Fixing the Economy by Breaking It Yet Again

The op-ed section of the weekend edition of the Wall Street Journal offers another look at Austrian economics as it relates to the ongoing economic crisis in this commentary by hedge fund manager Mark Spitznagel.

The Man Who Predicted the Depression
Ludwig von Mises was snubbed by economists world-wide as he warned of a credit crisis in the 1920s. We ignore the great Austrian at our peril today.

Mises's ideas on business cycles were spelled out in his 1912 tome "Theorie des Geldes und der Umlaufsmittel" ("The Theory of Money and Credit"). Not surprisingly few people noticed, as it was published only in German and wasn't exactly a beach read at that.

Taking his cue from David Hume and David Ricardo, Mises explained how the banking system was endowed with the singular ability to expand credit and with it the money supply, and how this was magnified by government intervention. Left alone, interest rates would adjust such that only the amount of credit would be used as is voluntarily supplied and demanded. But when credit is force-fed beyond that (call it a credit gavage), grotesque things start to happen.

Sadly, as the economic crisis enters its second (or third?) year, the Journal Opinion page is about the only place in the mainstream financial media where you'll see this sort of thing, along with the occasional call for a hard money standard and, from time to time, some vitriol directed at the Federal Reserve.

Is there any other field of endeavor in the world (with the possible exception of religion) where there is a school of thought that is so diametrically opposed to conventional wisdom that most adherents to the status quo will immediately dismiss it out of hand rather than contemplate what it might really mean for their profession?

There is perhaps no better example of cognitive dissonance than when mainstream economic theory confronts "Austrian" economic theory.

Government-imposed expansion of bank credit distorts our "time preferences," or our desire for saving versus consumption. Government-imposed interest rates artificially below rates demanded by savers leads to increased borrowing and capital investment beyond what savers will provide. This causes temporarily higher employment, wages and consumption.

Ordinarily, any random spikes in credit would be quickly absorbed by the system—the pricing errors corrected, the half-baked investments liquidated, like a supple tree yielding to the wind and then returning. But when the government holds rates artificially low in order to feed ever higher capital investment in otherwise unsound, unsustainable businesses, it creates the conditions for a crash. Everyone looks smart for a while, but eventually the whole monstrosity collapses under its own weight through a credit contraction or, worse, a banking collapse.

The system is dramatically susceptible to errors, both on the policy side and on the entrepreneurial side. Government expansion of credit takes a system otherwise capable of adjustment and resilience and transforms it into one with tremendous cyclical volatility.

"Theorie des Geldes" did not become the playbook for policy makers. The 1920s were marked by the brave new era of the Federal Reserve system promoting inflationary credit expansion and with it permanent prosperity. The nerve of this Doubting-Thomas, perma-bear, crazy Kraut! Sadly, poor Ludwig was very nearly alone in warning of the collapse to come from this credit expansion. In mid-1929, he stubbornly turned down a lucrative job offer from the Viennese bank Kreditanstalt, much to the annoyance of his fiancée, proclaiming "A great crash is coming, and I don't want my name in any way connected with it."

We all know what happened next. Pretty much right out of Mises's script, overleveraged banks (including Kreditanstalt) collapsed, businesses collapsed, employment collapsed. The brittle tree snapped. Following Mises's logic, was this a failure of capitalism, or a failure of hubris?

Mises's solution follows logically from his warnings. You can't fix what's broken by breaking it yet again. Stop the credit gavage. Stop inflating. Don't encourage consumption, but rather encourage saving and the repayment of debt. Let all the lame businesses fail—no bailouts. (You see where I'm going with this.) The distortions must be removed or else the precipice from which the system will inevitably fall will simply grow higher and higher.

Mises started getting some much-deserved respect once "Theorie des Geldes" was finally published in English in 1934. It is unfortunate that it required such a disaster for people to take heed of what was the one predictive, scholarly explanation of what was happening.

But then, just Mises's bad luck, along came John Maynard Keynes's tome "The General Theory of Employment, Interest and Money" in 1936. Keynes was dapper, fresh and sophisticated. He even wrote in English! And the guy had chutzpah, fearlessly fighting the battle against unemployment by running the currency printing press and draining the government's coffers.

He was the anti-Mises. So what if Keynes had lost his shirt in the stock-market crash. His book was peppered with fancy math (even Greek letters) and that meant rigor, modernity. To add insult to injury, Mises wasn't even refuted by Keynes and his ilk. He was ignored.

Fast forward 70-some years, during which we saw Keynesianism's repeated disappointments, the end of the gold standard, persistent inflation with intermittent inflationary recessions and banking crises, culminating in Alan Greenspan's "Great Moderation" and a subsequent catastrophic collapse in housing and banking. Where do we find ourselves? At a point of profound insight gained through economic logic, trial and error, and objective empiricism? Or right back where we started?

With interest rates at zero, monetary engines humming as never before, and a self-proclaimed Keynesian government, we are back again embracing the brave new era of government-sponsored prosperity and debt. And, more than ever, the system is piling uncertainties on top of uncertainties, turning an otherwise resilient economy into a brittle one.

How curious it is that the guy who wrote the script depicting our never ending story of government-induced credit expansion, inflation and collapse has remained so persistently forgotten. Must we sit through yet another performance of this tragic tale?

All indications are that the answer to that last question is a resounding 'yes'.

