Hat tip Rolfe Winkler.

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Steve Horwitz had an interesting read last week on Friedrich von Hayek, the Nobel Prize winning Austrian School economist. Von Hayek is best known for his 1944 Libertarian call to arms “Road to Serfdom” and is generally considered one of the fathers of the free market ideology.

In Horwitz’s piece, he points out that Hayek was not a ‘liquidationist’ and he uses the title quote to demonstrate that Hayek saw deflation as destructive. Was this an evolution in beliefs? it’s hard to say.

Horowitz goes on to say:

Those Austrians who think deflation is always and everywhere a good phenomenon strongly overlap with those Austrians who wonder whether Hayek is really an Austrian (or a even a classical liberal) anyway, so I’m doubtful this will convince them of the claim that a concern with monetary deflation has been, and should be, a core part of Austrian monetary and macro theory.  However, it does, in fact, bolster the case for a monetary equilibrium reading of Hayek.

The question, of course, is if price stability is the ultimate goal of monetary policy, how does one achieve that in a deflationary environment?

Source

Hayek on Deflation and the Great Depression – Steve Horwitz

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As a follow-up to my post on debt and it’s exclusion as a subject of merit amongst several schools of economic thought, I wanted to bring a New York Times article from 1988 to your attention. This article by Peter Kilborn, a Washington, D.C. based and long-time former correspondent for the New York Times, is timeless.

It reads like an article right out of 2008 or 2009 and highlights how little has been decided in the debate about the economic effect, size and role of government. Many of the key players – Paul Krugman, Larry Summers, and Robert Lucas to name a few – are the same. At issue is the divide between freshwater and saltwater economists that has been raging for at least a generation now. Kilborn says:

To tinker or not to tinker? For decades most politicians and professors of economics have taken it for granted that the Government must adjust the engines of the economy to avoid recessions and create jobs. But lately, a long-belittled school of skeptics who think the Government usually just gums things up is gaining attention and influence.

The skeptics are known as ”fresh water” economists, less for the purity of their thought than for their origins at universities along the shores of the Great Lakes.

The school’s views are filtering into such lofty citadels of mainstream ‘’salt water” economics as Harvard, the Massachusetts Institute of Technology, Princeton and Stanford. Its theories also appeal to economists who are advising the Presidential election campaign of George Bush, and, to a lesser extent, those working for Michael S. Dukakis.

The fresh-water people build their case for minimal intervention on the view that workers, consumers, business executives and investors anticipate changes in the economy faster than the Government and can adjust to them better on their own.

On some level, one could say this divide is manifest in how the political fault lines in the U.S. are forming. Larry Summers, President Obama’s chief economic advisor, is a saltwater type with definite freshwater sympathies. 

On the other side of the political spectrum are those who want small government, a view championed by Ronald Reagan in the 1980s. Republicans are drawn to this positioning because it invokes the Reagan presidency, which was a high point for the post-Nixonian Republican Party. 

You will have noticed my post earlier today on Sarah Palin walking in the small government, Libertarian mantle as she crafts a strategy to take control of the party.

In the article, Krugman sums up the crux of the divide nicely, with Robert Lucas taking the other side:

”The basic distinction,” he said, ”is do you think recessions present a problem? And do you think the Government can do something to avert them? The fresh-water people say that recessions either are nothing to worry about or that in any case, the Government can’t do anything about them.”

Robert E. Lucas, the undisputed dean of the fresh-water school and chairman of the economics department at the University of Chicago, said, ”What we’re turning against is the idea that you can fine-tune the economy with any policy at all.” The university has long been the home of monetarist economics, which maintains that steady, noninflationary growth results from steady growth of the money supply and of which the newer theory is an offshoot.

So, if you are wondering where all of the back and forth is coming from on economic theory and why it has failed us, take a step back in time to the late 1980s. The debate is pretty much the same today.

Source

‘Fresh Water’ Economists Gain – NY Times

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Sarah Palin the populist has become Sarah Palin the free trader. In a wide-ranging and well-received speech in Hong Kong, Palin supported a more Libertarian free-market approach, slamming the recent imposition of tariffs on Chinese tires by the Obama Administration.

