Sunday, August 9, 2015

A Tale of Two Smiths (and Austrian Economics)

By Robert Wenzel

Two Smiths have dabbled in economics. One some time ago, the other does so now.

The earlier dabbler was Adam Smith (1723-1790), the current dabbler is Noah Smith. Aside from both having first names with deep biblical origins, they have little in common besides their economic scribblings.

Adam. no doubt, wrote with feather in hand, Noah, likely, pounds away at a keyboard. The great Austrian school economist Murray Rothbard (1926-1995) examined the work of Adam and found his contributions to economics dubious.

Since Rothbard has passed, we will never know first hand what he thinks of the writings on Austrian economics of Smith, Noah. However, it may be fun to guess what Rothbard and other serious Austrians might have to say about Noah's take.

Noah, in a short essay. discusses Austrian school economics and tells us:
The Austrian school, for the uninitiated, is a hodgepodge of beliefs, usually holding that fiat currencies are doomed to fail, that a return to the gold standard is inevitable and that central banks are responsible for bubbles, market crashes and recessions. But this group has grown relatively quiet of late, and it isn't hard to see why.    
First, there was the dramatic failure of the Federal Reserve's program of quantitative easing to cause even a hint, even the slightest whiff, of inflation. For a few years, the fears of inflation were kept on life support by Austrian claims that inflation was being hidden from the public eye, that asset price increases were actually a form of inflation, or -- my personal favorite -- that QE itself is inflation. Eventually, even the most diehard supporters of these silly backup arguments were forced to quiet down; reality can only be denied for so long. 
Here Noah confuses Austrian school theory with Chicago school theory. It is the Chicago school theory, not the Austrian school theory, that holds there is a direct correlation between increases in the money supply and price inflation.

If Noah believes that this isn't so, then he is not reading the great Austrian theorists, Ludwig von Mises, F.A.  Hayek and Rothbard. Not one of them argued that there was a direct correlation between increasing money supply and price inflation. Indeed, they went out of their way to distance themselves from that view

Here is the Nobel Prize winner Hayek distancing himself on this point from Milton Friedman, a key member of the Chicago school :

Rothbard wrote the damn definitive book, from an Austrian perspective, on America's Great Depression, and wrote in that book (in 1963!)
We can  not prove [monetary] inflation by pointing to price increases...Suffice to say here that the stability of wholesale prices in the 1920s was the result of monetary inflation offset by increased productivity, which lowered costs of production and increased the supply of goods...The economists who emphasized the importance of a stable price level were thus especially deceived, for they should have concentrated on what was happening to the supply of money. 
And Ludwig von Mises said in a speech:(In Paris in 1938!)
What is fundamental for economic theory is that there is no constant relation between changes in the quantity of money and prices.
Thus, there is no surprise, to hardcore Austrians,that immediate price inflation has not developed as a result of an increase in the money supply. Mises, Hayek and Rothbard taught us that there is no direct correlation, a long time ago. Decades before the current cycle!

That said, Noah is highlighting an important problem. There are a lot of quacks out there, who pretend to be Austrians, but who are really doom and gloomers, who forecast doom tomorrow, the next day and everyday. I have objected particularity with regard to their perspective on unemployment and the booming capital goods sector, to them it is not occurring. We are always going down, down, down. This is nonsense. The Austrian business cycle theory is just that, a theory of a cycle that includes periods of boom and bust.

I do not cheer the mad manipulations of the Federal Reserve and I made that clear to their face, But at the same time, we need to be grounded relative to where the economy is. And since the 2008 financial crisis, which I called here at EPJ in real time, the stock market has been in a boom phase.

What occurs from here, though, could be very different. A serious price inflation threat does hang over the economy, likewise, the boom phase might be over for the stock market. These are topics I am discussing in the EPJ Daily Alert. It is, right now, a very complex period and we are on the edge with things potentially developing in many different ways.In other words, the doom and gloomers could soon be right on many things, though they are far from correct most of the time.

As for Noah printing a 5 year chart of gold and declaring gold investors wrong because gold has declined over that period. I ask, did he short gold 5 years ago? To paraphrase Warren Buffett in a way which should have extra meaning to someone named Noah, predicting rain after the fact doesn't count building an ark in advance does.

Noah does then go on to provide something of a thumbs up to Austrian school business cycle theory,when it comes to China. He writes:
That brings us to another interesting Austrian notion -- the instability of financial markets. Mainstream macroeconomics is only just barely starting to deal with the idea that financial markets may have a natural tendency to boom and bust. Austrians have been saying this for almost a century. The seeming inevitability of the reversal in Chinese real estate and stock prices looks like one more slap in the face for bubble skeptics.
But Austrians must accept this praise only by adding a cautionary comment.

