Austrian Theory and the Great Recession

1.  Axel Leijonhufvud, “Keynes and the Crisis,”

The Federal Reserve System under Greenspan put this proposition to the test in the years following the dot.com crash, pursuing an extreme low interest policy.  The result was more Keynesian than Monetarist and, as I have already noted, more Austrian than Keynesian: virtually no CPI inflation, but drastic asset price inflation and very serious deterioration of credit standards (p. 4).

Leijonhufvud is an incredibly interesting character.  He is familiar with Austrian theory, and he was influenced by the line of Keynesian scholars (including Shackle) that focused on Keynes’ contributions to disequilibrium economics.  Leijonhufvud’s most well-known work, perhaps, is that which deals with interpreting Keynes within the framework of coordination and discoordination.

H/T John Cochran.

2.  In a PowerPoint to a lecture Paul Krugman gave at Cal Poly Pomona yesterday the following graph is presented,

Krugman uses it to confirm that this recession is not one characterized by structural problems.

This is why I prefer a pure Austrian story to other structural “recalculation” theories.  Others envision huge shifts in the structure of production, almost like entire shifts in industrial production (between different markets).  So, for instance, this recession should be typified by a shift from construction-based industries to others.  But, according to the unemployment figures, this is not the case.

Austrian theory makes a much broader claim.  Malinvestment is about aggregate investment; namely, aggregate investment that requires more than the actual available quantity of capital goods.  This is caused by distorted profit signals, in turn caused by money injections through the loanable funds market to entrepreneurs.  When the monetary injections slow or cease, prices adjust, suddenly causing profitable lines of investment to be revealed as unprofitable.  The point is that the consequences can be felt by any industry, not just by certain industries.  Some, true, may suffer more than others, but, in general, malinvestment is an economy-wide phenomenon.

Yes, there is a structural readjustment that follows.  But, this is not a readjustment between entire industries, only.  It is a more general rearrangement of the factors of production, and it is one which affects the entire economy.  It also has to be considered that institutional forces (such as regulations and other sources of incentives) will affect how the structure of production changes.  This is why I don’t think looking at patterns of unemployment in more “roundabout” industries, as Daniel Kuehn put it, would be a fruitful empirical verification.

31 thoughts on “Austrian Theory and the Great Recession

  1. Bob Roddis

    I am always concerned by the argument that the malinvestment must be due to the lack of resources to finish the project. It seems to me that what is revealed when money injections cease is the lack of customers for the final goods. What empirically happens is that the money injections make EVERYONE believe that they and everyone else are much wealthier than is truly the case. Due to the degree of time and investment involved, these miscalculations will tend to be more catastrophic in capital goods industries.

    However, the housing bubble is an unusual case of the ABCT but clearly a case of malinvestment due to distortions of economic calculation brought about by money dilution. Most everyone refuses and/or fails to understand what causes inflation and it is generally believed to be an incomprehensible force of nature (thank you, government schools). Most everyone believed that purchasing real estate was a wise LONG TERM and permanent hedge against this mysterious inexplicable inflation. Everyone failed to realize that at the end of the musical chairs game, there had to be willing buyers with $800,000 worth of real goods and services waiting in the wings with which to exchange for that former $100,000 house.

    That is clearly and empirically what caused the housing boom/bust. What further data do we need? What exactly are we supposed to be looking for that we don’t already know?

    Reply
    1. Jonathan Finegold Catalán Post author

      That there aren’t willing customers is one side of the story, but largely because the costs of production (the real costs of capital goods) are higher than expected profits. There is a scarcity of capital goods, and some projects just aren’t worth completing because the loss of the malinvestment is lower than the lost of completing the investment and not selling enough of your output (i.e. the opportunity cost of finishing the investment is higher).

      Monetary injections through the loanable funds market targets the capital goods industry because of profit signals — this is explicit in Hayek’s writing. The theory states that entrepreneurs will increase investment in second order goods, which will in turn increase demand for third order goods, and so on and so forth until the rate of profit is equalized throughout the entire structure of production. There are some minutiae in Hayek’s theory that might be contested by someone who rejects some of the Ricardian influences, but the gist of Hayek’s theory is correct.

      In large part, the housing boom was actually carried forth not only as a result of monetary injections, but also because of the regulations which controlled how banks invested their capital. The result is an overconcentration in mortgage backed securities, because these were deemed the safest. So, in a sense, the housing boom was made much worse than it would have otherwise been. I think that if banking regulations had been different, the boom would have materialized differently (not necessarily “better,” but just different).