Palin spoke at a closed-door investor forum organized by CLSA in which no media representatives were allowed. While attendees were reportedly impressed with her preparation and command of the facts, Palin only took pre-approved questions.

The New York Times reported:

“The speech was wide-ranging, very balanced, and she beat all expectations,” said Doug A. Coulter, head of private equity in the Asia-Pacific region for LGT Capital Partners.

“She didn’t sound at all like a far-right-wing conservative. She seemed to be positioning herself as a libertarian or a small-c conservative,” he said, adding that she mentioned both Ronald Reagan and Margaret Thatcher. “She brought up both those names.”…

Melvin Goodé, a regional marketing consultant, thought Mrs. Palin chose Hong Kong because, he said, it was “a place where things happen and where freedom can be expanded upon.”…

Mr. Goodé, an African-American who said he did some campaign polling for President Obama, said Mrs. Palin mentioned President Obama three times on Wednesday.

“And there was nothing derogatory in it, no sleight of hand, and believe me, I was listening for that,” he said, adding that Mrs. Palin referred to Mr. Obama as “our president,” with the emphasis on “our.”

Mr. Goodé, a New Yorker who said he would never vote for Mrs. Palin, said she acquitted herself well.

“They really prepared her well,” he said. “She was articulate and she held her own. I give her credit. They’ve tried to categorize her as not being bright. She’s bright.”

Edward here. Notice how the NY Times story mentions only one attendee’s race. What does Goodé’s being Black have to do with this story? The writer, Mark McDonald, should be condemned for inserting this language as he is obviously trying to spin the story, suggesting that even a black pro-Obama supporter thought well of Palin’s performance. If he’s going to spin it that way, then just say it directly. The way he words it is cringe-worthy.

This speech and others to come should be seen not only as a way for her to earn shed loads of cash, but as a way to position herself to lead the Republican party ahead of the 2012 Presidential election.  It seems that she is re-casting herself as a libertarian to do so. She has already come out against healthcare, positioning her opposition to Obama’s plan as libertarian. Attendees of the CLSA speech report that she spoke about this subject in Hong Kong as well.  However, she also took on the tire tariffs issue, rejecting an inviting populist take on the issue in favor of more free-market rhetoric (for more on the issue see my post “Murder-Suicide in Chimerica”).

Not everyone was impressed.

“She started the speech with the Alaskan fishing industry, which I think is a safe topic for her,” said Suyeon An of RCM Asia Pacific Ltd, who left before Palin stopped talking. “She was avoiding the important economic issues. She tried to talk some about Hong Kong in general, but it was nothing specific. It was a very safe speech, boring I have to say.”

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Ron Paul was on CNN this morning talking about unemployment, the credit crisis, the Federal Reserve and a lot more.

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The following is an excerpt from Murray Rothbard’s excellent book, “A History of Money and Banking in the United States.”  The passage outlines how the gold standard prevented governments from using inflation as a device to manipulate their currencies, something of great concern to China now in 2009.  However, Word War I brought that to an end as expenditures during the ‘Great War’ resulted in massive wartime spending throughout Europe.  When the war ended, a jerry-rigged and bogus new gold standard was created which went into effect in 1925 with the U.S. dollar and the British pound at its core.  However, the inherent flaws in this system were to have fatal repercussions made plain in 1929 and during the Depression.

The prewar monetary order was genuinely “international”; that is, world money rested not on paper tickets issued by one or more governments but on a genuine economic commodity – gold – whose supply rested on market supply-and-demand principles. In short, the international gold standard was the monetary equivalent and corollary of international free trade in commodities. It was a method of separating money from the State just as enterprise and foreign trade had been so separated.  In short, the gold standard was the monetary counterpart of laissez-faire in other economic areas.

The gold standard in the prewar era was never “pure,” no more than was laissez-faire in general. Every major country, except the United States, had central banks which tried their best to inflate and manipulate the currency. But the system was such that this intervention could only operate within narrow limits. If one country inflated its currency, the inflation in that country would cause the banks to lose gold to other nations, and consequently the banks, private and central, would before long be brought to heel. And while England was the world financial center during this period, its predominance was market rather than political, so it too had to abide by the monetary discipline of the gold standard…

The advent of the World War disrupted and rended this economic idyll, and it was never to return. In the first place, all of the major countries financed the massive war effort through an equally massive inflation, which meant that every country except the United States, even including Great Britain, was forced to go off the gold standard, since they could no longer hope to redeem their currency obligations in gold. The international order not only was sundered by the war, but also split into numerous separate, competing, and warring currencies, whose inflation was no longer subject to the gold constraint. In addition, the various governments engaged in rigorous exchange control, fixing exchange rates and prohibiting outflows of gold; monetary warfare paralleled the broader economic and military conflict.

