Wednesday, August 24, 2011

Are Austrian Economists Into Pain?

Barry Eichengreen at the National Interest does a fairly decent job of explaining Austrian Business Cycle Theory:

The engine of instability, according to members of the Austrian School, is the procyclical behavior of the banking system. In boom times, exuberant bankers aggressively expand their balance sheets, more so when an accommodating central bank, unrestrained by the disciplines of the gold standard, funds their investments at low cost. Their excessive credit creation encourages reckless consumption and investment, fueling inflation and asset-price bubbles. It distorts the makeup of spending toward interest-rate-sensitive items like housing.

But the longer the asset-price inflation in question is allowed to run, the more likely it becomes that the stock of sound investment projects is depleted and that significant amounts of finance come to be allocated in unsound ways. At some point, inevitably, those unsound investments are revealed as such. Euphoria then gives way to panic. Leveraging gives way to deleveraging. The entire financial edifice comes crashing down.
But then Eichengreen launches into the supposed Austrian "pain" theory of how the business cycle should be cured:
But the Austrians then go on—and this is where they and other economists part company—to argue that the best and, ultimately, only feasible response to this destabilizing cycle is inaction. Inaction is counseled first because of the existence of moral hazard. If the culprits don’t feel pain and learn a lesson, they will engage in the same reckless behavior over and over again.

Second, the overhang of unsound investment projects must be liquidated in order to prevent them from becoming a drag on the economy, and discouraging that process only delays the subsequent recovery. Eighty years ago Lionel Robbins, then Hayek’s colleague at the London School of Economics, famously made these arguments about how governments and central banks should respond, or more precisely not respond, to the Great Depression of the 1930s. An American member of the Austrian School, Murray Rothbard, later applied the same argument to the Great Depression in the United States.

The first part of their logic is impeccable: inaction in the face of an unfolding financial crisis is a sure way of inflicting pain. Unfortunately, the pain is meted out to the innocent as well as the guilty. It is felt by the workers thrown out of jobs in the resulting recession as well as by financiers who see their portfolios shrink.

Society, in its wisdom, has concluded that inflicting intense pain upon innocent bystanders through a long period of high unemployment is not the best way of discouraging irrational exuberance in financial markets. Nor is precipitating a depression the most expeditious way of cleansing bank and corporate balance sheets.
I'm not sure most Austrian economists would not agree with  Eichengreen's contention that there will be pain during the liquidation phase of the business cycle. But I think this "pain theory" that is identified with Austrians and embraced by some is distorting.

One would not, for example, say that a heart surgeon attempting to save a man's life by heart surgery is in favor of pain as the way to save the man, even though pain is most assuredly a byproduct of a major heart operation.

There would never be a critique of a heart surgeon, "Oh, he causes pain." We all know such an operation is performed only to prevent further pain, and possibly death, down the road. In the same way, an Austrian economist who calls for a laissez faire attitude during the down phase of the business cycle is doing so only because he knows that the down the road alternative is worse. A resumption of money printing may prop up the earlier central bank manipulated capital structure, short-term,  but it will only mean a greater liquidation down the road or hyper-inflation.

Thus, an Austrian calling for liquidation of malinvestments is more like a surgeon calling for a malignant tumor to be cut out. In either case, do you really want the alternative, for them to grow?

Austrian economists aren't into pain anymore than heart surgeons and cancer surgeons. Austrian economists look at the business cycle and are really saying, "Look you better stop this now because it will only get worse." That's not a pain theory. It's a theory to limit pain.

Thus Eichengreen next points, though understandable given current views, is off the mark:
Society, in its wisdom, has concluded that inflicting intense pain upon innocent bystanders through a long period of high unemployment is not the best way of discouraging irrational exuberance in financial markets. Nor is precipitating a depression the most expeditious way of cleansing bank and corporate balance sheets. Better is to stabilize the level of economic activity and encourage the strong expansion of the economy.
First, Eichengreen's talk of stabilizing the economy and encouraging a strong expansion shows that while he is able to regurgitate Austrian theory, he doesn't get it. Malinvestments don't go away. Isn't the current housing mess evidence enough of that, despite all the "stabilizing" efforts? And what does a "strong expansion" mean? It either means allowing free market forces to liquidate malinvestmnets and move on, or it means more money printing which is what Austrians warn is dangerous since greater problems will develop down the road.

