Critique of Austrian Economics
Part I: The Legacy of Friedrich Hayek
Section VII: The Severity and Recalcitrance of Depressions
The Hayekians are known more for their opposition to the Keynesians than for their own theory, so our critique cannot pass over a comparison of the two theories. Are interest rates procyclical [up in good times, down in bad] or anticyclical? In six words this question summarizes the difference between Hayekians and Keynesians. Keynesians believe, and every modern textbook proclaims, that interest rates are procyclical because the government is expected to lower them in its effort to rescue capitalism from its periodic bouts with recession. Hayekians believe that they are anticyclical because low interest rates lengthen the period of production, causing a boom, and then, when the currency is inevitably attacked, the defensive raising of interest rates shortens the period of production, causing a bust.
Basically, Keynesians believe that market forces are unreliable and the government responds to recessions by lowering interest rates. Depressions are endemic to capitalism and it is not their severity and recalcitrance but their absence that requires explanation. Hayekians believe that the government is unreliable and the market responds to unnaturally low interest rates with an attack on the currency which provokes a recession. But, since interest rates come back down as soon as the threat to the currency is past, the severity and recalcitrance of the slump still requires explanation.
There is some confusion on this interpretation. O’Driscoll and Rizzo write, “The more resources that have already been sunk in the capital-intensive production methods, the greater will be the demand for additional resources that can be used to complete the projects. If a project is nearly complete, then the incremental resources needed to complete it will have a far greater value than would have been the case ex ante... [This] capital complementarity effect helps explain the procyclical behavior of interest rates” (1985, p. 209). But on the next page they assert that “investment cycles typically end in a credit crunch, with a comparatively sudden and simultaneous financial ‘crisis’ for numerous firms.” The first statement suggests that interest rates are procyclical while the second statement supports the contention that Hayekians believe that interest rates are anticyclical.
Actually, they have not explained why interest rates are procyclical, or even demonstrated that they are. The only reason that the owners of nearly complete projects would bid up interest rates is because they anticipate a credit crunch. They are willing to pay more now to complete their project because they foresee getting cut off entirely. That is to say, they share the Hayekian belief that interest rates are anticyclical. Their actions in response to their Hayekian advisor’s forecast of a credit crunch do not make interest rates procyclical, they just ramp them up into the crunch period. O’Driscoll and Rizzo cite Hayek (1937), though he never used the word “procyclical,” and wrote specifically about “the rise of the rate of interest towards the end of a boom” (1937, p. 177), which supports this author’s interpretation.
Israel Kirzner writes:
We have before us two quite distinct theoretical disagreements. The first relates to the Keynesian belief that market forces cannot generally be relied upon to promote a powerful tendency toward full-employment of society’s resources. The second relates to the Clark-Knight belief that the time-structure can be usefully ignored. Skousen eloquently presented the theoretical case against the Clark-Knight view. But he has not, merely by presenting this case, as yet offered any reasoned case for the rejection of the offending Keynesian thesis (1991, p. 1762).
Kirzner is right in criticizing Skousen. If the Hayekian’s explanation of business cycles as the lengthening and shortening of the period of production was a rejection of the Keynesian theses, then how do they explain the persistence of recessions in the face of low interest rates? How do they explain the fact that we have seen depression/recession conditions long after a spike in interest rates was brought back down to more normal, low rates? The Hayekians can explain some temporary unemployment while the currency was under attack. But, after interest rates came back down, would not the structure of production have just lengthened again and the laid-off workers re-hired? As Skousen himself writes, “[An] aspect of the lower rate of interest is the lengthening of the production process. The reduced cost means that long-term projects that were previously put on the shelf can now be initiated” (1990, p. 287).
Garrison observes, “One key puzzle emerges from the writings of several economists who once embraced the [Hayekian] theory enthusiastically but subsequently rejected it. The key question underlying the recantations is easily stated: Can the intertemporal misallocation of capital that occurs during the boom account for the length and depth of the depression” (1996, p. 14)? Five years later he answered his own question: “the [Hayekian] theory of the business cycle is a theory of the unsustainable boom. It is not a theory of depression per se. In particular, it does not account for the severity and possible recalcitrance of the depression that may follow on the heels of the bust” (2001, p. 120).
