Austrian Business Cycle Theory Vs Keynesians
Economics / Economic Theory Jul 29, 2010 - 12:37 PM GMT
The current recession has brought back discussion on the merits of countercyclical fiscal and monetary policy. Broadly speaking, the economics profession is divided into two camps. One side is made up of "liquidationists" and "deficit hawks," supporting tight monetary policy and low — or no — government spending. The other group is composed of those fearing a fall in prices, who support easy credit and expansive fiscal policy to combat it. While most economists probably fall in between, this dichotomy represents the two poles. The extremes are occupied by the Austrian School on one end and Paul Krugman on (or close enough to) the other.
The growth of the Austrian School has forced economists like Paul Krugman — who, for the sake of simplicity, we will refer to as Keynesians[1] — to reconsider these opposing viewpoints. Krugman originally addressed Austrian business-cycle theory in 1998 and since then has continued to provide criticism.[2]
A recent contribution to the debate, "Antipathy to Low Rates," swipes at Friedrich Hayek's "liquidationism." The argument Krugman makes is that those who disapprove of countercyclical quantitative easing and fiscal policy inevitably support a long period of depression, and thus equally "persistent" high unemployment.
Krugman bases his antiliquidationism thesis on the following passage written by Hayek and quoted by Bradford DeLong in a as of yet unpublished history of economic thought in the 20th Century,[3]
still more difficult to see what lasting good effects can come from credit expansion. The thing which is most needed to secure healthy conditions is the most speedy and complete adaptation possible of the structure of production. If the proportion as determined by the voluntary decisions of individuals is distorted by the creation of artificial demand[,] resources [are] again led into a wrong direction and a definite and lasting adjustment is again postponed. The only way permanently to 'mobilise' all available resources is, therefore to leave it to time to effect a permanent cure by the slow process of adapting the structure of production.[4]
Krugman then provides his interpretation,
These days, relatively few economists are willing to say straight out that they regard persistent high unemployment as a good thing. But they find reasons to oppose any and all suggestions to use government policy — including monetary policy — to alleviate the slump.
While Krugman's position is erroneous, regarding both fiscal and monetary policy, it is important to understand Krugman's exact argument. The concept of the liquidity trap is the keystone to Krugman's thesis,[5] according to which the rules of the game change when there is a lack of private investment.[6]
As a general concept, the liquidity trap is legitimate in the sense that we are currently in a situation in which, despite the extreme provision of liquidity on the part of the Federal Reserve, there has not been a substantial increase in real private investment. As such, any Austrian rebuttal to Krugman should concede this point.
The real debate is whether or not fiscal stimulus can effectively revive an economy (or pull it out of a "liquidity trap") or if fiscal stimulus contributes to the existence of a liquidity trap — there is the distinct possibility that this so-called liquidity trap is the product of regime uncertainty, which may or may not be aggravated by government policy.
All considered — even conceding that we are in what Krugman would call a liquidity trap — within the Misesian-Hayekian framework, the only permanent solution to existing malinvestment is to allow its liquidation and the readaptation of the structure of production.
This suggests — like Krugman accuses — that following a boom of malinvestment there will be a period of relatively high unemployment. Krugman would temporarily alleviate the fall in employment and production through public expenditure; however, the problem with loose fiscal policy is that government cannot distribute and invest capital efficiently or profitably. Furthermore, government countercyclical policy tends to create regime uncertainty, which may directly contribute to the existence of this "liquidity trap."
Brief Overview of the Keynesian Liquidity Trap: From Keynes to Krugman
The concept of the "liquidity trap," a term coined by economist Dennis Robertson,[7] has returned to the forefront of Keynesian economic analysis. While Krugman's liquidity trap bears the same name as that of Robertson, Hicks, and Keynes, Krugman's liquidity-trap theory is fundamentally different.[8] In general, however, all liquidity-trap theories are meant to detail the limitations of monetary policy and the advantages of fiscal policy.
"Within the Misesian-Hayekian framework, the only permanent solution to existing malinvestment is to allow its liquidation and the readaptation of the structure of production."
