Critique of Austrian Economics
Part I: The Legacy of Friedrich Hayek
Section VI: The Natural Rate of Interest
With the average period of production and roundaboutness, the third leg of Hayekian economics is the natural rate of interest. Böhm-Bawerk’s theory of interest was muddled and somewhat resembled the productivity theories which he himself had criticized. Instead, the Austrians sought foundations from the Swedish economist Wicksell. However, though he was a better economist than Böhm-Bawerk, his natural rate of interest is really no stronger than the other two legs of Hayekian economics.
The reason that so much controversy surrounds this concept is because nobody has ever seen a natural rate of interest. Economists draw their usual crossed lines (here labeled “savings” and “investment” rather than “supply” and “demand”), but where they cross is pure speculation. It has nothing to do with real-life “Fed watching.”
So, if the Fed has so much control over the Federal Funds Rate that they appear to be setting it by decree, what are all those crossed lines for? This author’s treatise (1999), is certainly the only economics book that does not contain any crossed-line graphs.13 I do not believe in supply and demand. I believe in the demand distribution, which is a mapping between price and stock. Supply has no place at all in my theory. See (1999, pp. xvii-xviii):
A large part of the problem with supply and demand is that it is used descriptively, but called predictive. It is easy to predict the past. Economists just observe the quantity produced one month and what it sold for and they put a little × over that spot. Then, by pure conjecture, they draw four tails on their × to fill their graph paper. Supply and demand has never been used predictively, not even to make bad predictions. × marks the spot is a purely descriptive technique. Since they are using the 20-20 vision of hindsight, they can do this for three months in a row and, to nobody’s surprise, the sum of the quantities is the quarterly quantity. In the real world, price is constant for years at a time but, for most companies, their weekly and monthly sales figures swing wildly and unpredictably, sometimes by several fold from one month to the next.
The natural rate of interest is worse, since economists do not even know where to put their little ×, much less how to draw the four tails on it. Short term interest rates are set by the Federal Reserve.
Garrison has the interest rate determined by the supply and demand of present goods, labor for wages: “Labor services represent future consumption goods.... The sale of labor services, then, constitutes the demand for present goods and the supply of future goods” (1978, p. 175). The accompanying figure is reprinted here as Figure 5. This implies that production is not the complicated structure it was originally described to be, but is really quite simple: All labor is used at the high end (not spread throughout the structure), is paid for entirely with borrowed money and borrowed money is used for no other purpose (like buying capital) except paying wages.
First an ill-conceived change of variables, then a horizontal axis labeled with time running backwards and now a definition of interest that involves only present goods! Garrison’s Diagrammatical Exposition (1978) is certainly the low point in Hayekian economics. Twenty-three years later, Garrison would write that “it continues to appear on Austrian economics reading lists” and is “largely compatible with the graphical exposition offered in the present volume” (2001, p. xii). Frankly, that is hard to believe.
If the Hayekians must have a “natural” interest rate, they would have been better off sticking with the classical crossed-line graphs. However, this author declines to define a natural rate of interest.
Many people in the business community shun Austrian economists, not so much because they disagree with their theory, but because it comes across as being rather naïve.15 We saw in the previous section that Hayekian theory depends entirely too much on the specificity of capital goods. In reality, many companies make products or provide services which are used in all of Hayek’s five stages – and they experience cyclical behavior too. The dot.coms experienced more extreme cyclical behavior than many of their brethren on NASDAQ who can be placed solidly in one of the higher stages of production.
But Austrian economists' most egregious display of naïveté is in regards to their conception of a natural rate of interest. There is no such thing. In any case, credit limits are more important than interest rates and there are many people who cannot get credit at any rate.16 Interest rates only affect how much money is being transferred. They do not affect who gets it.
Economists define a “small business” as one with fewer than 500 employees. Once companies get close to that size they can borrow money, though not at rates anywhere close to prime. The prime rate does not become meaningful to companies until they are well past the junk bond classification and closer to the Fortune 500 classification. Companies big enough to be listed on the major stock indexes (DOW, S&P 500, etc.) sell most of their stock to large investors (mutual funds, insurance companies, etc.) who can borrow money for that purpose. Until companies reach that size, all talk of interest rates is irrelevant to them.17
Recently, Stiglitz and Greenwald have raised the same issue. “That some loans are not repaid is central... Thus, a central function of banks is to determine who is likely to default, and in doing so, banks determine the supply of loans” (2003, p. 3). This idea, that bank loans redistribute wealth from one class of people to another, is a fundamental departure from the classical view that banks merely divide the world into those who are willing to borrow at x% but not at x.1%, without any regard to who those people are, their class or their importance to the government.
