The Austrian Cure for Economic Illness

Economics / Economic Theory Jun 02, 2009 - 04:57 PM GMT

Best Financial Markets Analysis Article Don Miller writes: An ill person may have diabetes or an infection. When an economy becomes ill people lose their jobs and watch the value of their homes and stock portfolios fall.

A doctor evaluates symptoms and signs (physical findings), orders laboratory tests, and makes a diagnosis. Having determined the cause of the illness and its pathophysiology (how the disease alters bodily functions), the physician prescribes treatment and gives a prognosis, predicting how the patient will progress under the treatment and the likelihood of recovery.

Government officials and their financial advisors approach economic illness the same way – they diagnose the trouble, institute treatment, and provide a reassuring prognosis.

As in medicine, with its opposing schools of allopathic (pharmaceutically oriented) medicine and homeopathy, there are two diametrically opposed schools of economics: the Keynesian one and the Austrian School of economic thought. Based on the ideas of the John Maynard Keynes (1883–1946), a British economist, Keynesian economics is the one government officials, academic experts, pundits, journalists, editors, and establishment economists follow. Employing mathematical models, this school evaluates the economy from a macroeconomic perspective – as a whole. The Keynesian prescription for treating economic illness is more government spending, along with fiscal and monetary policies designed to achieve full employment and price stability.

Austrian economics focuses on the individual. Taking a microeconomic approach, this school studies the actions of individuals in the marketplace, where people act to achieve their chosen ends, governed by one’s perceived needs and wants. It eschews mathematical models. Instead, Austrian Economics addresses such subjects as marginal utility, the subjective theory of value, economic calculation, scarcity and choice, capital malinvestment, moral hazard, and the importance of free markets and a stable currency for setting prices.

Named for its country of origin, the Austrian School of economics was founded by Carl Menger (1840–1921), a professor of political economy at the University of Vienna from 1873 to 1903. Leading Austrian economists include his successor Eugen von Böhm-Bawerk (1851–1914); and then Henry Hazlitt (1894–1993), F.A. Hayek (1899–1992), Hans Sennholz (1922–2007), Murray Rothbard (1926–1995), and most importantly Ludwig von Mises (1881–1973), who taught at the University of Vienna from 1913–1934. His book Human Action, published in 1949, is the defining work of this school of thought. Austrian economics explains and predicted the last depression and also the one unfolding now.

The worst economic illness the U.S. has suffered so far is the Great Depression, which began in December 1930 with the collapse of the Bank of United States, a bank in New York not affiliated with the government. By 1932, more than 10,000 banks – 40 percent of all the banks in the country – had failed. The Dow Jones Industrial Average, after reaching a high of 381 in 1929, dropped to 43 in 1932, an 89 percent fall. GNP dropped 31 percent. International trade fell by two-thirds. The unemployment rate climbed to 25 percent. The Great Depression lasted for 17 years, through the Second World War (WWII) until 1946.

From a Keynesian point of view, the government should have intervened with sufficient fiscal and monetary stimuli to keep the recession of 1929 from turning into a depression. The money supply contracted 30 percent and the velocity of money also declined (people held on to their money and didn’t want to spend it). Farm prices fell 53 percent. President Herbert Hoover is said to have done little to try and prevent the economy from sliding into depression. But he did, in fact, pursue a vigorous Keynesian line of attack.

A Hoover "New Deal" preceded the one that Franklin Roosevelt put in place after he became president in 1933. Hoover had been an activist Secretary of Commerce under Presidents Warren Harding and Calvin Coolidge. He was in favor of government intervention and embraced central economic planning, which he called "economic modernization." He increased government spending on public works projects, propped up weak firms, and bolstered wage rates and prices, all to no avail. Hoover spent 13 percent of the GDP on various "stimuli" to combat the growing depression (compared to 5 percent of GDP President Obama is spending to stimulate the economy now – a $787 Billion stimulus package in a $14.1 Trillion economy). Nevertheless, despite three-and-a-half years of vigorous government spending in a Keynesian mold, the depression worsened and hit bottom by the time Roosevelt was inaugurated.

The Austrian School of economics holds the United States’ central bank, the Federal Reserve System, responsible for the Great Depression of the 1930s.