While the liquidity trap does not play an important or major role in Keynes's General Theory, there is a mention of it in the fifteenth chapter of the Keynesian magnum opus,
There is the possibility, for the reasons discussed above, that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest.[9]
Keynes believed that such a situation occurs out of a change in the "state of expectation."[10] In other words, an increase in uncertainty leads to an increase in the demand to hold money and a decrease in investment,[11] based on the belief that money's relatively riskless qualities makes it more desirable to hold than bonds and assets.[12] Given a "virtually absolute" liquidity preference, monetary policy becomes ineffective at stimulating "aggregate demand" since an increase in the supply of money cannot increase wage-earners' incomes.[13] Furthermore, even supposing a fall in the "pure rate of interest," Keynes argued that monetary stimulus cannot diminish the cost of lending, and therefore moneylenders are unwilling to lend under a certain rate of interest.[14] Keynes's solution to such an event is government spending.[15]
While Keynes provided the groundwork, it was John Hicks who refined the theory within the bounds of what was to become known as the Investment-Saving/Liquidity Preference-Money Supply (IS/LM) model. Hicks originally formulated the IS/LM in 1937, in "Mr. Keynes and the Classics,"[16] and later elucidated it in his 1939 book Value and Capital. Hicks believed that while monetary policy could check an increase in the price inflation by increasing the rate of interest, the central bank is effectively unable to stop price deflation[17] because of the positive floor to the interest rate — which prohibits newly created money from being introduced into circulation.[18]
Hicks also introduced key differences to interest rate theory, contra Keynes, including putting emphasis on the idea of the elasticity or inelasticity of the long-term rate of interest based on expectations.[19] Writes Hicks,
If the costs of holding money can be neglected, it will always be profitable to hold money rather than lend it out, if the rate of interest is not greater than zero. Consequently the rate of interest must always be positive. In an extreme case, the shortest short-term rate may perhaps be nearly zero. But if so, the long-term rate must lie above it, for the long rate has to allow for the risk that the short rate may rise during the currency of the loan, and it should be observed that the short rate can only rise, it cannot fall. This does not only mean that the long rate must be a sort of average of the probable short rates over its duration, and that this average must lie above the current short rate. There is also the more important risk to be considered, that the lender on long term may desire to have cash before the agreed date of repayment, and then, if the short rate has risen meanwhile, he may be involved in a substantial capital loss. It is this last risk which provides Mr. Keynes' "speculative motive" and which ensures that the rate for loans of infinite duration (which he always has in mind as the rate of interest) cannot fall very near zero.[20]
After receiving much attention from the likes of Nicholas Kaldor,[21] Franco Modigliani,[22] and Lawrence Klein, Hicks's IS/LM formulation of the liquidity-trap theory became the standard Keynesian representation.[23] Between 1940 and 1970, the liquidity-trap theory went through major changes and reformulations, only for Hicks to recant, suggesting that, "[w]hile one can understand that large balances may be held idle for considerable periods, for a speculative motive, it is harder to grant that they can be so held indefinitely."[24]
The prominence of liquidity-trap theory in mainstream macroeconomics began to rescind by the early 1970s. A change in focus in macroeconomics factored into this shift in thought,[25] as did high rates of interest throughout the 1970s and 1980s that made the idea of a liquidity trap largely irrelevant.[26] Furthermore, research by Milton Friedman and Anna Schwartz questioned the belief that the Great Depression was beset by a liquidity trap,[27] denying the Keynesian camp from any clear empirical evidence supporting their position.[28]
Interest in the liquidity trap resurfaced when Paul Krugman applied his own version of the concept to Japan's economic stagnation of the 1990s. Krugman explains that
[a] liquidity trap may be defined as a situation in which conventional monetary policies have become impotent, because nominal interest rates are at or near zero: injecting monetary base into the economy has no effect, because base and bonds are viewed by the private sector as perfect substitutes. By this definition, a liquidity trap could occur in a flexible price, full-employment economy; and although any reasonable model of the United States in the 1930s or Japan in the 1990s must invoke some form of price stickiness, one can think of the unemployment and output slump that occurs under such circumstances as what happens when an economy is trying to have deflation — a deflationary tendency that monetary expansion is powerless to prevent.[29]
Where Krugman parts ways with Keynesian precedents is in applying a theory of intertemporal expectations, where monetary policy is ineffective because of the expectation of future deflation — the public believes monetary policy to be only temporary, as opposed to sustained.[30] In effect, expectations of future deflation cause individuals to shift time preference: they prefer holding cash to investment, believing that in the foreseeable future the value of said cash will rise. As such, injections of liquidity have no impact on present aggregate demand.[31] Note, Krugman is not arguing that monetary policy is temporary, only that the public perceives it to be temporary. Krugman cites two reasons why: the public's knowledge that the Bank of Japan was unwilling to allow for a radical depreciation of the Yen, and its reputation for maintaining price stability and low inflation.[32]
There are two general "New Keynesian" solutions to Krugman's liquidity-trap problem,
1.Expansionary fiscal policy;
2.Expansionary monetary policy targeting for long-term inflation.
