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business cycles are different and economists learn something new from
every recession — or rediscover something old that was forgotten.
The current recession is no exception. This time what is being rediscovered
is something called the "Austrian" theory of the business
cycle.
The Austrian theory was developed in the 1920s by two Viennese economists,
Ludwig von Mises and Friedrich Hayek. Their idea was that business
cycles were caused primarily by the central bank. Through monetary
policy, central banks lowered the interest rate from what would exist
under free market conditions. This set off a chain reaction that ultimately
led to an economic boom, followed by the inevitable bust.
To the Austrians,
the interest rate is the central price for the entire economy, because
it establishes the discount rate used for all investment decisions.
Following the great Swedish economist Knut Wicksell, the Austrians
believe there is a "natural" rate of interest which ensures
that saving and investment are appropriately matched.
If the market
interest rate should be below the natural rate, due to government
regulation or monetary policy, then people will save too little
and businesses will investment too much. If the market rate is above
the natural rate, then people will save too much and businesses
will invest too little.
Monetary policy
can easily affect market interest rates. When the Federal Reserve
injects money into the financial system, it has the same effect
as if people suddenly increased their saving, causing interest rates
to fall. Because of supply and demand, more saving will lead to
lower interest rates, all other things being equal. When the Fed
withdraws money from the financial system, by selling government
bonds, it has the opposite effect.
In the Austrian
view, therefore, business cycles result mainly from businesses making
bad investment decisions that are caused by Fed interference with
the interest rate. This inevitably creates misallocation of resources,
so that factories are producing too many widgets and too few gizmos.
Moreover, in
the Austrian view, two wrongs don't make a right. The central bank
cannot undo its mistakes by reversing course. A period in which
the interest rate was too low cannot be fixed by raising the market
rate above the natural rate. There is nothing to do, Austrians say,
except stop fiddling with interest rates, allow the natural rate
and the market rate to come together, and wait for the economy to
reallocate its resources properly.
In this process
of readjustment, unemployment and bankruptcies are unavoidable.
It is the only way that scarce resources, such as labor, can be
reallocated from where they are not needed to where they have greater
value. Unfortunately, labor and capital are not homogeneous, making
this reallocation very painful and costly. Workers trained for one
purpose cannot immediately be used for another, and machines built
to make one type of good may not be able to be used to produce another.
Anything government does to prevent this reallocation process only
postpones it, delaying the time when full employment returns.
This is a neat
theory and was very popular until the Great Depression. At that
time, the problem did not appear to be overinvestment, but underconsumption.
Moreover, the Austrian view left no room for government action.
If nothing else, this was politically untenable. Politicians were
not going to just stand by and do nothing while the economy worked
things out. After World War II, the Austrian business cycle theory
was largely forgotten.
Lately, however,
Austrian theory has gotten a new lease on life. Economists studying
the current business cycle have taken note of the fact that it is
almost entirely caused by fluctuating investment. Heavy capital
investment in the Internet and high technology fueled the boom.
When market conditions could not sustain this investment, it collapsed.
Since the end of last year, real nonresidential fixed investment
has fallen 6%, explaining almost all of the decline in economic
growth that we have seen. By contrast, real consumption has risen.
This fact has
rejuvenated interest in Austrian business cycle theory, as an explanation
for the current recession. This month the International Monetary
Fund published a paper on the subject by economist Stefan Erik Oppers.
And articles mentioning Austrian theory have popped up recently
in prominent business publications such as Forbes, Barron's
and the Financial Times. There has also been renewed interest
in Wicksell's work.
It may be too
soon to predict vindication for Austrian theory. Getting one recession
right doesn't necessarily mean that the Austrian view can be taken
as a general explanation for all recessions. Moreover, politicians
have not changed their stripes — Republicans are just as eager
to pass "stimulus" legislation as Democrats these days,
differing only on its form. Thus, even if economists accept the
Austrian explanation for this recession, the Austrian "do nothing"
cure still won't fly.
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