Eichengreen's objection to pain from an immediate liquidation is like the patient scheduled for heart surgery saying, "Oh the hell with it, lets go out, party and pick up some steaks and beers. Why should a nice guy like me have to deal with pain?"

Thus, Eichengreen's charge, that Austrian policy prescription would be "inflicting intense pain," must be examined relative to the options, which are, again, greater liquidation pain down the road, or hyper-inflation, both of which will cause greater damage to even more "innocent bystanders."

Eichengreen's further contention that a long period of high unemployment would result from a liquidation of malinvestments would be disputed by most Austrians. They view the extended unemployment as being the result of government interventions.

The business cycle can reach deep into  the economy. The only options to "fighting" and propping up malinvestments during the down phase of the business cycle will result in creating greater problems down the road. The call of Austrian economists for immediate liquidation of malinvestmnets is not becasue they are into pain, but because they understand that if liquidations don't take place now pain will be much more severe down the road. In this sense, Austrians offer the most sound treatment to limit pain.

16 comments:

  1. I think the key to his flaw lies in this statement: "If the culprits don’t feel pain and learn a lesson, they will engage in the same reckless behavior over and over again."

    Those outside of understanding of ABCT think it points the finger at the entrepreneurs that use the phony credit during the boom. We understand, however, that even the most aware of enterprenuers must go along for the ride or get left behind or swallowed by the boom.

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  2. "Society, in its wisdom," should read "The elites, in their greed, and short-sightedness..."

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  3. I like how the Hayek character in the "Fight of the Century" video puts it when he says it isn't that I want to do nothing, there's plenty to do, the question is who plans for who? Do I plan for myself or leave it to you?

    This idea that Austrians want to do nothing is a misconception by economists and the general public who think action is only a function of government. When the bust comes we all take action and come up with our own plans on how to deal with the crisis. We are prohibited from dealing with the crisis by the same institution that cause the boom and bust in the first place, the State which interferes with our plans through regulations, taxes and all other forms of distortion.

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  4. In the 5 years I've known of and studues Austrin economics I have NEVER heard an attempt to refute the theory that didn't present a straw man.

    I don't know if it is by innocence, ignorance, or intention, but no one presenting an opposing theory to the ABC theory ever states the theory fully or correctly.

    Ever.

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  5. When all else fails the anti-austrians just claim that ABCT is anti-semitic.

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  6. So much is wrong with his critique.

    Glaringly, in the last paragraph, he ignores empirical evidence right in front of his nose that "extended unemployment" and "precipitating a depression" are the consequences we see today (as well as in the depression of the '30s) as a result of policies that are the exact opposite of the Austrian prescription.

    Furthermore, he mis-orders the two pillars of ABCT. Mises and Hayek approached economics from a more pragmatic perspective and laid great importance to the need to liquidate unsound investments as a utilitarian necessity for a properly functioning economy. It was Rothbard who helped to join Austrian economics with ethics and the deontological moral hazard argument came about. Now, Eichengreen completely dismisses the moral hazard argument with a snide comment and doesn't even attempt a serious rebuttal. His argument is from a utilitarian standpoint and the rightness or wrongness of an action is only determined after the fact("Unfortunately, the pain is meted out to the innocent as well as the guilty. It is felt by the workers thrown out of jobs in the resulting recession as well as by financiers who see their portfolios shrink."). This argument approach is in complete and utter conflict with the conclusions shown in his later paragraphs. I.e., he dismisses the Rothbardian moral hazard argument because it doesn't take into account empirically verifiable consequences but then in the same breath he refutes the Misisian/Hayekian utilitarian approach based on what? The very empirically verifiable consequences coming to fruition that Austrians have warned against vis a vis monetary and fiscal intervention.

    It's as if because the Austrians were the ones who predicted this mess, their theory must be the one that caused it.

    I'm astounded.

