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 then Eichengreen launches into the supposed Austrian "pain" theory of how the business cycle should be cured:
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 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.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.
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.
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.