Austrians Can’t Get their Story Straight on the Effects of Austerity

Here is something I have noticed of late in the ongoing debates on austerity: some Austrians argue that fiscal contraction can directly lead to GDP growth and recovery (a line taken by some neoclassical economists with their pro-growth austerity fables), and they argue that, if only governments would do nothing and pursue austerity, strong recoveries would ensue. In the process, these Austrians seem to deny that recession or depression is the result of fiscal contraction.

The idea is blatantly contradicted by their own business cycle theory, which holds that prolongation of a recession or depression to its “natural” end, and purging malinvestments in the process, is a necessary consequence of the “do nothing” response itself (called “liquidationism”). Therefore it is bizarre and stupid in the extreme for any Austrian adherent of the Hayekian business cycle theory to argue that austerity or a “do nothing” policy will lead directly to growth.

Before he renounced liquidationism, Hayek in Prices and Production explained exactly why nothing must be done during a credit-caused recession, and why the economy and society must suffer the consequences:

“If the foregoing analysis is correct, it should be fairly clear that the granting of credit to consumers, which has recently been so strongly advocated as a cure for depression, would in fact have quite the contrary effect; a relative increase of the demand for consumers’ goods could only make matters worse. Matters are not quite so simple so far as the effects of credits granted for productive purposes are concerned. In theory it is at least possible that, during the acute stage of the crisis when the capitalistic structure of production tends to shrink more than will ultimately prove necessary, an expansion of producers’ credits might have a wholesome effect. But this could only be the case if the quantity were so regulated as exactly to compensate for the initial, excessive rise of the relative prices of consumers’ goods, and if arrangements could be made to withdraw the additional credits as these prices fall and the proportion between the supply of consumers’ goods and the supply of intermediate products adapts itself to the proportion between the demand for these goods. And even these credits would do more harm than good if they made roundabout processes seem profitable which, even after the acute crisis had subsided, could not be kept up without the help of additional credits. Frankly, I do not see how the banks can ever be in a position to keep credit within these limits.

And, if we pass from the moment of actual crisis to the situation in the following depression, it is still more difficult to see what lasting good effects can come from credit expansion. The thing which is needed to secure healthy conditions is the most speedy and complete adaptation possible of the structure of production to the proportion between the demand for consumers’ goods and the demand for producers’ goods as determined by voluntary saving and spending. If the proportion as determined by the voluntary decisions of individuals is distorted by the creation of artificial demand, it must mean that part of the available resources is again led into a wrong direction and a definite and lasting adjustment is again postponed. And, even if the absorption of the unemployed resources were to be quickened in this way, it would only mean that the seed would already be sown for new disturbances and new crises. The only way permanently to “mobilize” all available resources is, therefore, not to use artificial stimulants—whether during a crisis or thereafter—but to leave it to time to effect a permanent cure by the slow process of adapting the structure of production to the means available for capital purposes.

(10) And so, at the end of our analysis, we arrive at results which only confirm the old truth that we may perhaps prevent a crisis by checking expansion in time, but that we can do nothing to get out of it before its natural end, once it has come.” (Hayek 2008: 274–275).

In other words, if we take the logic of this Hayekian solution of liquidationism seriously, honest Austrians should be telling us that their solution requires recession or depression, possibly protracted and devastating depression, which must be allowed to continue until it reaches its “natural end.”

Of course, these ideologues are wrong for the simple reason that their business cycle theory is hogwash.

Moreover, an approximation* of the Hayekian liquidationist “do nothing” approach was taken by Chancellor Brüning in Weimar Germany. The depression and suffering to which the Germans were subjected did not have encouraging results:

“… the German authorities responded to their external difficulties by depressing their internal economy. Schacht, president of the Reichsbank until March 1930 and chief German negotiator for the Young Plan, had consistently pursued a deflationary strategy. Hans Luther, his successor at the Reichsbank, followed suit, keeping the discount rate well above the rates in London and New York in attempt to reduce the bank’s continuing loss of gold ... the fiscal authorities were even more aggressive in their deflationary efforts. The move toward highly restrictive government budgets came in the beginning of 1930. Heinrich Brüning, chancellor from March 1930 to May 1932, continued this, relentlessly attempting to deflate the economy to restore equilibrium in the manner of the gold standard. Germany, unable to pay its foreign bills at gold par, had to reduce internal prices until it could” (Temin 1989: 30–31).

