Anti-intervention

Does “Depression Economics” Change the Rules?, by Robert P. Murphy

we need to understand what is causing so many resources to be unemployed in the first place. According to the Austrian theory of the business cycle, the housing and stock market booms were fueled by Alan Greenspan’s decision to slash interest rates in an effort to provide a “soft landing” after the dot-com crash and 9/11 attacks. This artificial stimulus goaded entrepreneurs into starting numerous projects that were unsustainable.

In short, people in the private sector made decisions as if there were far more real resources at their disposal to “fund” the projects to completion. When reality set in, many of the projects had to be abandoned, meaning that the workers and other resources involved had to be laid off. (See this article for Mises’s analogy of the master homebuilder being misled by an erroneous resource inventory, and why workers would be unemployed once he discovers his error.)

Once people in the private sector realized they had made horrible decisions during the boom years, they needed to stop business as usual and figure out how to make the best of a bad situation. Homeowners who had skimped on their savings for years (relying on booming house prices) had to slash spending to compensate for years of overconsumption, while entrepreneurs needed to decide which activities were likely to be profitable going forward, in light of the new information.

…

the period of “idle unemployment” serves a real function in a market economy. It is true that such periods of massive discoordination are almost always the fault of government interference, but whatever the initial cause, there is no denying that the discoordination is real. Writers such as Krugman and Thoma act as if recessions are caused by massive bouts of irrational consumer anxiety, and that all problems can be patched up by a simple boost of “aggregate demand.”

On the contrary, the economy’s capital structure really was thrown into an unsustainable condition during the boom years, and it takes time for the mess to be sorted out.

…

if the government wants the economy to recover as quickly as possible, the solution is simple: cut spending, cut taxes, stop inflating the money supply, and stop changing the rules every three days. But this solution won’t be adopted, since it doesn’t allow the politicians to pose as generous saviors.

There was a series on PBS about the Great Depression some years ago. Remarkably, there were no actual economists interviewed about the causes of the Depression. Instead, pseudo-authorities, like Gore Vidal, and ordinary people from the time were asked what the problem was. They repeated phrases about “overproduction and underconsumption.” Like Herbert Hoover and Franklin Roosevelt themselves, they thought that people simply did not have enough money to buy the output of industry. In a sense that was true, but the program that such a theory evidently called for, raising wages and protecting jobs, which would presumably give people the extra money needed to buy all industrial production, had disastrous results: Unemployment hovered around 20% for a decade, despite all the bells and whistles of the New Deal. Vidal said that Roosevelt “saved capitalism,” but the New Deal did not revive the economy or substantially lower unemployment. Most people are aware of this — otherwise the Depression after 1933 would not still have been the Depression — but acknowledging its implications is avoided.

Even today, economics is often still thought of in “underconsumptionist” terms — not often by economists but frequently in politics and in public debate — and the Los Angeles Times still prints articles to the effect that the basic problem of economics is “how to achieve sufficient demand to absorb available production”. In fact, public policies including everything from protective tariffs and “fair trade” to unionism and the minimum wage are based on this principle. These kinds of ideas in the post-World War II world are usually identified with John Maynard Keynes. A biographer of Keynes, Robert Skidelsky, says that Keynes’s “aim was simply to ensure a level of aggregate demand sufficient to enable market-clearing real wages to be established without price inflation”.

But Hoover, Roosevelt, and Keynes had it all backwards. The proper economic principle is called “Say’s Law,” for Jean Baptiste Say (1767-1832), that “supply creates demand.” This means that “overproduction” in a free economy is actually impossible.

Why Say’s Law is correct is evident from one simple consideration: if inventory doesn’t sell, then prices will be cut until it does… When industrial production increases and more goods become available, some old goods will go unsold as money moves over to the new goods, and prices will have to fall right across the board. That is called “deflation,” and it is what happened in the United States from the end of the Civil War until 1896, while the United States grew into the largest economy in the world. Money became more valuable, and wages continued to buy as much as was desired of total production…

Why hasn’t there been any deflation since World War II, even though the U.S. economy has grown vastly since then? Deflation will only happen if the money supply does not grow fast enough as production increases. Prices will remain stable or even increase (inflation) if the money supply grows as fast or faster than production. Under the gold standard, what happened to the money supply depended on the supply of gold. As gold from California slowly ran out, there was deflation; but, after 1897, gold strikes in the Yukon and South Africa created a mild inflation until World War I. Now that nations are no longer on the gold standard, governments can increase the money supply and even create permanent inflation just by printing money. Indeed, most people today, including reporters, businessmen, politicians, and even many economists, unaware of monetary history, think that a growing economy somehow actually causes inflation.