The business cycle – "boom-bust" cycle – is not a component of free-market capitalism, as the Keynesians would have it. The Austrian economists show that central banks – and/or a government-sanctioned and supported fractional reserve banking system – spawn cycles of boom and bust. Central banks inject new money into the economy and push interest rates below where the market would set them. These actions generate a boom, which ends in a bust. With interest rates held artificially low, entrepreneurs misdirect capital into unsustainable investments, creating malinvestments such as building too many shopping malls and an oversupply of expensive homes. Thomas Woods, author of Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse (2009), puts it this way:

The bust is the period in which the economy sloughs off the capital misallocation, re-establishes the structure of production along sustainable lines, and restores itself to health. The damage is done during the boom phase, the period of false prosperity."

President Woodrow Wilson signed the Federal Reserve Act into law in 1913. It created the Federal Reserve System, with its presidentially appointed Board of Governors, twelve regional Federal Reserve Banks acting as fiscal agents for the U.S. Treasury, and in a 1930 amendment, the Federal Open Market Committee, which sets interest rates. The 16th Amendment to the Constitution was also ratified that year, launching a federal income tax. As Austrian economists make clear, these two signal events helped turn our Republic into the Empire it is today.

The current era of big government began in 1913 – except during the Civil War and Reconstruction (1861–1877), which serves as a prelude (like Das Rheingold to Wagner’s Ring Cycle). Prior to this watershed year federal government spending averaged 3 per cent of GDP – except during the War of 1812 and the Civil War. It rose to 20 per cent of GDP during the First World War (WWI) and up to 44 percent in the Second World War (WWII). For the last half-century federal government spending has ranged between 17 and 24 per cent of GDP.

Wilson was a Progressive and believed that, if they had enough power, experts could make the world better. He wanted to expand the power of government to bring about a revolution in society, both at home and abroad. Seeking to "bring light and liberty and peace to all the world," Wilson sent U.S. troops to intervene in a European war that had no bearing on American national interests. When U.S. troops arrived in France in 1917, this three-year-old war had reached a stalemate. With American troops coming in on the side of Britain, France, Russia, and their allies, however, the balance shifted; and in 1918 this coalition of states defeated Germany and its Central Power allies.

The Wilson-inspired Treaty of Versailles effectively destroyed Germany as an economically and politically viable nation and led to the rise of Adolph Hitler and the Nazis. Had the United States not intervened and allowed the war to end in a stalemate, there would have been no Hitler and an intact Hohenzollern Germany could have thwarted the Bolshevik takeover of Russia and Central Asia and prevented the rise of Stalin. Wilson turned a stalemated European war into WWI, which led twenty years later to WWII.

Sixteen million people – soldiers and civilians – died in WWI; 72 million, in WWII. There are parallels between WWI leading to WWII and the Great Depression (GD-1) leading to the economic illness that now afflicts the world, which may come to be known as "Great Depression-2" (GD-2).

Ignoring, or, more charitably, unaware of the tenets of Austrian economics, Roosevelt and his Progressive academic advisors, like Wilson, believed that the government could run the economy better than profit-seeking businessmen. They viewed businessmen as scoundrels and blamed the free-market economy for causing the depression. Roosevelt established many agencies, bureaus, and acts. The NRA (National Recovery Act) Code Authority, for example, established 700 state-supervised trade associations that codified union privileges; stipulated regulations for wages and working hours; and regulated qualities, prices, and distribution methods of what goods the Authority allowed to be produced. The AAA (Agricultural Adjustment Administration) paid farmers to burn oats, plow under cotton, and kill millions of hogs in order to keep prices up. The WPA (Works Progress Administration) made government the employer of last resort.

Entrepreneurs and private investors became concerned about the security of their property rights and stopped investing. The unemployment rate remained high. Instead of recovering, the economy took a downturn and dropped to another low in 1937.

Keynesian economists think that WWII ended the depression. Unemployment dropped from 20 percent to 1 percent, but the rate dropped because 10 million men were drafted into the military. Government deficits of $3.5 Billion in the 1930s did not lift the U.S. economy out of its depressed state. Then during the war deficits peaked at $55 Billion ($2.2 Trillion in today’s dollars). Keynesians conclude that the right dose of the government-spending treatment needed to cure the depression was $55 Billion rather than the much smaller $3.5 Billion.

