Friday, May 25, 2012

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.

12 comments:

  1. 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.

    I guess you were baiting a response along these lines but to clarify, I don't think you meant to use the term "Marxism." Nobody will deny, for example, that Marxism-Leninism was Marxism-Leninism. They may argue that there is no real "Marxism" because his materialist analysis just constitutes a germ of an idea, and any actually implemented system has to fill in so many blanks that the theorist may as well hyphenate in his or her own name. But insofar as they all draw from the same source, I don't think even a naive student will deny calling them types of Marxism.

    But then, as the man himself famously said of certain "Marxist" movements already springing up in the 1870s, "All I know is that I am not a Marxist." As a Keynesian, you must have some idea of what this is like.

    I think what you're actually reaching for is that people will argue that there has not been "real" communism. Instead it will be argued that "communist" countries were all trying for the communist ideal, but all wound up somewhere more along the lines of highly authoritarian state socialism or state capitalism. So far as Marx defined the term (as a society of superabundance characterized by the voluntary association of free individuals), they actually do have a point. But then it has to be admitted that that's never existed anywhere, at any time, and can't simply be "implemented," as it hinges on revolutions in production.

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  2. I get the impression that "Austrian economists" muddle normative notions of a "just" economy with independent assumptions about how it "should" operate in the absence of government interventions. On the one hand they oppose government interventions because supposedly these produce "unjust" economic outcomes. Yet on the other hand they assume that a left-alone economy will automatically produce decent living standards and even economic growth. What if an economy which meets their standards of "justice," where the government doesn't intervene, happens to result in a Malthusian situation where we accept that so many people have to die of starvation every year as the cost of having "economic freedom"? Humans basically lived that way as their default state until the Industrial Revolution transformed living standards in parts of the world.

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  3. "modern Austrian advocates of pure and absolute liquidationism take a view that even Hayek rejected."

    "Austrian economists" feel free to say whatever they want because they know that they don't have to deal with the consequences of their own ideas, unlike people who have real economies to manage. For example, Ron Paul knows he'll never become president, and he doesn't have that long to live, so he can spout all the nonsense he wants about the alleged evils of the Federal Reserve System.

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  4. I don't think the story is quite as contradictory as you think.

    ABCT is pretty clearly saying that monetary stimulus via the banking sector will lead to distortions to the structure of production that will eventually lead to a crash. I think most Austrians would accept this view.

    Austrians are however divided into two camps in terms of how they view the post-crash situations. Rothbardians (who are strict liquidationists) think the recession just needs to take its course and allow an appropriate structure of production to be rebuilt and "monetary-disequilibrium" Austrians who follow Hayek's lead in believing that a "secondary deflation" may follow the crash and make the recession worse than it needs to be. This camp ,while still to a degree liquidationists, also believe that actions to stabilize the demand for money will allow recovery to take place faster. They typically are supporters of Free-Banking and believe that a free, fractional-reserve banking system would prevent ABCT by preventing distortions in the money supply.

    While the latter of these camps might (even under a CB system) support some monetary stimulus both would be against any kind of fiscal stimulus that would further distort the "structure of demand".

    In regards to "Austrians argue that fiscal contraction can directly lead to GDP growth and recovery". I think this is true to the extent that Austrians believe that long-term a smaller role for the state would be beneficial - but in the short term I don't think many Austrians would see an immediate correlation between reduced budget deficits in the current climate and recovery. Most would believe something like "if we reduced govt spending and other govt intervention tomorrow there would undoubtedly be a period of disruption and dis-ordination as AD initially fell sharply, but quite quickly market forces would kick in soon the economy would recover and be healthier as a result".

    In addition Free-Banking Austrians would see that this recovery would be aided by an expansion in the money supply to address increased demand for money during the recovery phase.

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  5. Those Austrians who have intelligence to get their story straight and stick to it will evade one of my criticisms above. But point of the post is to point out that other Austrians are inconsistent.

    Moreover, you ought to add a third kind of Austrian to your list, who accept some qualified fiscal stimulus:

    (1) those who would follow Hayek when he departed even from the free banking Austrians and came to accept fiscal stimulus in a deep depression:

    http://socialdemocracy21stcentury.blogspot.com/2011/09/did-hayek-advocate-public-works-in.html

    (2) the Lachmann/radical subjectivist wing:

    “In the British situation of 1932, Hayek and his friends rejected the proposals of Keynes and some non-Keynesian British economists – that at the bottom of the depression the government should take certain steps, and so on. Hayek has now realised that that was wrong. That is to say, I think Austrians today would not reject all measures to relieve unemployment and increase employment, in a situation in which nothing really is scarce. And in this respect I think Austrians … would have … have ... learned.”

    http://socialdemocracy21stcentury.blogspot.com/2012/02/lachmann-endorsed-keynesian-stimulus-in.html

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  6. I should also point out that, from a historical perspective, some of the early Austrian school were progressive liberals (Austrian equivalent of Fabian socialists):

    http://socialdemocracy21stcentury.blogspot.com/2010/10/friedrich-von-wieser-and-eugen-von.html

    http://socialdemocracy21stcentury.blogspot.com/2011/06/why-are-there-no-austrian-socialists.html

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  7. The Austrian economic school was really never intended to be a 'pro- laissez-faire ' school, it was started by Menger to deal with methodological concerns.

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    1. The early history of the Austrian school is fascinating, to say the least.

      I find Friedrich von Wieser and Eugen von Philippovich worthy of further study.

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  8. LK -> "prolongation of a recession or depression to its “natural” end ... is a necessary consequence of the “do nothing” response itself"

    Not really. Some austrians think the government can "do" something. Cut back on regulation.
    http://www.phoenix-center.org/PolicyBulletin/PCPB28Final.pdf
    http://www.phoenix-center.org/perspectives/Perspective12-01Final.pdf

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    1. Cutting regulation while you cut spending or balance the budget wouldn't evade a recession.

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  9. I have an interesting story on this theme. I met one Sajid Javid MP, a former banker and an advisor to Chancellor George Osborne in the UK. He made a speech in which he said, "We've got businesses and consumers deleveraging, and that's causing problems...and we've got high budget deficits, and that's causing problems too." I was going to ask - but ended up getting distracted by a debate with him about modern monetary theory (which he hadn't heard of before...!) - if he wanted government to deleverage also, where he'd expect the growth to come from?

    Only later did I realise, perhaps he doesn't want growth at all...perhaps he is a liquidationist. Now whether or not he is, and whether or not, if he is, that view is actually the secret view of the British government, who knows? But it would certainly explain a lot.

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    1. reasoninrevolt,

      I suspect the Tories really did believe in the fable of "expansionary austerity" - but they are learning the hard way it is tommyrot.

      It is a pity everyone else in the UK has to suffer their lesson in reality too.

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