At the end of the war, the major powers sought to reconstitute some form of international monetary order out of the chaos and warring economic blocs of the war period. The crucial actor in this drama was Great Britain, which was faced with a series of dilemmas and difficulties.On the one hand, Britain not only aimed at re-establishing its former eminence, but it meant to use its victorious position and its domination of the League of Nations to work its will upon the other nations, many of them new and small, of post-Versailles Europe. This meant its monetary as well as geral political and economic dominance. Furthermore, it no longer felt itself bound by the old-fashioned  laissez-faire restraints from exerting frankly political control, nor did it any longer feel bound to observe the classical god-standard restraints against inflation.

While Britain’s appetite was large, its major dilemma was its weakness of resources. The wracking inflation and the withdrawal from the gold standard had left the United States, not Great Britain, as the only “hard,” gold-standard country. If Great Britain were to dominate the postwar monetary picture, it would somehow have to take the United States into camp as its willing junior partner. From the classic prewar pound-dollar par of $4.86 to the pound, the pound had fallen on the international money markets to $3.50, a substantial 30-percent drop, a drop that reflected the greater degree of inflation in Great Britain than in the U.S. The British then decided to constitute a new form of international monetary system, the “gold-exchange standard,” which it finally completed in 1925. In the classical, prewar gold standard, each country kept its reserves in gold, and redeemed its paper and bank currencies in gold coin upon demand. The new gold-exchange standard was a clever device to permit Britain and the other European countries to remain inflated and to continue inflating, while enlisting the United States as the ultimate support for all currencies. Specifically, Great Britain would keep its reserves, not in gold but in dollars, while the smaller countries of Europe would keep their reserves, not in gold but in pounds sterling. In this way, Great Britain could pyramid inflated currency and credit on top of dollars, while Britain’s client states could pyramid their currencies, in turn, on top of pounds. Clearly, this also meant that only the United States would remain on a gold-coin standard, the other countries “redeeming” only in foreign exchange. The instability of this system, with pseudo gold-standard countries pyramiding on top of an increasingly shaky dollar-gold base, was to become evident in the Great Depression.

But the British task was not simply to induce the United States to be the willing guarantor of all the shaky and inflated currencies of war-torn Europe. For Great Britain might well have been able to return to the original form of gold standard at a new, realistic, depreciated parity of $3.50 to the pound. But it was not willing to do so. For the British dream was to restore, even more glowingly than before, British financial preeminence, and if it depreciated the pound by 30 percent, it would thereby acknowledge that the dollar, not the pound, was the world financial center. This it was fiercely unwilling to do; for restoration of dominance, for the saving of financial face, it would return at the good old $4.86 or bust in the attempt. And bust it almost did. For to insist on returning to gold at $4.86, even on the new, vitiated, gold-exchange basis, was to mean that the pound would be absurdly expensive in relation to the dollar and other currencies, and would therefore mean that at current inflated price levels, Britain’s exports—its economic lifeline— would be severely crippled, and a general depression would ensue. And indeed, Britain suffered a severe depression in her export industries—particularly coal and textiles—throughout the 1920s. If she insisted on returning at the overvalued $4.86, there was only one hope for keeping her exports competitive in price: a massive domestic deflation to lower price and wage levels. While a severe deflation is difficult at best, Britain now found it impossible, for the new system of national unemployment insurance and the new-found strength of trade unions made wage-cutting politically unthinkable.

But if Britain would not or could not make her exports competitive by returning to gold at a depreciated par or by deflating at home, there was a third alternative which it could pursue, and which indeed marked the key to the British international economic policy of the 1920s: it could induce or force other countries to inflate, or themselves to return to gold at overvalued pars; in short, if it could not clean up its own economic mess, it could contrive to impose messes upon everyone else. If it did not do so, it would see inflating Britain lose gold to the United States, France, and other “hard-money” countries, as indeed happened during the 1920s; only by contriving for other countries, especially the U.S., to inflate also, could it check the loss of gold and therefore halt the collapse of the whole jerry-built international monetary structure.

