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 skeptical 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:
- Inflationary monetary policy leads to an expansion of credit throughout the economy, the basic building block for a boom-bust business cycle.
- 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.
- Companies, flush with cash, invest heavily to prepare for expected future growth. An investment and capital-spending boom ensues.
- Higher asset prices lower the cost of capital, fuelling a further boom in investment and capital spending, creating overcapacity in goods and services industries.
- The increase in asset prices produces the so-called ‘wealth effect’ for consumers: a decrease in savings and an increase in consumption.
- As the whole episode rests on an excess creation of credit, debt levels increase greatly.
- 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.
- Runaway asset price/consumer price inflation ultimately demands higher interest rates and a contractionary monetary policy, whereupon the whole house of cards collapses.
- When the asset price bubbles pop, revulsion steps in, credit contracts and the bubble currency depreciates, as hot money flees the depreciating assets.
- 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.
- The result is a wealth effect in reverse, leading to a collapse in consumption, a secular bear market and recession.
- 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 (OTC:LEHMQ) 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 (NYSE:GM), bankrupting Royal Bank of Scotland (NYSE:RBS) and Citigroup (NYSE:C) 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:
- 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).
- 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.
- 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 redux
The stimulus should therefore involve most of the following measures in order to mitigate the effects of deleveraging:
- Supportive government spending in infrastructure (human and capital) - (the risk being malinvestment as government misallocates resources or shifts funds to special interest groups.)
- 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.
- 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.
- 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.
- 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.
- 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.
- Re-regulate to will 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.
- 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.