When I was in high school, an American history textbook had a diagram of the “wage and price spiral.” Workers would press for higher wages. Then businesses would raise prices. Then workers would press for even higher wages. This was supposed to explain how inflation happened. However, there is a very simple reason why this isn’t correct: If the money supply does not increase, the “wage and price spiral” runs out of money. If a business raises prices to offset wage increases, less of its production will be sold. If enough is sold that revenue actually increases, as desired, this will have two effects: (1) people are getting less for their money from this business, which decreases the value going to consumers; and (2) money is drawn from elsewhere in the economy, which means that there is less money left to buy the production of other businesses. Somebody gets the short end of the stick. Somebody has to cut prices.

If a business must cut prices to sell its inventory, will it not also cut wages to preserve its profit margin, meaning that the growing value of deflating wages will simply be offset by wage cuts? Wages will indeed fall with prices in a deflation, but falling nominal wages in the post Civil War era actually meant rising real wages: Wages did not fall as fast as the prices of goods. If the value of wages simply fell equally with the value of production, then cutting prices to move inventory would be ineffective — no new products, like cars or radios, could ever be introduced into an economy, since the purchasing power would not be there to buy them. Why real wages would rise as nominal wages fell may be understood in terms of another simple consideration: expanded production will always mean expanded demand for labor. Drawing off labor to produce new goods bids up the value of labor, which would offset the downward tendency of deflation…

Artificially raising wages, on the other hand, or maintaining nominal wage levels during a deflation, as with Hoover and Roosevelt, only manages to produce unemployment…

Say’s Law and Supply Side Economics

“It elaborated the monetary or circulation credit theory of the business cycle which clearly showed how the recurrence of depressions of trade is caused by the repeated attempts to “stimulate” business through credit expansion. Thus it conclusively proved that the slump, whose appearance the inflationists attributed to an insufficiency of the supply of money, is on the contrary the necessary outcome of attempts to remove such an alleged scarcity of money through credit expansion.

The economists did not contest the fact that a credit expansion in its initial stage makes business boom. But they pointed out how such a contrived boom must inevitably collapse after a while and produce a general depression. This demonstration could appeal to statesmen intent on promoting the enduring well-being of their nation. It could not influence demagogues who care for nothing but success in the impending election campaign and are not in the least troubled about what will happen the day after tomorrow. But it is precisely such people who have become supreme in the political life of this age of wars and revolutions. In defiance of all the teachings of the economists, inflation and credit expansion have been elevated to the dignity of the first principle of economic policy. Nearly all governments are now committed to reckless spending, and finance their deficits by issuing additional quantities of unredeemable paper money and by boundless credit expansion.

…

Neither did Keynes try to refute by discursive reasoning the teachings of modern economics. He chose to ignore them, that was all. He never found any word of serious criticism against the theorem that increasing the quantity of money cannot effect anything else than, on the one hand, to favor some groups at the expense of other groups, and, on the other hand, to foster capital malinvestment and capital decumulation. He was at a complete loss when it came to advancing any sound argument to demolish the monetary theory of the trade cycle.”

Lord Keynes and Say’s Law, by Ludwig von Mises

Keynes:

Credit expansion performs the “miracle… of turning a stone into bread.”

Mises:

“there is never any economic benefit to be conferred by an increase in the supply of money”

Economic growth and the credit myth, by Gerard Jackson:

“The free credit myth is one of the oldest and certainly one of the most enduring of economic fallacies. The essence of the fallacy is quite simple: interest is a monetary phenomenon, that is, it is determined by the supply of and demand for money. Therefore interest can be virtually if not entirely eliminated by a continuous increase in the supply of money. Once interest has been eliminated society will enjoy an abundance of capital. It should now be clear that this view also sees the scarcity of capital as being artificially created in order to earn interest.

But who is responsible for this scarcity and the existence of interest? The answer, according to the monetary cranks, is that the banks have been given a monopoly of credit. Well, like every monopoly, it is claimed the banking system acts to restrict the supply of their product (credit) so as to artificially raise its price (interest) to consumers and businesses. The solution is abundantly clear (except to dreaded economic rationalists like myself, i.e., free marketeers) and that is for the government to use the central bank to bypass the monopoly banks and make credit freely available to governments or to others at very low rates or even free of any charge.

…

Monetary cranks are forever confusing credit with capital. Because they believe abundant credit would eliminate interest they then assume an equally abundant supply of capital would appear. But credit is not capital. As Professor von Lachman and so many others put it: “Capital is the material means of production. Capital comes from savings and savings are forgone consumption. ‘Gratuitous’ increases in credit are therefore not additions to savings.

When credit expansion gets under way the rate of interest is artificially lowered and that expands the demand for more credit. The situation then arises where investment exceeds savings: but this only means that we are suffering from inflation. The newly created credit did nothing to increase real savings. Eventually, in accordance with the social rate of time preference (society’s savings/consumption ratio), the additional spending created by the credit expansion will be spent by factors on consumption goods.