This author writes:
I assert that, during boom times, capital is being wasted by every company, from the largest multinational down to the smallest mom-and-pop outfit. This is a harsh assessment of their business practices and the directors of small businesses might complain that I am being unfair to them. Small businesses cannot get credit at any interest rate, even during boom times, and are rarely seen building the grandiose projects that large businesses embark on during a boom. If they are large enough to be publicly traded, however, then some of their stock is held by people or organizations that can borrow from banks. Also, if the rest of the stock market is overvalued, companies will be pressured into reporting unrealistic profits to keep up. Slow, steady growth is unacceptable. Those who do not report extraordinary profits fail. Thus, during boom times, every quarterly report is treated as an emergency18 and companies consume their capital to meet that emergency. Because of this, the first sign of a bust is when small companies that had previously reported extraordinary profits start to fail and are suddenly discovered to be operating on a shoestring with worn-out and obsolete capital. Unfortunately, this usually goes unnoticed in the glow of the still rising stock indexes, which measure the value of large companies. Companies that are too small to be publicly traded also waste capital. Their owners do not reinvest their profits but let their businesses deteriorate while they buy stocks of larger, publicly traded companies. Thus, boom times are characterized by a transfer of capital from smaller companies to larger ones, and the big ones waste it. Also, while small businesses cannot get credit during a boom, home loans and car loans are easy to obtain, so a lot of capital is converted directly into consumer goods (1999, p. 160-161).
Stiglitz writes, “During the bubble, of course, all kinds of resources get wasted – in amounts that are often hard to fathom, and make government waste look small by comparison” (2003a, pp. 62-63). This may seem like a safe and even an obvious thing for an economist to say, but it is actually a dramatic departure from the mainstream.
First, he admitted that government waste exists. Anyone who has taken a college economics class knows that government expenditures, G, are just added into national income, Y, without any comment on whether they were well-spent or not. Even more remarkable, he mentions problems during the boom. Every textbook in America begins its analysis of the business cycle with an exogenous shock which knocks the economy into recession. Then, they examine what actions the government can take to bring it back to its norm. The idea that there are problems during the boom which pre-exist the exogenous shock is truly revolutionary. Coupled with his admission that bank loans redistribute wealth from one class of people to another, this makes Stiglitz a genuine leader. He is leading the Keynesian’s retreat.
13 Mises (1966) does not either, though for a different reason. He believes in supply and demand, but not in the continuity of their graphs. This author does not believe in supply and demand at all.
14 Block writes, “Supply and demand have been with us for a long time, yet no one is calling for their amendment” (2001, p. 64). I call for their rejection. Block, Hoppe and Salerno write, “scientific progress occurs not by a process of smooth and ever-broadening consensus among different approaches, but via jarring and revolutionary paradigm shifts” (1998, p. iii). However, a year later Hoppe did not find the rejection of supply and demand sufficiently jarring to bother reviewing Axiomatic Theory of Economics (Aguilar 1999). Instead, and in spite of their bold mission statement, they continue beating the same horse that threw Hayek in 1936, apparently expecting it to rise from the dead and finish the race with Garrison at the reins.
15 People in the engineering community shun Austrian economists because their math is so weak. This is too bad because, the skills of engineers being among the highest order of goods, they suffer from volatile employment. Thus, if they were not put off by the Austrian’s weak math, they would believe in their theory.
16 The fact that many people cannot get credit at any rate is obscured by calling certain transactions loans when they are not. When two people sign a contract exchanging present goods for future goods, which one is the creditor and which one the debtor? This may seem obvious, but let us spell it out: The creditor is the one taking the risk, who provides present goods and trusts the other to deliver something of greater value in the future. When a poor working person goes hat-in-hand to the auto dealership and asks “Will you give me credit?” he has got the question backwards. He is giving them present goods (his trade-in and/or down payment) in exchange for future goods, the title to the new car five years hence (when it is not new anymore). In the meantime he makes monthly payments to the bank, the insurance company and the dealership for their warranteed repairs. Being allowed physical possession of something that someone else owns is what is called “rent” and that is what these payments are. Until he gets a clear title he has not bought anything. At any time, regardless of payment history, the bank is within their rights to repossess that car and rent it to someone else. The customer trusts them not to do this but cannot legally prevent it. The bank takes no risk because the customer pays for insurance and repairs. If he skips out, the car he has been renting is of no value to him because he cannot sell it, register it or insure it without their consent. If he drives it without current plates, the police will quickly send him to jail and the car back to its owner, the bank.
17 If it is not clear already, it will be soon: This paper was not intended to help me get on Roger Garrison’s good side. Nevertheless, let me take this opportunity to offer him an olive branch. Chapter Six of his recent book (2001) is good and his suggestion of “attempting to explain episodes of boom and bust by con-trasting the market’s allocation of risk-bearing and policy-induced distortions of risk-related market mechanisms” (p. 110) has merit. This author would emphasis credit limits over interest rates, however, and would point out that “risky” is often just a euphemism for “politically unconnected.” Bankers loan money to their friends and call it “risk management” when, in fact, their friends are the least likely to pay it back.
18 On the subject of companies being pressured into reporting unrealistic profits and on how every quarterly report is treated as an emergency, I refer the reader to Berenson (2003).