In the short run, the British scheme was brilliantly conceived, and it worked for a time; but the major problem went unheeded: if the United States, the base of the pyramid and the sole link of all these countries to gold and hard money, were to inflate unduly, the dollar too would become shaky, it would lose gold at home and abroad, and the dollar would itself eventually collapse, dragging the entire structure down with it. And this is essentially what happened in the Great Depression.

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Peter Schiff is that market wizard people were laughing at just a year ago because of his extreme views. Well, things have turned out much as he has indicated they would. So, now he has a captive audience. And what is he saying? Government is a burden that we need less of. The way forward is not government stimulus but less government, less consumption and higher savings.

Well Peter, I have news for you: that game plan of yours is a recipe for deflation, depression, civil unrest and financial Armageddon. You see, Schiff is an ideologue from the small government, free markets crowd. While I agree with his broader themes about less consumption and more savings, I do not see eye-to-eye with his ideology. What America needs now is a practical solution to a real problem, not ideology from the small government crowd.

Schiff suggests stimulus is seen as a way to increase consumption in order to keep the gravy train going. I would suggest it is a way to ease America into a downturn and prevent the death spiral that would be likely if we took his approach. Private citizens can spend less and save more but having the government do the same will certainly lead to a collapse of our banking system. Witness Bank of America and Citigroup as case examples. And if you want to see what less government spending will do for an economy, take a look at what is happening in California where spending cuts are likely. I predict this will lead to economic hardship, mortgage defaults, lower home prices and on it goes.

No one is saying that government spending is going to save us — at least I am not. However, it can temporarily replace some of the collapsing private consumption until we have beaten back the worst of this downturn. (For what its worth, I am a small government, lower, flatter taxes proponent – when depression is not at our door.)

I see Schiff’s views as ideological and not practical. The ‘free market’ is not going to save us. Here’s the video. Judge for yourself.

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I was chatting with Marshall Auerback about some of my recent posts on Keynesianism and Austrian Economics — Marshall is a post-Keynesian — and he convinced me that my posts were somewhat misleading and that I had only presented half of the argument for stimulus. This led me to thinking about the role of government, stimulus and recession which I felt compelled to present here.  Your comments are appreciated.

Government is redistributive

Let me start my argument this way: Government, by its very existence, is always redistributive. Therefore, a key role of government is to redistribute income. This statement is self-evident to some, but provocative to many. So let me explain why this is so.

Most reasonable people would agree that a large society requires government to maintain order, provide basic services and assemble military defenses. These are all considered basic roles of government. However, to take on these roles, government requires funding and this means taxation. Now, taxes, by their very nature, are redistributive. Levying a tax on one person or one good takes money away from that person or that business and puts it in to the common pot. This is the definition of redistribution. Government cannot function without taxes and taxes are by their very nature a redistribution of income from some agents to others. Therefore, government is a naturally redistributive agent.

To my mind, the redistributive nature of government is obvious. In fact, it struck me as extremely disingenuous during the U.S. election this past year when John McCain led the Republican Party in admonishing Barack Obama for suggesting he was going to “spread the wealth” — as if that’s not axiomatic.

The real question is this: Because government must tax to fund its existence and this tax will redistribute monies from some agents to others, what are our priorities as a people as to how that redistribution should take place? Who should we tax, by what means and by how much? And who should receive the benefits of those taxes and for what purposes? These are questions actually worthy of debate and are fundamental to democracy.

My answer is fairly simplistic: how we tax and how we spend government money depends on the economic, political and military situation, on the wisdom of our leaders and on the priorities of the people. There is no ideological answer to this question. One problem I have with the small government crowd is the ideological view that the answer must always be the same regardless of the circumstances we face. I certainly believe very much in limited government. I think most people would label me a Libertarian or a fiscal conservative. However, I am not ideological. I am pragmatic and I believe public policy must adjust to the specific requirements of the time.

