Recently I wrote a post which claimed that Keynesian stimulus is what we need in the global economy right now. These ideas are considered heresy in Austrian School circles because trying to stimulate the economy out of recession only puts off the day of reckoning and often worsens that day of reckoning. This is exactly what we saw when Alan Greenspan lowered interest rates to 1% after the last recession.
So what exactly does Ludwig von Mises, the most revered Austrian School economist, say about this? The short answer is that he would say stimulus is only going to make matters worse. He has written on this very subject in his essay “The ‘Austrian’ Theory of the Trade Cycle.” Let me provide you with some of the text from that essay and an explanation of why I believe stimulus is necessary despite what he warns. And remember, his essay was written in 1936, the same year Keynes released his seminal work so that everyone forgot about the Austrians.
In issuing fiduciary media, by which I mean bank notes without gold backing or current accounts which are not entirely backed by gold reserves, the banks are in a position to expand credit considerably. The creation of these additional fiduciary media permits them to extend credit well beyond the limit set by their own assets and by the funds entrusted to them by their clients. They intervene on the market in this case as “suppliers” of additional created, created by themselves, and they thus produce a lowering of the rate of interest, which falls below the level at which it would have been without their intervention. The lowering of the rate of interest stimulates economic activity. Projects which would not have been thought “profitable” if the rate of interest had not been influenced by the manipulations of the banks, and which, therefore, would not have been undertaken, are nevertheless found “profitable” and can be initiated. The more active state of business leads to increased demand for production and the wages of labor rise, and the increase in wages leads, in turn, to an increase in prices of consumption goods. If the banks were to refrain from any further extension of credit and limited themselves to what they had already done, the boom would rapidly halt. But the banks do not deflect from their course of action; they continue to expand credit on a larger and larger scale, and prices and wages correspondingly continue to rise.
This upward movement could not, however, continue indefinitely. The material means of production and the labor available have not increased; all that has increased is the quantity of the fiduciary media which can play the same role as money in the circulation of goods. The means of production and labor which have been diverted to the new enterprises have had to be taken away from other enterprises. Society is not sufficiently rich to permit the creation of new enterprises without taking anything away from other enterprises. As long as the expansion of credit is continued this will not be noticed, but this extension cannot be pushed indefinitely. For if an attempt were made to prevent the sudden halt of the upward movement (and the collapse of prices which would result) by creating more and more credit, a continuous and even more rapid increase of prices would result. But the inflation and the boom can continue smoothly only as long as the public thinks that the upward movement of prices will stop in the near future. As soon as public opinion becomes aware that there is no reason to expect an end to the inflation, and that prices will continue to rise, panic sets in. No one wants to keep his money, because its possession implies greater and greater losses from one day to the next; everyone rushes to exchange money for goods, people buy things they have no considerable use for without even considering the price, just in order to get rid of the money. Such is the phenomenon that occurred in Germany and in other countries that followed a policy of prolonged inflation and that was known as the “flight into real values.” Commodity prices rise enormously as do foreign exchange rates, while the price of the domestic money falls almost to zero. The value of the currency collapses, as was the case in Germany in 1923.
Basically Mises has laid out very concisely the fact that the business cycle is due to the extension and over-extension of credit. Trying to continue to expand credit eventually ends in a hyper-inflationary scenario as it did in Weimar Germany in 1923. As a result, most countries are forced to stop.
If, on the contrary, the banks decided to halt the expansion of credit in time to prevent the collapse of the currency and if a brake is thus put on the boom, it will quickly be seen that the false impression of “profitability” created by the credit expansion has led to unjustified investments. Many enterprises or business endeavors which had been launched thanks to artificial lowering of the interest rate, and which had been sustained thanks to the equally artificial increase in prices, no longer appear profitable.
If you read this and think about the Technology Bubble or the Housing Bubble, these are textbook cases. Investment money was diverted from other more useful sectors to fund over-investment in technology and telecom in the 1990s and to fund overbuilding in residential property this last decade. Both of these episodes were a direct result of low interest rates. And when Mises speaks of an “artificial increase of prices”, he means asset prices.
Some enterprises cut back their scale of operation, others close down or fail. Prices collapse;crisis and depression follow the boom. The crisis and ensuing period of depression are the culmination of the period of unjustified investment brought about by the extension of credit. The projects which owe their existence to the fact that they once appeared “profitable” in the artificial conditions created on the market by the extension of credit and the increase in prices which resulted from it, have ceased to be “profitable.” The capital invested in these enterprises is lost to the extent that it is locked in. The economy must adapt itself to these losses and to the situation that they bring about. In is case the thing to do, first of all, is to curtail consumption and, by economizing, to build up new capital funds in order to make the productive apparatus conform to the actual wants, not to artificial wants which could never be manifested and considered real except as a consequence of the false calculation of “profitability” based on the extension of credit.
Later, in the same essay Mises gets to the point about stimulus:
It has often been suggested to “stimulate” economic activity and to “prime the pump” by recourse to a new extension of credit which would allow the depression to be ended and bring about a recovery or at least a return to normal conditions; the advocates of this method forget, however, that even though it might overcome the difficulties of the moment, it will certainly produce a worse situation in a not too distant future.
Essentially, over-extension of credit is the problem. It is not the solution. One could say credit is a drug to which we have become addicted. So, how can giving more of that drug help us kick the habit? Why am I proposing more stimulus?
Using the drug analogy, I would say I am proposing “government stimulus” as methadone for addiction treatment to help with the heroin-like credit addiction. It is only a stop-gap. Going cold turkey is likely to lead to unpredictable — or even dangerous — results.
I do like to use the Weimar example to make this point. I lived and worked in Germany for quite a while and am very familiar with German history as a result. The Weimar Republic was Germany’s first attempt at democracy from 1919-1933. It was widely considered a failure and led to fascism and the Nazis as a result.
In assessing Weimar’s failures, most focus on the war reparations from the Treaty of Versailles that ended World War I as a principle reason for hyperinflation in 1923 and Weimar’s ultimate failure. In fact, the hyperinflation episode of 1923 is one reason the ECB and the Bundesbank before it had been noted for having a tight money policy. Germans fear 1923 the way Americans fear 1929.
However, the severity of Depression of 1921 was a significant contributing factor to both Mussolini’s political success and Hitler’s initial political success in the early 1920s and the rise of fascism. Ultimately, economic depression again in the early 1930s created the pre-conditions for World War II and the breeding ground for despots.
So, my thinking is fairly simple: cushioning the fall with government stimulus will prevent worst-case outcomes — nothing more. It will not prevent depression.
Update: I have added an addendum to this article in my post “A brief philosophical argument about the role of government, stimulus and recession.” I wrote the second post to talk more about the efficacy of stimulus in hastening recovery. Please read that post in conjunction with this one.
The Austrian Theory of the Trade Cycle, Ludwig von Mises, Gottfried Haberler, Murray Rothbard, Friedrich Hayek