As the Austrian economic historian Robert Higgs has shown, the economy did not begin to recover from GD-1 until after the war had ended, and Roosevelt had died. During the war, with price controls and rationing, the public’s economic well-being deteriorated. Spending for civilian consumer goods declined through 1941–1943 and was still below the 1941 level when the war ended. People spent a lot of time in lines trying to purchase things. The quality of consumer goods deteriorated. Rationing of tires and gasoline limited where people could go. After the war, Federal spending contracted by two-thirds, freeing up money for businesses to invest for civilian purposes. And with a less threatening Harry Truman now president, investors became more sanguine about the security of their property and went back into the market.

War does not cure economic illness. Ludwig von Mises puts it this way: "War prosperity is like the prosperity that an earthquake or a plague brings."

Measured by military and civilian deaths, World War II was four times worse than World War I. Likewise, the unfolding Great Depression-2 has the potential to become much worse and more protracted than the 1930–1946 Great Depression. In GD-1, the U.S. was a creditor nation. There were no subprime mortgages (and no property taxes), no credit cards (and thus no credit card debt), and no financial derivatives (there are $600 Trillion of them today). The country had a trade surplus. The U.S. now has a trade deficit (the gap between the nation’s imports and exports), ranging between $612 and $759 Billion a year since 2004.

Nine months into Great Depression-2, U.S. federal debt is $11.3 Trillion ($37,000 per capita). The government also has $62.9 Trillion in unfunded liabilities. Part of that amount is for Social Security, a legacy of the New Deal.

Tax receipts are plummeting. In the first six months of fiscal year 2009, which began in October 2008, income tax receipts fell 31 percent and corporate tax receipts, 64 percent. The budget deficit this April was $20.9 Billion, the first deficit in this tax-paying month in 26 years. April 2009 tax receipts dropped 44 percent compared with those in April 2008. Money collected by taxes is only going to cover half of the fiscal 2009 federal budget, requiring the government to borrow and print more than $1.8 Trillion to fund it. Equal-sized deficits loom for fiscal year 2010 onward. Tax receipts fell 50 percent in GD-1. Now eight months old, GD-2 is already rivaling that drop.

In the 1930s the country had a strong manufacturing base and was self-sufficient in oil. Only 12.2 million people in a total civilian labor force of 154.7 million (8 percent) are now employed manufacturing goods, while the government employs nearly twice that number, 22.6 million people (15 percent of the labor force).

The official government-reported "U3" unemployment rate was 8.9 percent in May. Using the older "U6" method it is 15.8 percent (this includes workers who have given up looking for a job and those working part-time who cannot find full-time work). The true rate of unemployment is closer to 20 percent, as John Williams shows in his Shadow Government Statistics Newsletter. For the last six months more than 500,000 people each month have lost their jobs. In March, 633,000 people lost their jobs; in April, 568,000 – 149,000 in manufacturing, 110,000 in construction, 269,000 in the service sector, and 40,000 lost jobs in the financial sector.

One in every 10 Americans – 32.5 million people – now receive food stamps. Fourteen million homes in America stand empty, one out of every nine. And the United States now imports 62 percent of its oil. The U.S. economy today is in a much more precarious state than it was at the onset of GD-1.

Americans trusted their currency in the 1930s, even after Roosevelt (in his April 5, 1933 Presidential Executive Order 6102) no longer allowed people to redeem their Dollars in gold – only central banks could still do this. President Richard Nixon closed the central-bank "Gold Window" in 1971, taking the Dollar completely off the gold standard. During GD-1 the U.S. Dollar was worth a fixed weight of gold. Now it is a fiat currency. The Latin word fiat means "let it be done," and Nixon did it. The Dollar now is simply a piece of paper with printing on it, or it exists as electronic digits in a computer. It is not backed by any tangible assets. Nevertheless, the government declares the U.S. Dollar to be legal tender "for all debts public and private." It is the only form of currency that people can use as a medium of exchange in the U.S. economy.

While the government can decree that it be used as a medium of exchange and serve as a unit of measurement, the U.S. Dollar has proved to be a poor store of value. A basket of goods that cost $100 in 1913, when the Fed was formed, cost $409 in 1971 and now cost $2,152. Over the 96 years that the Federal Reserve System has been in existence it has inflated the money supply (M2) 500-fold, from $16.4 Billion in 1914 to $8,264 Billion in April, 2009. The U.S. Dollar has lost 96 percent of its value. The life blood of an economy is its currency, which makes economic calculation and efficient markets possible. Federal Reserve monetary policy is like a cancer that is ravaging the body of a leukemic patient.