This piece attracted some 125 comments over at the WSJ at last count. Having read through about the first 30 or so, a defense of the status quo has yet to be offered.

Comments

[Michael Clark:]

'Mises's solution follows logically from his warnings. You can't fix what's broken by breaking it yet again. Stop the credit gavage. Stop inflating. Don't encourage consumption, but rather encourage saving and the repayment of debt. Let all the lame businesses fail—no bailouts. (You see where I'm going with this.) The distortions must be removed or else the precipice from which the system will inevitably fall will simply grow higher and higher.'

This is a wonderful quote and an approach which we need to follow -- and, so, Bernanke must be fired and replaced by a disciple of that grim Austrian who did not lose his shirt in a stock market crash.

Nov 09 05:16 AM

[Jason Kelly:]

From Ron Paul's book, "End The Fed," I offer the following excerpt:

"Artificially low interest rates are achieved by inflating the money supply, and they penalize the thrifty and cheat those who save. They promote consumption and borrowing over saving and investing. Manipulating interest rates is an immoral act. It's economically destructive.

"The Fed encourages irresponsible accumulation of personal debt. People live beyond their means with the help of an expansionist monetary policy. They trade in their futures for the present. They neglect the need to save in order to consume more and more. In this sense, the Fed is the ultimate promoter of consumerism and living for the present. This amounts to a terrible cultural distortion in which short-term thinking wins out over long-term planning."

Nov 09 06:54 AM

[Davewmart:]

People like Anatole Kaletsky, of 'The Times' , are still arguing that 'no-one saw this coming'.
He attracted such a barrage of critical comment that they now appear to be censoring comment, presumably on the grounds that Kaletsky is doing his duty as a paid up member of the mainstream media by exonerating the guilty and supporting the status quo ante.

Still, not to worry, we are told that there are green shoots everywhere.

Nov 09 06:59 AM

[dingding:]

The day of reckoning will come and America will be forced to repay its debts by selling parts of the United States.

Nov 09 07:07 AM

[jkh307:]

This country has been going in the wrong direction for about 50 years....
just WHAT would make ANYONE think that will change ? The young
and the smart people ... are leaving the US ... permanently.

Nov 09 07:56 AM

[TeresaE:]

"... Must we sit through yet another performance of this tragic tale?

All indications are that the answer to that last question is a resounding 'yes'..."

For decades I contemplated the Holocaust.

HOW did good people (and all Germans were not evil - at least at first) allow such horror and evil to flourish? Even taking into account the collapse of their economy, just how do you get a Christian mother to embrace hatred, blame and concentration camps?

It dawned on me a couple years ago, people WANT to believe that all things are done with goodness in mind, so they believe it with all their hearts and defend the status quo - or those in power - and will stand by watching themselves and their childrens' futures being destroyed and shackled.

Those that stand to lose the most refuse to believe anything except that which they are told and that things are just going to be okay.

Our Founding Fathers warned us of this. We continuously fail to listen to those brave, intelligent, groundbreaking men.

Sadly, we ignore them to our own peril.

Nov 09 08:47 AM

[The Geoffster:]

Most of our fiscal and monetary problems stem from poor values. The founding fathers tried to protect us from our vices by enshrining their values in the Constitution. That document, like the Federal Reserve Note has proven to be mere paper, often lauded, but more often debauched. Liberty requires vigilance and sacrifice. Sadly, we seem to prefer comfort and ignorance.

Nov 09 08:57 AM

[JudeJin:]

Mises shines so brightly in the sky to the right eyes.

Krugman and Friedman are just shooting star at their very best!

Nov 09 09:09 AM

[JudeJin:]

i sincerely wish that seekingapha.com could take the lead in establishing a online forum dedicated to the Austrian economics.

Nov 09 09:11 AM

[LoveShorting:]

jkh307 - - you are wise indeed.

Nov 09 11:26 AM

[5142152-337:]

Up to this point, the posters here have been brilliant, perceptive, clear thinking, and CORRECT. It is truely a breath of fresh air to read words that people--not sheeple--are capable of when they look at the big picture!

Thank you all. And thanks to Tim for broaching this topic with us.

God have mercy on us all.

Nov 09 01:59 PM

[Glen L.:]

Thoughtful people just learning about the Austrian school will wonder why, if the great Austrian thinkers (many of whom are/were not Austrians, of course) have been proven right so many times, does the mainstream press and academia continue to ignore them? The answer to this question is simple: the Austrians correctly identified governments and central banks as the culprits responsible for the destructive booms and busts that have plagued the markets throughout history. All other economic schools worship the state to at least some degree, and so they produce court economists who will never bite the hand that feeds them.

Peter Schiff expresses it better than most. He says there is only one economics (Austrian), just as there is only one physics. We don't go around talking about Chinese physics, and one day, sooner than later, we may drop the Austrian and just know that there is one true economic school, which teaches free market capitalism, advocates a true gold standard, and treats money as just another good that governments should have no control over.

Nov 09 10:00 PM

[JamesK:]

How true. It is refreshing to read a real article for a change without all the smoke and mirrors.
The current administration's tactics remind me of the fairy tale "The Kind has no clothes" as they expect the American people and the rest of the World to believe the never-ending BS. The jobless recovery, the ridiculous and wasteful bailouts, which are nothing more than buying votes, the endless rhetoric, etc.

Nov 10 07:37 AM