      Reply
      1. Daniel Kuehn

        If you think the lengthening of the capital structure isn’t the best way to approach this, that’s fine – but you would at least recognize that you’re emphasizing something different from what Hayek and Garrison were emphasizing, right?

        You’re almost taking a more Keynesian approach to capital theory here. Length of the production process isn’t terribly important – what matters is what investments have a net benefit given a particular interest rate. An interest rate distortion that is revealed to be a distortion is going to cause some dislocation. The only difference between you and most other Keynesians is that you see the distortion in the boom and we see the distortion in the bust.

        Of course that’s fine – in a sense you’re closer to what I think is important to talk about… but I have a harder time calling that Austrian business cycle theory if you’re going to dispense with the emphasis on the capital structure.

        Reply
        1. Jonathan Finegold Catalán Post author

          Well, I don’t know Garrison’s views too well, because I didn’t think his exposition in Time and Money was too great — I feel that it wasn’t a book on capital theory, as much as it was an attempt to make a basic model that allowed comparisons between Keynesian theory, monetarism, and Austrian capital theory. I do think there are differences between “me” and Hayek, just like there are differences between Mises and Hayek, and between Lachmann and Hayek.

          With regards to interest rates, that’s not my position at all. The rate of interest, actually, is not the primary factor behind monetary distortions. Like I wrote in the comments section to that post on interest rate theory: the rate of interest is not the return on capital. Returns on capital are exploitations of price differences. What causes these price differences is changes in nominal demand for products relative to others. So, what matters is the allocation of new money, not so much the rate of interest. What a lower rate of interest does is provide an incentive for the entrepreneur to borrow. So, it has to do with setting the boom off, but the malinvestment is more directly an issue related to price distortions.

          I am not dispensing with the emphasis on the capital structure. What I’m saying is that the shape of the capital structure will be more “ad hoc” than what Hayek leads us to believe in Prices and Production (I can’t speak for the Hayek of Pure Theory of Capital), although “ad hoc” might be the wrong word. There are other factors which guide investment, which is why Mises didn’t really accept the deterministic nature of Hayek’s theory (that the capital structure must lengthen until there is uniformity of profits).

          Finally, with regards to Keynesianism and the bust, I can’t really make a good argument now, but one criticism an Austrian might make of your theory (of too high of interest rates) is that the concept of the marginal efficiency of capital is bunk. I’ll be better able to make these criticisms myself when I finish reading The General Theory.

          Reply
          1. Daniel Kuehn

            Marginal efficiency of capital is bunk?

            And hear I was, reading Walter Block’s essay on marginalism in the Elgar Companion to Austrian economics, thinking you all were less hostile to that than I originally thought?

            What’s the issue with MEC?

          2. Jonathan Finegold Catalán Post author

            I haven’t read Block’s essay on marginalism. Does it deal with the marginal efficiency of capital? For critiques in lieu of mine (like I said, I will make mine when I finish TGT) I would see Huerta de Soto’s in Money, Bank Credit, and Economic Cycles and Reisman’s in Capitalism.

        2. Bob Roddis

          1. I don’t think we have any common ground with the Keynesians. All of the economic mis-calculations were caused by some form Keynesian-type policies in the first place (whether or not the particular policy would have been the “perfectly proper” policy for a particular time as defined by a particular strain of Keynesianism).

          2. When Mises and Hayek were formulating their versions of the ABCT, they could not imagine the completely insane fiat system we have today. That system brings about several important variations on the types of malinvestments that were not foreseen 80 years ago, like in consumer credit and housing. “Lord Keynes” makes of big deal out of that. But that’s because he refuses to comprehend economic calculation, much less its expressive variations. As Jonathan points out, government spending and regulation cause serious price distortions too.

          3. The impact on long term production is still the most devastating result of Keynesian policy. All that I’m saying is that, while interest rates are a most important price, distortions of other prices are important too and fiat money-induced malinvestments also turn up in many other shorter-term lines of investment and production.

          4. It’s still all the Keynesians’ fault and by being oblivious to the basic concept of economic calculation, they can explain nothing. As DK’s paper demonstrated in showing that the 1920 depression was caused by “the stroke of luck” budget cuts and not by the market, depressions are caused by government, not the market. Thus, “stimulus” doesn’t even make any sense because it is only going to continue the fatal mispricing.