I would add that limited government does not mean we should forgo universal health care for example.  It is often argued that we need to get back to the days when government was smaller and America was a much better country.  When was this? The last time I checked America was a much richer nation than it was in 1900 or 1950, or whenever those who want to return to the past are arguing. Do you really want to go back to 1900 when we had no safety net in America?  I believe the lack of a social safety net is a major reason that the Great Depression was such a human trauma for the United States.

Moreover, government expenditures are less than a quarter of GDP in the United States today.  It is much larger in Europe.  It seems foolhardy to me that the so-called richest country on earth could allow tens of millions of its citizens to live without guaranteed access to free basic health care.  What is the point of being a rich nation, then?

These are the questions that any democracy must answer regarding how it reallocates its resources through the taxing power of government.

Stimulus is necessary and warranted

This leads me to the question about stimulus. Where Marshall has a problem is with this statement: “So, my thinking is fairly simple: cushioning the fall with government stimulus will prevent worst-case outcomes — nothing more. It will not prevent depression.” from my post “What does Mises say about trying to stimulate the economy out of recession.” This statement focuses entirely on the recession and not at all on the recovery. It looks like this:

when it could look like this:

So, I would say this: in the absence of stimulus, the present global downturn would be much more severe. In fact, it could threaten systemic collapse — a rupturing of our entire financial system if allowed to continue without some measure of countervailing monetary and fiscal stimulus. Moreover, stimulus is likely to speed recovery. Therefore, stimulus mitigates worst-case outcomes and speeds recovery.

My argument here looks like this:

As to what form this stimulus should take, I will leave that argument for another day.  I do feel that we need to invest in health care, education, energy and infrastructure.  Obviously, massive stimulus means deficit spending. And I would anticipate this deficit spending to last many years, leaving a mountain of debt. However, the speeded recovery will be quite helpful in defraying the burden of that debt. And, let’s not forget that the alternative could be collapse.

The purpose of recession

My final argument involves the purpose of recession. In my view, policy makers, especially in the Anglo-Saxon world have long felt that avoiding recession is an important goal of economic policy. However, that view is misguided because it has led to an asymmetry whereby stimulus is applied in much greater amounts to end recession than to stop overheating. This asymmetry, often called the Greenspan Put when Alan Greenspan was Federal Reserve Chairman, is directly responsible for the build up of debt, leverage, over-consumption, and current account deficits in many of the Anglo-Saxon economies.

While painful, recession serves a useful purpose. It purges the excess of the preceding period. Avoiding recession leads to bubbles and bubbles lead to systemic risk and depression. It is far better to allow the recession to occur, mitigate its effect if necessary through limited fiscal or monetary stimulus than to risk a depression in which massive stimulus is necessary.

Those are my arguments. I would appreciate hearing yours.

Related posts:

• Japan does not demonstrate the failure of stimulus
• Peter Schiff: “Government is a burden on the economy”
• What does Mises say about trying to stimulate the economy out of recession
• Some tidbits about stimulus, recovery, and the Great Depression
• The Great Depression II meme

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 wold 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 equaly 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 a 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.

Source
The Austrian Theory of the Trade Cycle, Ludwig von Mises, Gottfried Haberler, Murray Rothbard, Friedrich Hayek

Related posts:

• A brief philosophical argument about the role of government, stimulus and recession
• Liquidity trap of a different sort
• Why should central banks cut interest rates?
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There is a school of thought amongst economists called the Austrian School because it first came to the fore due to the teachings of Ludwig von Mises, Eugen von Böhm-Bawerk, and Gottfried Haberler, all well-known Austrian economists popular at the beginning of the 20th century.  The Austrian School is founded on conservative, fiscally prudent principles that see credit as central to the business cycle. I have long been a devotee of the Austrian School.

As a result, I am sceptical of the current fiat money world we now live in and I reject the profligate, debt-inducing, easy money policies of the Federal Reserve under Alan Greenspan.  In fact, for quite a number of years I have warned that this experiment of debt, easy money and fiat currency would end in disaster.  And so it has.