“Economic breakdown [sc. during the Great Depression] led to political upheaval which in turn destroyed the international status quo. Germany was the most striking example of this complex interaction. Without the depression Hitler would not have gained power. Mass unemployment reinforced all the resentments against Versailles and the Weimar democracy that had been smouldering since 1919. Overnight the National Socialists were transformed into a major party; their representation in the Reichstag rose from 12 deputies in 1928 to 107 in 1930. The deflationary policies of the Weimar leaders sealed the fate of the Republic” (Adamthwaite 1977: 34).

A call for liquidationism is nothing less than a call for mass unemployment, impoverishment, starvation, homelessness, breakdown of families, and society – and the political system. In societies with militant extremes on the left or right, authoritarianism may well result.

What is especially telling is that not even Hayek was so stupid as some of his modern followers in calling for a “do nothing” policy as an actual solution to downturns in the business cycle, because
Hayek eventually renounced liquidationism at some point after 1933.

Hayek even went so far as to say that “liquidationism” as a serious policy in Germany in 1930 was, in essence, sheer madness and would lead to revolution:

“… a ‘secondary depression’ caused by an induced deflation should of course be prevented by appropriate monetary counter-measures. Though I am sometimes accused of having represented the deflationary cause of the business cycles as part of the curative process, I do not think that was ever what I argued. What I did believe at one time was that a deflation might be necessary to break the developing downward rigidity of all particular wages which has of course become one of the main causes of inflation. I no longer think this is a politically possible method and we shall have to find other means to restore the flexibility of the wage structure than the present method of raising all wages except those which must fall relatively to all others. Nor did I ever doubt that in most situations employment could be temporarily increased by increasing money expenditure. There was one classical occasion when I even admitted that this might be politically necessary, whatever the long run economic harm it did.

The occasion was the situation in Germany in, I believe, 1930 when the depression was beginning to get quite serious and a political commission—the Braun Committee—had proposed to combat it by reflation (though that term had not yet been coined), i.e., a rapid expansion of credit. One of the members of the committee, in fact the main author of the report, was my late friend, Professor Wilhelm Röpke. I thought that in the circumstances the proposal was wrong and wrote an article criticising it. I did not send it to a journal, however, but to Professor Röpke with a covering letter in which I made the following point:

‘Apart from political considerations I feel you ought not—not yet at least—to start expanding credit. But if the political situation is so serious that continuing unemployment would lead to a political revolution, please do not publish my article. That is a political consideration, however, the merits of which I cannot judge from outside Germany but which you will be able to judge.’

Röpke’s reaction was not to publish the article, because he was convinced that at that time the political danger of increasing unemployment was so great that he would risk the danger of causing further misdirections by more inflation in the hope of postposing the crisis; at that particular moment this seemed to him politically necessary and I consequently withdrew my article.

To return, however, to the specific problem of preventing what I have called the secondary depression caused by the deflation which a crisis is likely to induce. Although it is clear that such a deflation, which does no good and only harm, ought to be prevented, it is not easy to see how this can be done without producing further misdirections of labour. In general it is probably true to say that an equilibrium position will be most effectively approached if consumers’ demand is prevented from falling substantially by providing employment through public works at relatively low wages so that workers will wish to move as soon as they can to other and better paid occupations, and not by directly stimulating particular kinds of investment or similar kinds of public expenditure which will draw labour into jobs they will expect to be permanent but which must cease as the source of the expenditure dries up.” (Hayek 1978: 210–212).

At the end of this passage, Hayek advocates public works as a solution to “secondary deflation,” so modern Austrian advocates of pure and absolute liquidationism take a view that even Hayek rejected.


Further Reading
See my posts here:

“Did Hayek Advocate Public Works in a Depression?,” September 25, 2011.

“When Did Hayek Renounce Liquidationism?,” January 1, 2012.

“Austerity and the Weimar Republic ,” June 5, 2011.

Note

* I say “approximation” because Austrians are like Marxists: Marxists, when confronted with real world examples of Marxist systems that are horror stories, will say that it was not “real” Marxism. When approximate empirical evidence of real world examples of their policy prescriptions are cited, showing that they don’t work, the Austrian response is usually: “it wasn’t really pure liquidationism!”

BIBLIOGRAPHY

Adamthwaite, A. P. 1977. The Making of the Second World War, Allen & Unwin, London and Boston.

Hayek, F. A. von. 1978. New Studies in Philosophy, Politics, Economics, and the History of Ideas, Routledge & Kegan Paul, London.

Hayek, F. A. von, 2008. Prices and Production and Other Works: F. A. Hayek on Money, the Business Cycle, and the Gold Standard, Ludwig von Mises Institute, Auburn, Ala.

Temin, P. 1989. Lessons from the Great Depression, MIT Press, Cambridge, Mass.