Given the true cause of the country’s economic illness, the only way to keep GD-2 from worsening and reaching WWII proportions is to take the following Austrian medicine:

1) End the Fed. Repeal the Federal Reserve Act of 1913. If the economy is going to be able to recover any time soon, the market must be free to set interest rates, without a central bank that can inflate the money supply. The government must play no role in monetary affairs. Banks will exist as free-enterprise institutions with no privileges from the state; and if they engage in fractional reserve banking, they do so at their own risk.

2) Restore sound money to the economy. Have no legal tender laws that restrict what currency the market chooses to use. Privatize the country’s monetary system and allow the free market to determine the forms of money it prefers: gold and silver; new currencies based on gold and silver, or other commodities; PayPal dollars; a Google currency based on any number of goods; foreign currencies, etc. There has to be a separation of money and banking from the state, just as there is with church and state.

3) Lower taxes and cut government spending. Repeal the 16th Amendment and abolish the personal income tax. Like cutting government spending by two-thirds after WWII helped end GD-1, the government needs to cut spending by a similar amount in this depression. Close the 865 U.S. bases around the world, bring the troops home, and end the U.S. Empire. Abolish unconstitutional departments and programs like Education, Energy, Housing and Urban Development, Health and Human Services, and Agriculture. Limit cabinet departments to State, Defense, and Justice. Cut the government’s budget as drastically as possible, thereby releasing resources for use by the productive sector of the economy. An economy where the government employs twice as many people as its manufacturing sector does will stay sick.

4) No bailouts. Stand aside and allow malinvestments, bankrupt firms, and insolvent banks to fail. The economy needs to liquidate all the mistakes made during the boom in order to recover from the bust.

5) Allow prices and wages to fall to levels set by the market. Government must not pass laws that prevent wages from adjusting to circumstances, despite pressure from vested interests and labor union monopolies. Prices are the vital signals that enable people to decide what to produce and consume. Propping them up artificially stifles recovery.

6) Regulate the government, not private property and markets. Investors will only make long-term investments that spur recovery and boost employment if they think that their property is secure. Fifteen cabinet-level departments control different aspects of the economy, along with 100 Federal regulatory agencies that have produced 73,000 pages of regulations – not including those set by state and local governments.

In a nut shell, this is the Austrian prescription for curing economic illness, as per Murray Rothbard in America’s Great Depression:

If government wishes to alleviate, rather than aggravate, a depression, its only valid course is laissez-faire – to leave the economy alone. Only if there is no interference, direct or threatened, with prices, wage rates, and business liquidation will the necessary adjustment proceed with smooth dispatch... The proper injunction to government in a depression is cut the budget and leave the economy strictly alone.

If government refuses to undergo this treatment, the economic collapse that some analysts are predicting will likely occur. A Weimar-Zimbabwe-like hyperinflation could result. If that happens, the suffering that a depression can cause will seem mild compared to the devastation an inflationary depression wreaks. The astute observer William Buckler, Editor and Publisher of the Privateer Market Letter, predicts:

The action of governments and central banks everywhere is guaranteeing a catastrophic collapse in the purchasing power of the money they are borrowing into existence. [And…]

The last of the big time spenders, the U.S. Treasury, is on a countdown to bankruptcy with its gargantuan borrowing. When it goes, the final U.S. underpinning – the international value of the U.S. Dollar – will go with it.

I recently finished rereading Ayn Rand’s Atlas Shrugged. It is timely. I certainly hope that an Obama-led U.S. economy does not go the way of the Thompson-led economy in Atlas Shrugged. There are some disturbing parallels. But we have some valuable resources in GD-2 that GD-1 lacked that can help cure this depression. We have Congressman Ron Paul, authors like Thomas E. Woods, Jr., LewRockwell.com and Mises.org, and vast amounts of information available at our fingertips on the internet. Tea Parties reminiscent of the one that sparked the American Revolution have been held across the nation by students and people from all walks of life, and some states are beginning to assert their 10th Amendment rights.

Austrian economics is most compatible with a Jeffersonian republic – one with free trade, private property, and limited government.

There is hope. The treatment Austrian economics prescribes for 21st century America can restore us to the republic we once were and salvage our economy before its illness proves fatal.