In the April 2009 Freeman I continued my discussion of the Austrian theory of business cycles. My column is below the fold.
In my previous column I reported that the sustained and substantial economic growth over the past several decades caused me to question the empirical strength of the Austrian theory of boom and bust. According to that theory, the continued injection of fiat money into the economy should have led to excessive, unsustainable investments—investments that would inevitably turn sour. Some asset prices would crash, sending a harsh but necessary market signal that those investments were unwarranted. The result would be a recession as entrepreneurs reworked their production plans.
Since the early 1980s, however, no significant recession emerged.
Why not? The logic of the Austrian theory seemed sound. People do respond to changes in relative money prices, including interest rates. And whenever such changes are caused by money manipulation (rather than by changes in underlying economic reality), resources are certain to be channeled into activities that are economically inappropriate.
My curiosity about the apparent disconnect between empirical reality and the predictions of the Austrian theory intensified in recent years, spurred on by conversations I’ve had with a handful of Austrian-minded friends, each of whom disagreed with my claims that the economy has been growing and prosperity increasing. “Look,” they’d say, “much of this prosperity isn’t real! It’s an illusion created by excessive money growth that gives rise to malinvestments.We’ll have to pay too high a price for this ‘prosperity’ when it comes crashing down in the future.”
Everyday evidence of greater prosperity—better cars, faster microchips, greater varieties of offerings in supermarkets, less-expensive and higher-quality clothing— combined with the long period (nearly 30 years) over which such evidence built up, convinced me that this prosperity was real. It was no illusion.
So I began to speculate that capital goods are more flexible than Austrian theorists assume them to be. A machine designed, say, to help build automobiles might be rather easily converted into one that helps build motorcycles or even mattresses—so easily converted that little economic disruption occurs as a result. Sure, money injections divert the economy from its ideal path, but many of the less-than-ideal paths that it can find itself on probably are not so very different from the ideal. Or at least these less-than-ideal paths are nevertheless ones that generate perceived net improvements in living standards over time.
I did not formulate my hypothesis in any formal way. Nor did I subject it to empirical testing or to other economists for critical feedback. I was just beginning to think seriously along these lines when 2008 dawned—and with this annus horribilis, the scariest financial meltdown of my lifetime. In November, the Dow Jones Industrial Average was down 43 percent from its all-time high, which it had reached only 13 months earlier.
That figure represents an enormous crash in asset prices. In addition, unemployment is rising, so workers are being shed from uses that are now proving to be unprofitable.The underlying economic reality is exerting itself, destroying a crust of bad investments that, we now know beyond doubt, had built up over the years.
Perhaps the Austrian theory is correct after all. Perhaps the appropriate length of time necessary for the boom-bust scenario to play out is much longer than I’d assumed it to be—not a few years but a few decades. And perhaps many of the outputs produced by the malinvested capital turn out, in their own way, to be genuine and positive additions to society’s material prosperity—not additions compared to total output without any money manipulation, but compared to total output in a world in which no further investment at all took place.The best evidence that I’ve seen reveals that the Federal Reserve under the chairmanship of Alan Greenspan (and certainly under his successor, Ben Bernanke) was very loose with the money supply—a policy that, according to economist Lawrence H. White, fueled the recent real-estate boom that has now gone bust. Here’s White writing on December 2, 2008, at Cato Unbound:
“As calculated by the Federal Reserve Bank of St. Louis, the Fed from early 2001 until late 2006 pushed the actual federal funds rate well below the estimated rate that would have been consistent with targeting a 2 percent inflation rate for the PCE deflator.The gap was especially large—200 basis point or more— from mid-2003 to mid-2005. The excess credit thus created went heavily into real estate. From mid-2003 to mid-2007, while the dollar volume of final sales of goods and services was growing at a compounded rate of 5.9 percent per annum, real-estate loans at commercial banks were . . . growing at 12.26 percent. Credit-fueled demand both pushed up the sale prices of existing houses and encouraged the construction of new housing on undeveloped land. Because real estate is an especially long-lived asset, its market value is especially boosted by low interest rates.The housing sector thus exhibited a disproportionate share of the price inflation predicted by the Taylor Rule [the formula devised by economist John Taylor of Stanford University for estimating what federal funds rate would be consistent, conditional on current inflation and real income, with keeping the inflation rate at a chosen target]. (House prices are not, however, included in standard measures of price inflation.)”
I’m not sure where recent events—the economy’s still-ongoing turmoil—leave my assessment of the Austrian theory. But I am much more inclined now to find in it the empirical oomph that for so many years I thought it lacked.