Austrian business cycle theory is not about a natural tendency to boom and bust. Austrians view the boom-bust cycle as caused by central bank manipulations of the money supply. In the Austrian school view, if you remove the money manipulations, you remove the cycles.Rothbard made this clear and recognized the importance of the general understanding of this perspective.
Without bank credit expansion, supply and demand tend to be equilibrated through the free price system, and no cumulative booms or busts can then develop...The time is ripe — for a rediscovery, a renaissance, of the Mises theory of the business cycle. It can come none too soon; if it ever does, the whole concept of a Council of Economic Advisors would be swept away, and we would see a massive retreat of government from the economic sphere. But for all this to happen, the world of economics, and the public at large, must be made aware of the existence of an explanation of the business cycle that has lain neglected on the shelf for all too many tragic years.
  Robert Wenzel is Editor & Publisher at and at Target Liberty. He is also author of The Fed Flunks: My Speech at the New York Federal Reserve Bank. Follow him on twitter:@wenzeleconomics


  1. For the 487th time, I submit that our opponents are scared to death of us. Otherwise, they would lay out our positions without the inevitable distortions and refute us. That has never happened.

    Smith also wrote:

    “It has never been very clear exactly why malinvestment causes an economic hangover. Why don't businesses just cut their losses and immediately start investing in something more useful, as soon as they realize that they're doing the wrong thing? Austrian theory has never been particularly clear on that (and its notorious refusal to use precise mathematical models certainly doesn't help).”

    It is quite clear why malinvestment causes an economic hangover. Artificial money and credit expansion induces false and unsustainable prices which do not reflect actual demand but reflect unsustainable stimulated demand. This is most damaging in the prices of the capital structure. When a boom or a bubble is finally seen for what it is, the quickest way to cure the problem is to allow those distorted prices to fall or reach their unsubsidized un-stimulated levels. The politically powerful folks holding those assets will always demand that the government prop them up. When Austrians demand prices be allowed to find their un-stimulated and undistorted levels, they are ignored and mocked. Duh.

    1. Noah is a smart guy. Too smart for his own good. Too smart to bother attempting to understand his opponents' viewpoints.

      There is no one with a crystal ball. That is why it is so important to allow prices (and demand) to remain undistorted. Artificial distortions only make it MORE difficult for entrepreneurs to "realize that they're doing the wrong thing".

    2. “It has never been very clear exactly why malinvestment causes an economic hangover. Why don't businesses just cut their losses and immediately start investing in something more useful, as soon as they realize that they're doing the wrong thing? Austrian theory has never been particularly clear on that (and its notorious refusal to use precise mathematical models certainly doesn't help).”

      Is Noah trying to use logic to poke a hole in the ATBC? Nice attempt, for a logical positivist. Saddly, this only exposes the extent of his ignorance. The entire first part of America's Great Depression is devoted to explaining how and why depressions happen, and how they are cured. The rest of the book goes on to show WHY they didn't, or couldn't, "start investing is something useful".

      Then theres the work of Robert Higgs and his theory of Uncertainty.

      Noah's in good company, though. Even the highest and most mighty of court intellectuals ignores actual Austrian theory (and ducks outta debating them, too.) At least Noah had the balls to debate Peter Schiff. And, even though Peter isn't as savy an Austrian as some, he still reduced Noah down to a screaming little turd, which he is.

      Seems that when it comes to (real) economics, Smith doesn't no-ah thing!

      (btw, RW, great article)

    3. Smith fails to grasp that the necessary information does not exist due to prior intervention. In a 1975 speech, Hayek stated:

      These discrepancies of demand and supply in different industries, discrepancies between the distribution of demand and the allocation of the factors of production, are in the last analysis due to some distortion in the price system that has directed resources to false uses. It can be corrected only by making sure, first, that prices achieve what, SOMEWHAT MISLEADINGLY, we call an equilibrium structure, and second, that labor is reallocated according to these new prices. ****

      The primary cause of the appearance of extensive unemployment, however, is a deviation of the actual structure of prices and wages from its equilibrium structure. Remember, please: that is the crucial concept. The point I want to make is that this equilibrium structure of prices is something which we cannot know beforehand because the only way to discover it is to give the market free play; by definition, therefore, the divergence of actual prices from the equilibrium structure is something that can never be statistically measured. ****

      In contrast, the modern fashion demands that a theoretical assertion which cannot be statistically tested must not be taken seriously and has to be discarded. As a result of this belief, a theory which, in my opinion, is the true explanation has been discarded as not adequately confirmed, and a false theory has been generally accepted merely because it happens to be the only one for which statistical evidence, even though very inadequate evidence, is available.”

  2. See Walter Block's incisive refutation of Noah Smith at today.

  3. I believe we are in a debt bubble. Cascading defaults would lead to a deflationary depression, a Fed over-response could lead to an inflationary depression. They are propping up the debt bubble.

  4. My view is that Austrian Economics is more in line with physical sciences than macroeconomics. The cutting edge physicists consistently find that the universe is non-deterministic, which is in congruence with Austrian Economics, as I understand it.

    The macroeconomists are like classical physicists trying to operate a nuclear reactor. Most of the things they do don't seem to change anything in the reactor, but a few things generate observable changes that are indescribable with their equations. They continue to effect these changes causing either increases in temperature so rapid that the reactor vessel ruptures in a violent steam explosion, or the reactor just keeps slowly heating up indefinitely and melts the whole thing down, releasing massive amounts of fissionable material and radioactive waste into the environment. Meanwhile, a college professor is publishing to the New York Times about how there is no other way to account for an apple falling on one's head.

  5. What gloom and doomers are you talking about? Who believes that it is a going to be a collapse tommorrow, certainly not Peter Schiff, I know there a a lot that misunderstand that's it.