Saturday, January 8, 2011

A Problem with "Austrian Economics"

The Austrian Theory of the Business Cycle is just one element of "Austrian Economics." Unfortunately, in the context of the Great Recession, "Austrian Economics" has become short hand for that one aspect of the contributions of Menger, Mises, and Hayek and those working in their tradition.

As with most perspectives on the economy, I believe there is an important element of truth in the theory, but I believe that even otherwise sound economists are led astray by an excessive focus on the approach. In particular, there is too much focus on the thought experiment of an increase in the quantity of money given the demand to hold money, the supply of saving, and the demand for investment.

In that circumstance, the natural interest rate is given (coordinating saving and investment) and any increase in the quantity of money is an excess supply of money. There is usually a plausible institutional assumption that the increase in the quantity of money is lent into existence. Given all of these assumptions, the expansion in bank loans results in the market interest rate decreasing. Given even more assumptions, the lower interest rate impacts the composition of demand across industries, and leads to specific investments that depend on this lower level of the interest rate. These are malinvestments. Ceteris paribus, they will generate losses in the long run.

When the theory is used to interpret history, like the housing boom of the last decade, the assumptions, given demand for money, given supply of saving, and given demand for investment, are imposed, so that a decrease in observed market interest rates is taken to be a sign of an excess supply of money. The problem is less with complaints about interest rates in a boom, but instead with a completely wrongheaded notion that because the problem was interest rates that had fallen too low during the boom, recovery should be associated with higher interest rates.

The problem is a confusion of the thought experiment of a given demand for money, supply of saving, and demand for investment and the real world. In the real world, the demand for money, the supply of saving, and the demand for investment are all subject to change. First of all, suppose the demand for investment is rising and the demand for money is falling. Even if the market interest rate is rising and the quantity of money is falling, it would be possible for there to be an excess supply of money, and a market interest rate below the natural interest rate. Malinvestment would be generated even though observed interest rates rose and the quantity of money fell. The problem would that interest rates failed to rise enough and the quantity of money failed to fall enough.

Now, if the demand for money remained low, and the demand for investment remained high, then as the purchasing power of money falls, the real supply of credit decreases along with the real quantity of money. The market interest rate will rise to meet the natural interest rate and any malinvestents will lose money and be liquidated.

More importantly, suppose there was a boom generated exactly according to the traditional assumptions. The quantity of money rose, the demand for money was given as was the supply of saving and demand for investment. The market interest rate did fall too low, and malinvestment was generated. In the "long run," the purchasing power of money would fall, reducing the real quantity of money and the real quantity of credit. Other things being equal, the market interest rate would rise. The malinvestments would lose money. Remarkably low interest rates in 2002 results in too many single family homes being built, and when the purchasing power of money falls, interest rates rise and the housing construction industry must shrink. Sawmills lose money.

But, suppose, during this period, the supply of saving rose or the demand for investment fell, or both. While one can imagine that these would be indirect effects of problems associated with losses on malinvestment, they don't have to be. Things happen. The natural interest could fall. While it would be true that the problem is that interest rates fell during the boom, it would be wrongheaded to assume that during the recovery interest rates should be at pre-boom levels.

It is true, of course, that if an excess supply of money is created, this would push the market interest rate below the natural interest rate. But the natural interest rate could be below the level of market interest rates that existed during the boom.

Similarly, there is no way to look at any measure of the quantity of money and use that to determine whether malinvestments are being generated. In particular, if the demand to hold money rises, the supply of saving rises, and the demand for investment falls, then an increase in the quantity of money and a reduction in market interest rates maintains monetary and credit market equilibrium. While too much money and excessively low interest rates might create malinvestments, malinvestments can also be generated by too little money and excessively high interest rates. The particular capital goods appropriate to the resulting pattern of demand may be in appropriate to the pattern that will exist when the purchasing power of money adjusts, the real quantity of money rises to meet the demand, the real quantity of credit rises, and the market interest rate falls to the natural interest rate.

And, of course, it is possible that in the period after a boom, a decrease in the supply of saving, an increase in the demand for investment and a decrease in the demand to hold money would require that market interest rates rise and the quantity of money fall. Perhaps market interest rates must rise to levels higher, and the quantity of money should fall to levels below, those that prevailed during the boom.

In my view, the solution is simple in abstract. Keep the quantity of money equal to the demand to hold money, and let market interest rates adjust. Don't impose preconceptions based on history. Prices and quantities can and should change--and that certainly includes market interest rates, and I believe the quantity of money too.

3 comments:

  1. I'm puzzled as to why the title of this post is "Problems with 'Austrian Economics'". What you've just written down is a perfectly valid example of Austrian Economics.

    Furthermore, you're right to conclude that interest rates should not automatically go up. I'm not aware of any Austrian School economist who believes this. I can say, though, that Mises himself makes this point Human Action.

    As usually tends to happen, I think people assume a wider gap between Austrian economics and "mainstream" economics than actually exists. The main difference to me seems to be that Austrian economists tend to put a greater emphasis on capital, while mainstream economists tend to put too great an emphasis on the highly illogical concept of "aggregate demand."

    But leaving all that aside, I think you've just produced a very good example of Austrian economics. Not all Austrians agree all the time. :)

    ReplyDelete
  2. In my view there are plenty of problem with whole world’s economy, I don’t worry all too much, and I just try to stay updated with things. I work with OctaFX broker and thanks to them, I am always well within the touching distance from profits, as that’s with their analysis service provided by highly qualified team of experts, so it is easy to follow and working with them leads to super benefits all the time especially in conditions that’s tough.

    ReplyDelete