Increased consumer spending will then bid against the higher stages of production for resources; these stages will then find themselves caught in a price-cost squeeze. With prices rising, foreign exchange problems worsening, the current account deteriorating and stocks booming the central bank then feels impelled to impose a credit squeeze that eventually brings the boom to an end. It is sometimes argued, however, that so-called bubbles deflate once prices exceed what some call a “rational assessment of value”. This view overlooks the fact that bubbles are always preceded by ‘cheap’ credit. Moreover, there are basically only two ways to end a bubble: apply the monetary brakes or allow the boom to follow its course until hyperinflation destroys the currency, as was the case in Weimar Germany.

…

The monetary cranks’ views can be easily summed up as:

1. Capital is abundant but is kept artificially scarce by interest.
2. Interest is created by monopoly banks to exploit the community.
3. Interest is a purely monetary phenomenon that can be eliminated by monetary expansion.
4. There really is a Santa Clause.

At least monetary cranks can be excused as economic illiterates but what are we to make of the great majority of economists who believe that central banks can promote economic growth by manipulating interest rates and the money supply? The difference between them and the monetary cranks is one of degree and not substance. After all, says the monetary crank, if the central bank can force down interest rates to stimulate the economy why can’t it eliminate interest altogether?”

“Perhaps the most important single contribution of von Mises to the economics of intervention is also the one most grievously neglected in the present day: his analysis of money and business cycles. We are living in an age when even those economists supposedly most devoted to the free market are willing and eager to see the state monopolize and direct the issuance of money. Yet Mises has shown that:

1. there is never any social or economic benefit to be conferred by an increase in the supply of money;
2. the government’s intervention into the monetary system is invariably inflationary;
3. therefore, government should be separated from the monetary system, just as the free market requires that government not intervene in any other sphere of the economy.

Here Mises emphasizes that there is only one way to ensure this freedom and separation: to have a money that is also a useful commodity, one whose production is like other commodities subject to the supply and demand forces of the market. In short, that commodity money — which in practice means the full gold standard — shall replace the fiat issue of paper money by the government and its controlled banking system.

Mises’s brilliant theory of the business cycle is the only such theory to be integrated with the economists’ general analysis of the pricing system and of capital and interest. Mises shows that the business cycle phenomenon, the recurring alternations of boom and bust with which we have become all too familiar, cannot occur in a free and unhampered market. Neither is the business cycle a mysterious series of random events to be checked and counteracted by an ever-vigilant central government. On the contrary, the business cycle is generated by government: specifically, by bank credit expansion promoted and fueled by governmental expansion of bank reserves. The present-day “monetarists” have emphasized that this credit expansion process inflates the money supply and therefore the price level; but they have totally neglected the crucial Misesian insight that an even more damaging consequence is distortion of the whole system of prices and production. Specifically, expansion of bank money causes an artificial lowering of the rate of interest, and an artificial and uneconomic overinvestment in capital goods: machinery, plant, industrial raw materials, construction projects. As long as the inflationary expansion of mo ney and bank credit continues, the unsound ness of this process is masked, and the economy can ride on the well-known euphoria of the boom; but when the bank credit expansion finally stops, and stop it must if we are to avoid a runaway inflation, then the day of reckoning will have arrived. For without the anodyne of continuing inflation of money, the distortions and misallocations of production, the overinvestment in uneconomic capital projects and the excessively high prices and wages in those capital goods industries become evident and obvious. It is then that the inevitable recession sets in, the recession being the reaction by which the market economy readjusts itself, liquidates unsound investments, and realigns prices and outputs of the economy so as to eliminate the unsound consequences of the boom. The recovery arrives when the readjustment has been completed.

It is clear that the policy prescriptions stemming from the Misesian theory of the business cycle are the diametric opposite of the “post-Keynesian” policies of modern orthodox economics. If there is an inflation, the Misesian prescription is, simply, for the government to stop inflating the money supply. When the inevitable recession occurs, in contrast to the modern view that the government should rush in to expand the money supply (the monetarists) or to engage in deficit spending (the Keynesians), the Austrians assert that the government should keep its hands off the economic system—should, in this case, allow the painful but necessary adjustment process of the recession to work itself out as quickly as possible. At best, generating another inflation to end the recession will simply set the stage for another, and deeper, recession, later on; at worst, the inflation will simply delay the adjustment process and thereby prolong the recession indefinitely, as happened tragically in the 1930s. Thus, while current orthodoxy maintains that the business cycle is caused by mysterious processes within the market economy and must be counteracted by an active government policy, the Mises theory shows that business cycles are generated by the inflationary policies of government and that, once underway, the best thing that government can do is to leave the economy alone. In short, the Austrian doctrine is the only consistent espousal of laissez-faire; for, in contrast to other “free market” schools in economics, Mises and the Austrians would apply laissez-faire to the “macro” as well as the “micro” areas of the economy.”