But Kirzner’s proposed solution is inadequate: “In order to reject the Keynesian policy implications it is necessary to appreciate the healthy dynamism of the entrepreneurially-driven market process as having the potential to identify pockets (large or small) of unemployed resources and to move to eliminate them” (1991, p. 1762). Since there are enduring pockets of unemployment that are definitely not being eliminated by the entrepreneurially-driven market process, Keynesians have an easy retort to Kirzner.
Basically, by 1990 there were three competing business cycle theories:
1) Hayek’s Theory is that slumps only occur if, and continue only as long as, interest rates are held high in defense of the currency. This does not explain why slumps have lasted for a decade or longer even though interest rates came back down after only a few years. If the business cycle depends entirely on the lengthening and shortening of the structure of production, would it not have just lengthened again after the crises was over?
2) Keynes’ Theory is that slumps occur due to “exogenous shocks” and/or “animal spirits” (i.e. irrational investors) and are thus inherent in the capitalist system and cannot be blamed on the government.19 But when slumps do occur, it is the government’s job to rescue capitalism with low interest rates and deficit spending. Even if we accept the dubious claim that investors are irrational people, this does not explain how recessions have so stubbornly resisted aggressive deficit spending and near zero percent interest rates. Nor does it explain why the U.S. government’s unprecedented ability to set interest rates and spending levels has not prevented America’s long downturn. As Brenner writes, “It cannot be emphasized enough that the revitalization of the US economy from around 1993 took place against a backdrop of economic stagnation in the US and on a world scale lasting at least two decades, beginning in the early 1970s” (2002, p. 7).
3) Kirzner’s Theory is that slumps do not exist because entrepreneurs are so healthy and dynamic that, in their quest to root out pockets of unemployment, they can overcome any obstacle, including changes in government spending and interest rates. By ignoring the existence of the Great Depression and the Long Downturn20, Kirzner is just living the stereotype of the classical economists’ blind faith in the market and denials of depression.
Kirzner’s theory can be rejected out of hand. As for the Hayekian’s interest rate spikes and Keynes’ exogenous shocks, both are overrated. Hayekians point to the abrupt monetary contraction in 1930, but they cannot explain why the Great Depression lasted for ten years – fifteen if one counts the war years. Keynesians point to the OPEC shock in the 1970s, but they cannot explain why, thirty years later, we are still in a Long Downturn.
The key to explaining the longevity of recessions is that capital has been wasted. Keynes (1953, p. 129) writes:
Pyramid building, earthquakes, even wars may serve to increase wealth.... If the treasury were to fill old bottles with banknotes, bury them at suitable depths in disused coal mines which are then filled up to the surface with town rubbish, and leave it to private enterprize... to dig the notes up again..., there need be no more unemployment and, with the help of the repercussions, the real income of the community, and its capital wealth also, would probably become a good deal greater than it actually is.
For Americans recalling their pre-Vietnam glory days or for Japanese looking back to the Asian Miracle of the 1970s and ‘80s, the obvious question is: Where did the wealth go? The answer should be equally obvious: It was wasted. It is at the bottom of a Keynesian coal mine. As I said earlier, “Boom times are characterized by a transfer of capital from smaller companies to larger ones, and the big ones waste it” (1999, p. 161).21
Once this capital has been wasted, it is gone for good. The nation is doomed to recession until they can liquidate their foolish ventures, regardless of whether the central bank is ever pressured into dramatic monetary contraction to defend the currency. The necessary condition for recovery is that the prodigal elements of society are cut off. The government must mercilessly send the crooks to jail and the failures to bankruptcy court.
19 Mises (1966, pp. 580-586) has eloquently written about the anarchy of production/animal spirits theory of incompetent businessmen causing trade cycles.
20 With a nod to Brenner, “Long Downturn” will henceforth be capitalized.
21 Lachmann writes, “Neo-Ricardian thought appears to be unable to cope with the problem of capital resources which can undergo considerable changes in value while retaining their physical form” (1986, p. 234). Actually, mainstream economists also appear unable to cope with this problem. Any mention of waste automatically gets one shunted off to the growth theorists who happily report back that the physical accumulation of capital is always up, up, up (unless it is getting bombed during wartime) and thus has nothing to do with business cycles. Like the Neo-Ricardians, they are looking at costs of production, not subjective value.