My Austrian School background has been useful as a lens through which to view the credit bubble and crash.  Central to this view is the precept that easy money is the problem and not the solution. However, as the crash has unfolded, I find myself parting ways with the Austrians.  I have always felt the Austrians are more useful for their economic framework. But they leave me underwhelmed when it comes to solutions for when problems occur.  Their “Let them eat cake” approach comes dangerously close to Andrew Mellon’s draconian Depression era prescription and is more likely to end in a deflationary spiral and a worsening of the problem.

And so it is today. If we are to find our way out of this crisis — the worst in three quarters of a century — it will not be the ideas of Ludwig von Mises or Murray Rothbard which will guide us.  It is more the work of John Maynard Keynes and his followers that is likely to offer useful prescriptions.  As much as I would like to look to the Austrian School in this crisis, I cannot.  These are the confessions of a former Austrian Economist.

If one looks back over the last quarter century or more of international economics, one cannot help but understand that debt and leverage have been central to the force that built up creating the calamitous financial crisis we are now experiencing.  I have previously said:

The monetary stewardship of Alan Greenspan’s Fed and the credit bubble it created has manifested itself in several ways that parallel previous episodes of credit-engendered over-investment:

1. Inflationary monetary policy leads to an expansion of credit throughout the economy, the basic building block for a boom-bust business cycle.
2. In a credit boom, less credit is available for productive assets because credit and resources are diverted to marginal debtors and high-growth/high-risk activities. Low interest rates and expansionary credit environment gives the illusion of profitability to unproductive investments and high-risk activities in the economy, that would appear foolish in an appropriate monetary environment.
3. Companies, flush with cash, invest heavily to prepare for expected future growth. An investment and capital-spending boom ensues.
4. Higher asset prices lower the cost of capital, fuelling a further boom in investment and capital spending, creating overcapacity in goods and services industries.
5. The increase in asset prices produces the so-called ‘wealth effect’ for consumers: a decrease in savings and an increase in consumption.
6. As the whole episode rests on an excess creation of credit, debt levels increase greatly.
7. The inflationary monetary policy is extremely distortionary as it redistributes capital to economic actors whose costs rise after their income from those whose costs rise before their income.  Those who live from a fixed and interest income like pensioners find their costs rising with higher inflation while their income decreases in real terms.
8. Runaway asset price/consumer price inflation ultimately demands higher interest rates and a contractionary monetary policy, whereupon the whole house of cards collapses.
9. When the asset price bubbles pop, revulsion steps in, credit contracts and the bubble currency depreciates, as hot money flees the depreciating assets.
10. Eventually, the inflationary monetary policy debases the fiat currency, leading to a relative appreciation of the prices of ‘hard’ assets (like gold and silver and commodities like oil and natural gas) relative to the home currency.
11. The result is a wealth effect in reverse, leading to a collapse in consumption, a secular bear market and recession.
12. An expansionary monetary policy in a post-bubble environment can cushion a hard landing but does only lengthen the period before full economic recovery.

And until recently, I might have rejected attempts to mitigate the crisis and the negative fallout it has on people’s lives because of the large potential for misallocating resources, feeding political patronage and special interests or for lengthening the crisis. In a previous post I said:

My economic viewpoint is founded on the Austrian economics. This framework rightly associates the business cycle with the credit cycle.  Moreover, the Austrians understood that monetary authorities have limited resources to correct the excesses of an investment-led boom/bust and, that attempts to mitigate the credit cycle invariably reflate and exacerbate the bubble.

But, the Lehman bankruptcy changed things significantly.  We went from a festering problem to a full-scale deflationary spiral.  We have entered a new stage where sitting on one’s hands as the Germans intend to do risks financial Armageddon.  We cannot sit by and watch this crisis liquidate assets, taking down good companies with bad, throwing people out of work, wreaking havoc on their lives, and leading to a brutal and painful downward spiral of asset and debt deflation and depression.  This is not a prescription for success, either economically or politically.  This is the prescription for chaos, turmoil, civil unrest and perhaps worse.

However, this is what the Austrians would have us do in the present downturn.  It is the same wrong-headed prescription given to the Asians in 1998 and to Argentina in 2001.  We squandered an opportunity for fiscal prudence when the economy was on more solid footing.  With depression on our doorstep, is now the right time to start cutting back?