The case for fiscal policy claims that a sufficiently large temporary fiscal stimulus to the economy would "jolt" the economy towards equilibrium, by increasing output and aggregate demand,[33] where expansionary monetary policy would once again be effective.[34] Krugman cites the Second World War as an example and writes that "the massive one-time fiscal jolt from the war pushed the economy into a more favorable equilibrium."[35]
Writing in support of deficit spending, Bradford DeLong puts it much more crudely, stating that "at this point, anything that boosts the government's deficit over the next two years passes the benefit-cost test — anything at all."[36]
While Keynes and Hicks would have perhaps shied away from massive monetary stimulus, operating with the understanding that monetary policy was ineffective during a liquidity trap, New Keynesian theory puts much more importance on a growing money supply. In fact, Krugman's monetary solution to a liquidity trap is sustained inflation, where the central bank reverses fears of future deflation by instead causing an increase in the price level through massive monetary pumping (Krugman estimates this to be in the area of $10 trillion, borrowing the figure from a prior study conducted by Goldman Sachs).[37] Periods of relatively high inflation would not be temporary, as to assuage fears of future deflation. Instead, the "optimum" monetary policy is one that targets relatively high inflation for a period long enough to shift the public's rational expectations.[38]
As is, the Keynesian "solutions" to a liquidity-trap run in the face of Austrian capital and calculation theory. The idea that government investment is as good as private investment is highly suspect, while a policy of monetary inflation is bound to lead to malinvestment. Thus, the Austrian capital and business-cycle theory are highly relevant. Understanding the Keynesian argument, we can now delve into Hayek's work.
Austrian Economics and Economic Restructuring
Although Austrian business-cycle theory is not simple — especially since it is rooted in a wealth of capital and monetary theory developed by a multitude of economists[39] — it can be concisely explained as a theory that recognizes disequilibrium between savings and investment.[40]
The relationship between consumption, saving, and investment is intertemporal in the sense that in order to accumulate the capital necessary to invest one must refrain from present consumption and opt for future consumption.[41]
This intertemporal relationship between consumption and investment is reflected through the interest rate, which serves as a price mechanism, transmitting information to the entrepreneur. An increase in savings, or a societal shift towards the preference to refrain from present consumption, leads entrepreneurs to borrow these savings and invest them to satiate the needs of these savers in the future. Austrians call this a lengthening and a widening of the structure of production, as entrepreneurs invest in stages farther away from the final consumer good.[42]
Given that the rate of interest reflects society's time preference — or preference towards present or future consumption — it thus acts as a mechanism by which savings and investments strive to reach equilibrium (or where the two are equal).[43] Disequilibrium would therefore imply that savings are unequal to investments, or, in other words, that the market is not acting according to society's time preference. Instead, a disequilibrium caused by credit expansion lowers the rate of interest, makes capital-good investment more lucrative,[44] and thusly lengthens the structure of production without a prior increase in savings.[45] In this case, an increase in investment is not met by an equal decrease in consumption, and so investment outstrips savings.
The productive boom, caused by this disequilibrium, must inevitably end when the price mechanism adjusts — or when the credit boom ends.[46] The structure of production is now pressured to return towards equilibrium.
"The idea that government investment is as good as private investment is highly suspect, while a policy of monetary inflation is bound to lead to malinvestment."
Despite this notion of disequilibrium, Austrian theory does not argue in favor of blaming "overinvestment," as the supply of capital goods does not necessarily increase. Instead, it examines price distortion where a price ceiling is effectively installed causing entrepreneurs to not recognize the actual scarcity of the capital goods in question — the adjustment of the price mechanism reveals this scarcity, and entrepreneurs must liquidate their "malinvestments."[47]
Knowing where Hayek was coming from makes his comment, as quoted by Bradford DeLong and Paul Krugman, far more understandable. The depression period is one in which the structure of production readjusts according to society's time preference, and so the most sensible approach to returning to economic stability is allowing this readjustment to take place the fastest possible.
One of the results of this readjustment is a fall in the supply of money — what Austrians refer to as deflation. There are three main reasons this occurs,[48]
1.A rise in demand for money, or a rise in demand for liquidity, in expectation of falling prices;[49]
2.Credit contraction due to a reduction in outstanding loans by banks fearing bankruptcy, or predicting a greater need for liquidity;
3.A fall in outstanding credit and loans caused by default or liquidation of malinvestment.
The common Keynesian argument is that of the "deflationary spiral." Finding its modern origins with Irving Fisher,[50] this argument suggests that a fall in prices makes it more difficult for debt to be repaid, increases demand for money, and feeds on itself in the sense that it causes a cycle of deflation.[51] It is not necessarily rejected by Austrians.[52] Where the Keynesians and the Austrians differ, at least on this point, is on the solution. While Keynesians, such as Krugman, argue for inflationary monetary policy,[53] Austrians instead see the resulting fall in the price level as the cure for deflation (or fall in the money supply).[54]
Recognizing the problem as the result of a fall in profit, due to the deceleration of credit expansion, the problem of demand necessarily stems from the inability to pay for products demanded. The solution is a fall in prices of relevant goods and services, to the point where demand for them can once again rise.[55] In other words, conceding that a fall in the money supply will lead to a decline in spending, the only method by which spending can rise is through a fall in the price level.