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  7. Also,
    BIG mistake on Eichengreen's part in mixing economic theories in his critique. "Irrational Exuberance" is akin to Keynesian "Animal Spirits" and is not at all Austrian. Austrians would likely prefer the term "mal-investment fueled by loose monetary policy".

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  8. Great, illustrative analogy for me, Doc, comparing the pain of the economic reordering process to the pain during surgery.

    Oh, and you probably know: heart disease is not caused by steaks and beer (read any of the Paleo diet literature; refined sugar and carbs are the causes of vascular, e.g., heart, disease). And, in fact, grass-fed steaks and good beer are foods that are great for you!

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  9. "First, Eichengreen's talk of stabilizing the economy and encouraging a strong expansion shows that while he is able to regurgitate Austrian theory, he doesn't get it. "

    This is the key. He doesn't get it. He sees the world through a distorted lens, where the wise, benevolent Central Planners are in charge, and must decide what must be done. The very concept that "those in control should--do nothing", does not compute, in his mind. Why, SOMEONE has to be in control. And how can they be "in control" if they're not doing anything?

    Like most statists, he needs to have an "Aha! moment" about this.

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  10. This just sounds like a more sophisticated version of the tired, old, "libertarians want poor people, illiterate children, heroin addicts, and terrorists around the corner of every privately owned toll road" argument.

    It's not that Austrians want everyone to do nothing; it's that Austrians want agents of the state, who are entirely responsible for the boom, to step aside and let the productive members of society handle the bust. And then those agents of the state need to go away forever to prevent the continuation of the boom/bust cycle.

    When these editorialists become a little more honest, and clearly understand and explain that there is a vast difference between private action and state action, then these arguments will be a thing of the past.

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  11. One could argue that Society "in its wisdom" got us into this mess.

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  12. Regarding the economy, it sounds like Eichengreen is confusing the disease, its causes, and the medicine used to treat it. I notice he didn't comment on avoiding the disease in the first place.

    He mentions trying to avoid inflicting pain on society's innocents, but doesn't recognize a necessary corollary to this line of thinking: if there are innocent bystanders, then there must be criminals, or at least negligent parties. Who are they? And what wrong did they do?

    And then there is this gem: "While there may indeed be a problem of moral hazard, it is best left for the future, when it can be addressed by imposing more rigorous regulatory restraints on the banking and financial systems." This is the last intellectual refuge of modern politics, modern economics, and modern morals. Let's not worry about making the difficult choices today, but leave them to some future angels who shall come down and make the choices that we are not able to make ourselves. Thus, spending cuts will be made by some future mystical congress, and the TBTF banks will be saved by regulatory geniuses not yet born, if we can just hang on until then. This plan is pure genius.

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  13. @Nouriel declares victory:

    "Leading historian Eichengreen smashes gold bugs, tea party & End-Fed wackos & lunatics in a smart conservative journal http://bit.ly/nmIaFt"

    Reading between the lines of Roubini's recent pro-Fed tweets, he is probably aware of a credible threat to the Western CB cartel. That is, a major power shift that gets rid of the Fed (and the ECB) and institutes something perhaps even more draconian. Some credible evidence is here:

    http://tradewithdave.com/?p=7173

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  14. I certainly don't see them as advocating inaction. There is plenty to be done against state power over the market and people to help the market and people.

    The mentioning of harming the innocent is a bit ridiculous and frustrating considering state interventionism most certainly does that with the forced inflation, price controls, bailouts and moral hazard, private property being confiscated to finance current government spending and also pledged in repayment of borrowing, and so on. On top of that, it all too often rewards the guilty!

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  15. Voluntary CooperationAugust 25, 2011 at 3:02 AM

    Do nothing = Robbers should stop robbing.

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  16. Mr. Wenzel's knowledge and insightful writing is unique, powerful and prescient. Great comments by his astute readers, too. Every lowly statist is going into overtime now to defend 21st century interventionist-imposed slavery. These ball bags always claim they're against slavery as long as it existed in the 18th and 19th centuries. The classically educated "Austrian" spells out the horrors of our current corporate-state system, and they scream their usual free-market perjoratives and Kafkaesque logic to defend their bankrupt positions.

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