This would mean liquidating General Motors, bankrupting Royal Bank of Scotland and Citigroup or allowing Iceland, Hungary and Pakistan to fend for themselves.  In theory, each of these measures seem prudent.  But, in practice, these measures would result in huge job loses, would induce further deleveraging and asset price declines, would deplete capital from an already fragile global baking system, and would lead to a probable depression of unimaginable severity.  It is in such a bleak environment that dangerous despots and dictators like Hitler and Mussolini rose to power, taking advantage of the natural human need for ’strong’ leader in a time of chaos and uncertainty.  Could we expect any different today?

Nevertheless, one must ask: “what does mitigating the effects of a burst credit bubble look like in economic and monetary policy?”

First, let’s look to the goals of stimulus:

1. Cushion the real economy effects of deleveraging so as to prevent the prospect of a downward spiral of unemployment, lowered consumption, lowered capital spending and production and more unemployment which could also engender civil unrest, revolution and war (see Greece to understand what I mean).
2. Restore liquidity to the financial system such that worthy profitable initiatives receive funding and promote economic growth — where they would not in an illiquid and capital constrained credit market.
3. Recapitalize the financial system through public and private funds to prevent systemic collapse as a result of deleveraging and restricted credit.

Deleveraging is what we should fear here because it creates a vicious spiral that reduces asset prices and credit availability sucking the entire economy into a deflationary spiral.  I have discussed this at length in other posts.  So I will gloss over this analysis here.  But, please see the posts below for more on this issue:

Credit deflation and the Japanese problem
The Japanese Problem is now ours
De-leveraging
De-leveraging redux

The stimulus should therefore involve most of the following measures in order to mitigate the effects of deleveraging:

1. Supportive government spending in infrastructure (human and capital) – (the risk being malinvestment as government misallocates resources or shifts funds to special interest groups.)
2. Most controversially, it may involve quantitative easing, which is inflation and currency depreciation plain and simple. (The risk being extremely high inflation if the central bank cannot retract the excess liquidity once the economy has found its footing – and we should remember that inflation is essentially theft through depreciation of the currency’s purchasing power).  I should also note that I am NOT a fan of massive interest rate cuts (easy money) as a policy response as it leads to bubbles and malinvestment – witness the current bubble in U.S. treasury and other G7 government securities.  The goal is liquidity, not bubbles.
3. Other measures would include debt relief, debt workout provisions/ mortgage relief so as to mitigate the real burden of mortgage debt which began this crisis and which is most important to the electorate.
4. Bankruptcy law reform (in the United States in order to allow cramdowns on residential property).  I have been advised by bankruptcy lawyers on the front lines that this is a major impediment to a residential mortgage workout.  In all other scenarios in the U.S., a cramdown is possible.  Only with residential mortgages it is not.  This must be addressed quickly or we will continue to see many mortgage defaults.

Simultaneously, the financial system must be reformed quickly in order to speed the turnaround much as the Austrians wold say.  Some of these steps have already been taken, but much remains to be done and it needs to be addressed comprehensively, not on an ad-hoc basis.

1. Liquidate or merge moribund financial institutions. This is the greatest oversight of the current policy response. It has been much too slow. An independent body should make a determination regarding the solvency of every single bank. This avoids the problem of having to bail out the Citigroups of this world. The faster the liquidation process is complete, the sooner confidence will be restored.
2. Create a Good Bank – Bad Bank split i.e. separate good assets from dodgy assets. This will bolster banks’ counter-party confidence. Lehman Brothers had it right when it attempted to do this.  But, that was just before the company failed.  The Swedes attempted this plan most successfully and it has been copied in the Citigroup bailout.  It needs to be undertaken comprehensively.
3. Re-regulate to prevent excessive leverage, imprudent lending, a favoring of debtors over savers, and the proliferation of dangerous unregulated markets like the market in Credit Default Swaps.
4. Create a global lender of last resort. The Fed seems to have taken on this role.  However, they are beyond their depth. Their ability to reflate the entire global economy is limited. We need a true global lender of last resort as posited by Charles Kindelberger.

I have gone in to great detail regarding the need for a comprehensive solution in past posts so I will leave it there.  For more on potential solutions, see:

The U.S. financial system is effectively insolvent
The $700 billion Paulson Plan is dead on arrival
Lehman’s bankruptcy: putting the cart before the horse?
The Swedish banking crisis response – a model for the future?