"The depression period is one in which the structure of production readjusts according to society's time preference, and so the most sensible approach to returning to economic stability is allowing this readjustment to take place the fastest possible."
The alternative method, or the Keynesian "solution" of inflation, can lead to a temporary "recovery."[56] Nonetheless, such a policy would inevitably result in greater malinvestment and a greater net loss of wealth.[57]
While the Keynesian case for inflation has been dealt with, there still lies the supposed problem of the liquidity trap. Krugman's liquidity trap becomes theoretically unsustainable once we dispel the myth of the supposed deflationary spiral.
However, rising uncertainty and low expectations for the future, brought about by economic depression, can be considered legitimate factors behind a liquidity trap. In this case, we define a liquidity trap as a situation in which private investment stagnates despite the readjustment of the structure of production. One such situation of this occurring was during the Great Depression. This topic is tackled by Robert Higgs, in which he attaches the blame to "regime uncertainty," or uncertainty caused by a general antibusiness climate produced by the government.[58]
While we cannot accuse the current government of causing the same disruption as did the Roosevelt administration during the Great Depression, it nevertheless stands that the onset of the current recession and the sheer amount of bankruptcies that resulted were enough to shatter confidence. While the bailouts perhaps managed to salvage the balance sheets of those banks fortunate enough to receive government money, it failed to aid these banks to stabilize. Since there are low expectations for stability, it only makes sense that private investment remains stagnant. Furthermore, it is very possible that the threat of higher taxes due to increased government debt and deficits has also factored into business expectations.
The final remaining question is whether or not a natural readaptation of the structure of production to society's time preference can be aided through government spending. This is, of course, the other side of the Keynesian coin — if not monetary policy, then fiscal policy must be the solution.[59]
An Austrian would argue a resounding "no." Wealth-producing investment relies on two underlying factors: that there exists a demand for the product and that the producer can satisfy that demand at a profit or by receiving greater satisfaction in return. That government cannot satisfy another's demand at a profit can be extrapolated empirically, because if it could, there would be no need for deficit spending — the capital necessary to fund these programs would come from received profits. As such, government spending usually results in a net loss in wealth, as less wealth is produced than the amount invested in the first place. Ergo, government spending absolutely cannot replace private investment.
The typical "redistribution of wealth" argument doesn't directly pertain to the Keynesian case for deficit spending, because the Keynesians adamantly believe that government spending will cause an increase in net and sustainable output, and as a result the burden of these deficits in terms of percentage of income taxed will be much smaller in the future than they are in the present (thus, the point of running deficits). But, the argument for deficit spending falls to pieces if government spending does not result in higher economic growth.
Fulfillment of satisfaction is dependent on individual subjective evaluations and voluntary exchange. Government, instead, distributes capital towards otherwise unwanted ends, taking it away from the private sector and "producing" at a net loss. The ultimate consequence is the destruction of wealth.[60] While in a vibrant economy wealth creation by the private sector may outstrip wealth destruction by the public sector, in eras of depressed private investment government spending could be potentially disastrous.
Hayek and Unemployment
Paul Krugman frequently suggests that "facts have a well-known liberal bias."[61] The present essay argues otherwise. The evidence overwhelmingly suggests that the best possible route to economic recovery is through the free-market and by allowing the structure of production to readapt itself. The Austrian case shows why monetary policy and fiscal policy are not effective methods by which to accelerate the pace at which this readaptation occurs.
Krugman accuses Hayek of seeing unemployment as a good thing, but nothing could be further from the truth. Hayek clearly considers unemployment a result of interference with the price mechanism, caused by credit expansion. Hayek, like anybody else, would rather see as many individuals employed as possible, as he was a defender of capitalism and as such valued economic growth through voluntary exchange. The difference between Hayek and Krugman is that Hayek was not a utopian, and realized that economic growth can only once again take place if the structure of production adapts to society's time preference — there is no formula by which government can centrally plan wealth creation.
While Krugman's policy could perhaps lead to a temporary surge in employment, we have shown that over the long run such policies are unsustainable. The only long-run results are the destruction of wealth and even greater unemployment. If Hayek supported "persistent unemployment," then there are few good words one could offer to describe Krugman's position.
Notes here.
Jonathan Finegold Catalán is an economics and political science major at San Diego State University. He blogs at economicthought.net. Send him mail. See Jonathan M. Finegold Catalan's article archives.
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