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The Austrian School of economics, like many here and elsewhere, believes the only way markets that crash can correct themselves is to go through a fairly lengthy process of purging self-adjustments in order to later set themselves right. But this is because the Austrians believe the markets must do that without any government help. Therefore there is no alternative. Secondly, the Austrian School also believes that markets will always do just fine unless they are interfered with by government. Unfortunately, the Austrians are simply wrong on both points here and so are U.S. conservatives who think the same thing. Let me explain.

Austrians believe markets have to correct themselves because, as a point of their own methodology, governments may not interfere in markets and so there is no other alternative but to let markets struggle over time to sort it out. Market self correction is inevitable if, on ideological grounds, you automatically rule out governmental corrective intervention and regulation. This is a circular argument entailing a self-fulfilling prophesy. Those who think a second Great Depression is inevitable almost invariably have the same kind of Austrian mind-set I describe here. The economy must go into depression sooner or later because that is the only way markets can correct themselves. We hear it all the time.

Mistakenly extrapolating from the failures of earlier socialistic government run economies, working under five year plans, the Austrians leaped to the conclusion that any government interference in a market is necessarily a bad thing, even if it is just to assure fair play and to protect the market from abuse by players in it. But that is not the only type of governmental interference possible. Governments can and do interfere when markets crash to help them recover, which is even worse, in the Austrian view. The U.S. government has done just that in our financial markets with considerable but not yet complete success. We have avoided a second Great Depression, but still have serious problems in those financial markets that the government has not fully resolved.

There is a bit of an inconsistency with the Austrian School, however. Left alone, markets will do just fine, but if they do crash, just leave them alone to sort themselves out and they will get back on their feet. Crashing, in the Austrian and American conservative view, is therefore invariably the fault of government intervention. That is the only way the Austrians can bail themselves out of the inconsistency. However, that does not leave Austrians with much of a good theory regarding the general business cycle, as opposed to Fed induced bubbles. And it leaves the Austrians without a good explanation for what just happened on Wall Street and how the government should realistically address it. U.S. conservatives face the same explanitory and remedial problem and the same core inconsistency.

On the second point, Austrians don’t really understand that markets all by themselves can get it wrong, indeed, massively wrong, just like governments can. They misunderstand the efficient market hypothesis. Many do. Here is what we do know about it and market efficiency that Austrians do not adequately appreciate:

Markets neutrally and quickly reflect the thinking and dispositions of the buyers and sellers collectively engaged in doing business in those markets. This is the efficient market hypothesis as better thinkers from the University of Chicago understand it. The theory is correct, but not as useful as it needs to be.

The liberal economists, on the other hand, reject the Chicago view and believe it is wrong in the sense that collectively buyers and sellers in the market don't necessarily "get it right" -- that is, they make collective mistakes and act on them, they collectively have their foibles and misconceptions and act on them, they bring their collective biases to bare and act on them, they collectively misjudge what will happen in the future and act on that misjudgment, and they make other errors of the type that humans do and act on them, too. The market result reflects a resolution that includes all this collective and weighted misinformation and foolishness and is often wrong from the vantage point of the here and now or hind sight.

Both views of markets are correct, with liberals liking the second interpretation and Chicagoans, the first. Neither is wrong, but neither recognizes the other's position. The Austrians and U.S. economic conservatives, on the other hand, believe the efficient market hypothesis, but from the vantage point from which liberals judge markets. That is simply not correct. Markets can and do make mistakes and often big ones for various reasons which the Austrians and those conservatives refuse to recognize. We should understand the core idea here because we readily recognize that the stock market does not always correctly value particular stocks, viewed sometimes contemporaneously, but certainly from the vantage point of hind sight.

For example here, we just saw our major financial markets collapse in near ruin, not from governmental interference, but from just the opposite -- too little governmental supervision and regulation to assure fair play and a lack of abuse of those markets. Private short sighted thinking was a major cause, e.g., “Housing prices will never go down” or “Why do we need reserves to back up CDS’s” or “What is the matter with packaging a few marginal loans in with a bunch of good ones in a CDO? Unrestrained greed was a second major cause of failure in our financial markets, e.g., “So what if the loan is bad, I’ll get my upfront fees and be gone if there is a problem” or “How many millions will my bonus be this year” or “If we set aside reserves for CDS’s, that will eat in to profits and therefore salaries and bonuses. We want the money now and we will sort it all out later.”

Finally, accounting abuses and slights of hand as well as leaning on credit rating agencies, were designed to mask the growing problems everyone wanted to ignore. These were a third cause of failure in the financial markets. Government had next to nothing to do with these failures. The Austrians and American economic conservatives can only ignore what has happened here because, as they view markets, this cannot have happened.

The point is that the financial markets – all by themselves – got it massively wrong, not just from the vantage of 20-20 hind sight, but from the then current viewpoints of some savvy observers who either did not care, were themselves taking advantage or were powerless or did not want to change things. This whole scenario simply does not fit within the Austrian School model. It can’t really have happened accord to them, but it cannot be sensibly rationalized away either.

While the lines I have delineated for the sake of exposition here blur significantly in the hands of the more sophisticated Austrians, the core truth is the Austrian School, as well as American conservatives, have had far too little useful to say in our circumstances, but their mistaken influence weighs heavily on the thinking of far too many who are not aware of these criticisms and seriously believe another inevitable Great Depression is the only way out.

Disclosure: none relevant

Source: U.S. Conservatives Too Influenced by Mistakes of the Austrian School