Ultimately, my position on the cure to our economic ills is largely unchanged. We need to save more, spend less and reduce debt. We need to invest in our infrastructure, human and capital, and we need to make things people want – not turn into a mass of money changers and finance wizards.

However, I now recognize the very real need to mitigate economic fallout from this downturn through monetary and fiscal stimulus in order to prevent worst-case outcomes that result from the deleveraging downward spiral. This means government must be involved.  And as such, there is always the potential for mischief when government inserts itself into the process.

None of this stimulus prescription is axiomatic.  I have a tough time advocating large-scale government intervention.  But, is there any other way out of this mess?  Is stimulus just a recipe for government meddling? And are we wasting our time by trying to prevent the inevitable?

These are all questions that need to be answered because we are about to embark on an historic and global experiment in fiscal and monetary stimulus.  Comments are appreciated.

Related posts:

• What’s different about 2008?
• Hayek: “I am not only against inflation but I am also against deflation.”
• One on One with David Rosenberg, Chief North American Economist at Merrill Lynch
• Debtflation
• Plosser: The Fed must stop qualitative easing

While I fully support Barack Obama’s presidential bid as the best opportunity for change, I respect former Democratic Presedential candidate Mike Gravel and his Libertarian viewpoints. As a Libertarian, I found it interesting that when I took the Select Smart survey to track how the individual candidates’ positions mirrored mine, Mike Gravel came out on top, followed by Ron Paul and then Barack Obama.

Democratic Presidential hopeful Mike Gravel has switched from the Democratic party to the Libertarian party. Gravel was a long shot candidate, who at 77, would have been the oldest President on inauguration (78 years old). In addition, he has a checkered financial past, having suffered both personal and corporate bankruptcies. by far.

Gravel was frustrated at his inability to take part in the Democratic primary debates in order to get his views heard. Ron Paul, a former Libertarian party member with similar views, benefited from his participation in the Republican primary debates. According to the Associated Press, Gravel defended his switch in an e-mail by saying:

“[the Democratic party] no longer represents my vision for our great country.”It is a party that continues to sustain war, the military-industrial complex and imperialism — all of which I find anathema to my views.”

Related posts:

• Hillary Clinton paid a heavy price for presidential run
• Pennsylvania goes to Clinton
• Hillary Rodham Clinton ran a good campaign
• Discount All Caucus Wins
• Geraldine Ferraro: what is she really saying?

As a Libertarian, I am definitely a fan of Ron Paul. It is sad that there is no mainstream party that is Liberal in the traditional sense of the word. Now, liberal means left-wing when I look at Liberal quite differently.

Anyway, there was an article from Time magazine a few days back that I just caught talking about Ron Paul and why he scares the Republicans. Read it yourself.

One quote in the article I want to take issue with is here:

“In some ways, Paul is a throwback to the frugal and isolationist wing of the old Republican Party, the fuddy-duddy GOP of Robert Taft and Calvin Coolidge.”

Isolationism is a red herring. Ron Paul may well be an isolationist, but that is a matter of opinion. Be skeptical when loaded words like “isolationist” are bandied about.

Another quote that begs skepticism is this:

“he is an extremist — partly in the Barry Goldwater extremism-in-defense-of-liberty-is-no-vice sense of the word, but also in the wacky let’s-relitigate-the-currency-debates-of-the-1820s sense of the word. The late William F. Buckley wanted conservatives to stand athwart history yelling stop; Paul seems to want to slam history into reverse. The guy genuinely wants to abolish the Federal Reserve and start circulating gold again.”

I have been following Paul for years and I know he wants abolish the Fed. Is that a bad thing? Irrespective, he is a political realist and is on record for saying that he does not want to make radical change from day one. Radical change may be his end goal, but he respects the need to work within the system to move our country in the right direction. Again be very skeptical when you see code words like “extremist” bandied about.

When I find a reference to his true position on how he would govern in moving toward these more radical changes over time, I will make an addendum to the post.

Related posts:

• Geraldine Ferraro: what is she really saying?
• The Audacity of Rhetoric
• Get ready for Biden v. Palin tonight
• Quote of the day: “That One”
• Mike Gravel switches parties