest rates make time-preference appear artificially lower than it really is, but they don't know how much lower.
Thirdly, though individuals (who are investors and consumers) may "know" their own time-preference, they do not have intrinsic knowledge of that of anyone else, but must determine that by interest rates. It is also doubtful that individuals put some kind of number on their time-preference. For example, an individual may have an intrinsic feel of his or her time-preference -- which will, of course, always be changing, depending on the time and situation -- he or she does not put a "number" on it. Time-preferences are not determined by mathematical formula's and numbers; rather, numbers can be assigned to approximate the average time-preference on the free market, or a section thereof.
Quote:
It stands to reason that if artificially low rates of interest cause over-investment, then artificially high interest rates cause under-investment, since investors will mistakenly believe that the discount rate has risen and hence will underestimate future consumption needs.
I agree with this reasoning. It is something that I feel is often overlooked, namely that deflation is also harmful. However, it is overlooked for a good reason -- it is rare. Furthermore, there is a hard limit on how much deflation can occur. The most that can possibly happen is that there can be a 100% deflation (e.g., a tyranical government confiscates the entire monetary supply). However, there is no limit on how much inflation can occur. Given that, I believe it is true that deflation can be harmful, though I would argue that it is not as harmful as the same amount of inflation, because the effects of deflation are seen more quickly. Deflation would cause entrepreneurs to assume that there is a higher demand for present consumption than there really is; thus, they would supply more consumer goods (like apples and lawn-mowers). However, many of these goods would sit in stores unsold, thus relatively quickly informing the entrepreneuer of his mistake.
On retrospect, I should have added that deflation is good when it acts to correct a previous inflation (when I spoke of deflation being slightly bad, I meant from a zero-starting point, not a starting point following great inflation). It is also interesting to note that a "benign" rate of inflation (say 1% of the monetary base) is actually less "benign" than it seems, due to compounding. A 1% per year inflation rate over 100 years does not produce 100% cummulative inflation; it produces cummulative inflation of 170% [(1.01^100 - 1)*100%].
Published: February 3, 2004 8:05 PM
I agree with the Austrians here, but I think they need to do a better job in refuting the common objection of investors not learning about monetary expansions.
Campan says "entrepreneurs in place before money pumping have no choice but to endure the pressure from new entrants who funded their projects with cheaper money."
I'm not sure how convincing this is. If these informed entrepreneurs will be hurt in the medium/long-run by expanding beyond the "natural" limits, shouldn't they do only the bare minimum to survive the boom, and wait for prices to come down in the bust?
Also, why didn't the recent stock-market boom have a much worse ending given the extent of the credit expansion? Empirical methodology aside, I'd bet all Austrians (myself included) expected a nastier bust, even with the Fed continuing to inflate.
Published: February 4, 2004 7:46 AM
I agree with the Austrians here, but I think they need to do a better job in refuting the common objection of investors not learning about monetary expansions.
I'm not sure how convincing this is. If these informed entrepreneurs will be hurt in the medium/long-run by expanding beyond the "natural" limits, shouldn't they do only the bare minimum to survive the boom, and wait for prices to come down in the bust?
What I find convincing about this argument is how sensitive entrepreneurial concerns are to shifts in supply and demand. If you try to sit out the distortions caused by a currency or credit inflation, when any of your competitors do not, they will be able to prevent your business from purchasing the labor, materials, and services at what had been the previous clearing prices since they will be able to out-bid you for them.
It was just a few years ago that the news was filled with fears of shortages of, and the very high wages paid to, skilled workers (especially in the tech industries). Electronics producers consumed vast amounts of credit and flooded the market with goods that got ever cheaper as they continually outstripped demand.
Let's say you ran a memory manufacturing business. In order to sit out the boom (and prevent painful contraction later), you refuse to let the price you pay for labor get bid up, or build additional capital goods to expand your production rates. Your market share shrinks and your employees leave for more attractive salaries at your competitors (or other industries entirely).
The worst thing is that you don't know how long the boom will last - no one does. It can go on for four or five years. Your competitors will take out loan after loan and issue bond after bond in order to balance the losses - but since you refuse to take part in the boom, and your profits are as non-existent as your competitors, the losses take their toll that much more quickly and you become one of the first businesses to close.
If, on the other hand, you went into debt to finance your operations, you'd be able to hang on: but in the end, it's a misallocation of resources and you'll just be one of the many businesses that will need to start laying off workers and closing factories once the credit dries up.
Published: February 4, 2004 9:05 AM
As for the stock market's soft landing - I don't think we've seen the worst of it.
I had an amusing episode of paranoia a week or two ago, when reading about Greenspan's roots in Objectivist thinking - and how much of a disappointment he turned out to be.
The conspiracy theory that struck my fevered imagination was that Greenspan is intentionally manipulating the credit markets - staving off a true crash as long as possible, pushing the markets deeper into malinvestment, and ever higher, with the ultimate goal of making the bust as damaging as possible. Greenspan didn't betray the objectivists - he's just our D'Anconia.
Or he may have just given in to the lure of absolute power. Who knows.
Published: February 4, 2004 9:11 AM
"he may have just given in to the lure of absolute power."
I think that one is much more likely!
As for your argument on entrepreneurs, I think you make some good points, especially regarding the uncertainty of the length of the boom. But I still find the "learning problem" to be somewhat troubling. If you're still looking at losses over the whole cycle, then presumably there should be some adjustment at the margin from smart entrepreneurs.
Published: February 4, 2004 4:52 PM