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        3. Long Dong Silver

          DK,

          What are you saying? Are you saying that DSGE they doesn’t have than are way overblow for (which is not even need GE that don’t)?. It’s not qualify aspectly it doesn’t. In fact, an accounts refer point innovations are imporant, Austreaux’s gross of Austrian mumblings overstatemes. The largument in favor (which Austrians like DSGE these of why these of Austrians discussions have corporant, we doesn’t. In favor of which Austrian mumblings over DSGE that more way ident about Lachmannians have corrects refer point about “kaleidic” some ommissione

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      2. Björn

        As an entrepreneur I find Hayek’s theory really difficult to swallow as is. For one thing I find it hard to believe that the problem Hayek describes would have such dramatic consequences. Profitability simply isn’t that sensitive to correlated errors of judgement.

        Take for instance a VAT of 25% as we have in Sweden. That exceeds by far any costs associated with capital structure, and yet doesn’t stop businesses from being profitable.

        But there is a lot of interesting conclusions to draw from Hayek if you backtrack to first principles. I have written about it here: http://conscienceofanentrepreneur.blogspot.se/2012/02/forget-about-money-its-opportunity-cost.html. Would be very interesting to hear your thoughts on it.

        Reply
        1. Jonathan Finegold Catalán Post author

          Björn, it’s about how changes in the supply of money cause changes in prices, and thus changes in price differences (that can be exploited to make profits). When money creation slows or ceases these prices change again. This is the source of the problem. The type of distortions caused by money injections is radically different from the type of distortions caused by taxes.

          Reply
          1. Björn

            I think I’m relatively familiar with the theory. It’s just not compatible with what I’m seeing in the real world. Goods are so heterogeneous and demand so inelastic that it’s ridiculous.

            Hayek seems to think that entrepreneurs are looking for tiny price differentials to exploit for profit, and that failure is about misjudging those differentials. But entrepreneurs are looking for new products and services that people want, and when they find one it’s usually profitable. Failure is about misjudging demand, not price. When you misjudge human needs and desires it usually can’t be fixed by lowering price.

            In a world where a pair of jeans can sell for $200 and another be unsellable at $20 I don’t think it makes much sense to focus so much on price. It’s what monetary expansion does to demand that’s interesting. Austrians have to start talking about demand.

          2. Jonathan Finegold Catalán Post author

            It’s not about tiny price differentials — I think Hayek uses the Ricardian concept of profits uniformity only to illustrate the argument. And, entrepreneur failure is not about misjudging these differentials. Entrepreneurial failure is caused by distortion of the prices: what some Austrians might call “false profits.”

            This is not a business topic. This is an economic problem. What kind of information do prices convey? They convey information on demand for the product. Entrepreneurs do look for new products where they can make profits, but in order to make a profit the price of the output must be higher than the costs of the inputs (which are based on prices) — these are price differentials.

            What Austrian business cycle theory tells us that liquidity injections through the loanable funds market to entrepreneurs will change these prices by increasing demand for inputs. Entrepreneurs will provide these inputs at a profit. The problem is that this pattern of investments is unsustainable, and this is why there is a collapse in investment.

            Austrians do think about demand. What you need to realize is that all of this is contained within the Austrian theory of prices, of which its business cycle theory is just a small part of.

        2. Jonathan Finegold Catalán Post author

          By the way, we distinguish between consumer and business credit, because each agent affects different prices. Consumers affect the prices of consumer-goods; entrepreneurs affect the prices of capital goods. Thus, new money distributed to consumers will have a different effect than money distributed to entrepreneurs. It’s not about lowering opportunity costs; it’s about changing prices, when it is prices which influence how entrepreneurs invest.

          Reply
          1. Björn

            But it’s not prices that affect how entrepreneurs invest. It’s demand.

            Have a look at the website http://www.kickstarter.com/. How do you think rapid monetary expansion would affect economic activity there? You could talk about how expanding business credit would drive up the cost of goods for some of these projects, but that would be dwarfed so many times over by changes in consumers willingness to spend money on something fun but non-essential.

            My bet is that rapid monetary expansion would make kickstarter flourish, because when credit is expanding money is simply easier to come by, and easy come easy go. You wouldn’t see any major changes in prices (consumer or producer), but you would see much more risky and “useless” projects funded. Malinvestment in nutshell. How do you explain that with “relative prices”?

            I’m not saying kickstarter is a perfect model of the economy, but I think the same principle applies elsewhere. Profitability is not so much a function of price as a function of demand. What the Austrians can teach the Keynesians is that sometimes the problem is the “false demand” during the boom and not the lack of demand in the bust.

