Sunday, September 15, 2013

Only Austrian Theory Can Explain and Expose Booms and Bubbles

Next week, beginning September 18, Mark Thornton will teach a new Mises Academy course on Bubbles, Booms, and Busts. To gain a better idea of some of the topics addressed in the course, Dr. Thornton recently answered questions about conflicting theories of how bubbles form and busts result.
Mises Institute: While elected officials and various pundits are clear that they believe the Keynesians can solve the current crisis, do the Keynesians have a theory that explains what caused the crisis in the first place?
Mark Thornton: Keynesian business cycle theories are based on the idea that cycles are caused by changes in aggregate demand. This theory, however, provides no purely economic cause for business cycles. The instigator or cause in Keynesian theory is a psychological factor that is driven by so-called “animal spirits.” Small changes in entrepreneurs’ optimism and pessimism affect their investment decisions and can spread and snowball out of control causing sharp increases and decreases in aggregate demand, profits, and employment.
The general solution for these problems within the Keynesian framework is for aggregate demand to be decreased or increased by the public sector as a substitute for the private sector. The primary means to increase public sector aggregate demand is to increase government spending financed by borrowing rather than taxes.
The problem with Keynesian business cycle theory is that cycles just happen or are brought about by random exogenous factors. With the Housing Bubble, people just went out and built too many houses and then realized they made a mistake. At that point, the animal spirits of depression took over the economy and in particular the housing and banking sectors went into a tailspin. The Keynesian explanation for the Housing Bubble crisis is correct in that expectations were psychologically impacted in a positive way during the bubble and in a negative manner after the crash and therefore do play a part in the narrative describing the cycle.


  1. He's mischaracterizing the Keynesian explanation for the last two recessions. So he's essentially making a straw man argument. The dot com and housing bubbles increased demand via the wealth effect, not simply animal spirts. Both bubbles were inflated by banks that were run for the benefit of senior management rather than shareholders. When the bubble collapsed, the destruction of wealth (8 trillion in home equity) reduced demand and the economy fell into a liquidity trap where monetary policy was ineffective (jobless recovery even though fed funds rate was 1% after dot com and .25% after housing bubble). In this situation, Keynesian economists believe fiscal policy should step in. Not simply to restore animal spirits and optimism but to give households time to repair their balance sheets (balance sheet recession).

    Attributing either bubble entirely to artificially priced money doesn't really pass a laugh test.

    1. LOL this is a great Keynesian parody