            Is there really no Austrian working along this direction?

          2. Jonathan Finegold Catalán Post author

            But it’s not prices that affect how entrepreneurs invest. It’s demand.

            Again, what do you think prices reflect?

            The great centerpiece of economics is the pricing process,is and this is where Austrian theory is at its best. It’s the pricing process which allows for economic coordination. These aren’t controversial ideas.

  2. Zack A

    I dont see how Krugman’s graph is a threat to Austrian theory whatsoever. When people are using their houses as their personal ATM’s, then use money (they really dont have) to buy other things like TV’s, cars, cellphones, and other goods (causing a boom in employment in those other industries), of course unemployment across the economy will rise once the artificial boom collapses. So whats his point here?

    Reply
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    1. Jonathan Finegold Catalán Post author

      I think I had some brief posts criticizing it on the old blog, but I’m not a big fan, no.

      Reply
  4. edarniw

    Firstly, I’m always confused when there’s talk of unemployment for given sectors. How is that calculated?

    Secondly, the data says that unemployment in the construction industry is twice that of nearly every other sector (17.2%): http://www.bls.gov/news.release/empsit.t14.htm

    Is that not consistent with a structural problem? And especially the Austrian explanation. Am I missing the interpretation here?

    Reply
    1. Jonathan Finegold Catalán Post author

      I don’t know how they harvest the data. Most likely from data mining unemployment records.

      There are, of course, structural issues — both general structural issues and issues specific with certain industries –, but I think Krugman’s graph shows us that even while construction took the greatest lost, when compared to total unemployment (minus construction) it is actually not that big. So, if you restore aggregate demand, you would see a return of the majority of the unemployed to work. I think Krugman is dismissing the structural story as one that can tell us the source of the recession.

      Reply
      1. Greg Ransom

        I think it is wise not to trust “the data” — economists don’t know what “the data” mean or what its significance really is “on the ground”, esp. in particular and constantly changing environments. Jobs are constantly turning over, people are going in and out of jobs and in and out of different sectors — constantly, in numbers swamping the unemployment numbers.

        Unlike biologists, economists “don’t do field research”, i..e. they don’t go into a place like Orange County, CA and do any sort of population study tracking every person in the population across time, to understand what the numbers really mean, in a rich environmental context.

        Until economists do something like that, they are mostly blowing smoke about the meaning of these “numbers” or “data points”.

        Reply
    2. Daniel Kuehn

      BLS unemployment figures come from the CPS, a monthly household survey. They assign unemployment rates to industries/occupations by asking the previous occupation and industry of the unemployed.

      Krugman’s graph comes from the fact that construction workers make up only a portion of the total workforce, so you still see the average trends when you exclude construction. It’s not the only story to tell (and I don’t think he’d deny that construction workers have it particularly hard) but it is important to remember this isn’t just a construction-worker-recession. There has to be more than structural shift issues.

      Reply
      1. Jonathan Finegold Catalán Post author

        I’d also add that intertemporal discoordination can’t explain it all — something I should have mentioned in the post. There is evidence (see Friedman & Kraus [2011]) that the credit contraction was worse than it needed to be, because capital reserve regulations forced banks to declare bankruptcy, even though they could have probably “weathered the storm.” So, investment was struck more than it needed to be.

        Reply
        1. Greg Ransom

          Of course, Hayekian macro isn’t in any sense _just_ about the bare lengthening and shortening of the time structure of the economy, unrelated to system-wide “disequilibrium” changes in debt relations, finance, money, etc. which create “their own” wide ranging employment / unemployment effects.

          And it is really dishonest of the Krugman’s of the world to pretend that construction work and construction unemployment is utterly unrelated in any way whatever to other parts of the economy.

          it’s a lie — a magicians trick of misdirection, and it is ethically disgraceful in a pretend “scientist”.

          Reply
      2. Greg Ransom

        In Orange County, CA, and many other places, in the first several years of the Great Recession 1 out of 4 unemployed workers came directly from the construction industry ….

        The areas hardest hit by the Great Recession were dominated by construction job loss and a decline in construction AND RELATED businesses (and occupations).

        Reply
  5. Chris

    Bob Murphy wrote an article over at mises.org the last time Krugman did this. Murphy found a chart that shows almost the opposite, that there were greater slumps in employment in some sectors than others. This seems to be one of those cases where you can almost find a chart to support your theory. Which is what Krugman is very good at.

    http://mises.org/daily/4682

    Reply
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