For the most part, Austrians have been doing theoretical battle with the Keynesians over the causes of why the current depression occurred and why it continues. Yet while Keynesians are both under attack and on the attack (read Paul Krugman and Brad DeLong and other Keynesians), nonetheless, the Chicago School also finds itself on the defensive — and correctly so.
The Wall Street Journal recently featured an interview of 1995 Nobel Prize winner Robert Lucas of “rational expectations” fame by Holman W. Jenkins Jr. — and if the interview reveals what they are thinking in the ivy towers of Hyde Park, then it seems that maybe “salt and fresh water” have been mixed to create an unsuitable brine that not only tastes bad but also is downright economically poisonous. One thing is for sure: neither the “salt water” nor “fresh water” economists understand what is happening to the economy. Perhaps it is time for what Murray N. Rothbard called the “no-water” economists to speak up.
The Lucas interview amazes me not so much for its wisdom, but rather the economist’s lack of understanding of why this depression not only continues but actually seems to be accelerating downward. However, not everything he says is untrue, although he fails to appreciate that there should be continuity and consistency in his views, which seem to clash with each other.
For example, he correctly points out the welfare burden carried by Europeans, telling Jenkins, “The welfare state is so expensive, it just breaks the link between work effort and what you get out of it, your living standard. And it’s really hurting them.” Score one for Chicago and put a minus sign in the Keynesian column.
Furthermore, Lucas does seem to get some reasons as to why the various Keynesian stimulus packages are not going to lower joblessness or give any long-term boost to the economy. Jenkins writes, paraphrasing Lucas,
Our stunted recovery, they [Keynesians] insist, is due to government’s failure to borrow and spend enough to soak up idle capacity as households and businesses “deleverage.” In a Keynesian world, when government gooses demand with a burst of deficit spending, the stick figures are supposed to get busy. Businesses are supposed to hire more and invest more. Consumers are supposed to consume more.
But what if the stick figures don’t respond as the model prescribes? What if businesses react to what they see as a temporary and artificial burst in demand by working their existing workers and equipment harder — or by raising prices? What if businesses and consumers respond to a public-sector borrowing binge by becoming fearful about the financial stability of government itself? What if they run out and join the tea party — the tea party being a real-world manifestation of consumers and employers not behaving in the presence of stimulus the way the Keynesian model says they should?
There is nothing wrong with what Jenkins and Lucas are saying on this point. Indeed, Keynesians view human activity in such Pavlovian terms that all that is needed to get the economy going is short-term spending, a cut in tax rates for a year or two, that they cannot even imagine that business owners and consumers might think differently than how Keynesians view them. Thus, to Keynesians, all that is needed is a big enough “stimulus” to get the wheels going, and somehow, after a while the automatic machine known as “the economy” moves by itself, and to challenge this view is to place oneself in the academic, journalistic, and political crosshairs with plenty of people willing to fire away.
It is important to note, however, that Lucas misses two important reasons why government/Keynesian stimulus schemes fail miserably, and why the efforts of President Obama and Fed chairman Ben Bernanke are not making the economy simply run in place, but actually are driving economic activity downward. The first is the presence of malinvestments, something that tends to clash with the Chicago view of rational-expectations theory and its “perfect-market hypothesis.”
The second is the “regime-uncertainty hypothesis,” which Robert Higgs has addressed in a number of articles and blog posts. While Chicago School economists might be more comfortable with this hypothesis, the lack of a coherent capital theory at Chicago serves as a barrier to the “fresh-water” economists fully understanding why a dearth of capital investment hinders economic growth.
The warning that perhaps Lucas does not fully grasp the current situation is found in this paragraph by Jenkins, when he writes that Lucas not only supported the government bailouts of Wall Street but also supported Federal Reserve policies:
Refreshing, even bracing, is Mr. Lucas’s skepticism about the “deleveraging” story as the sum of all our economic woes. “If people start building a lot of high-rises in Chicago or any place and nobody is buying the units, obviously you’re going to shut down the construction industry for a while. If you’ve overbuilt something, that’s not the problem, that’s the solution in a way. It’s too bad but it’s not a make-or-break issue, the housing bubble.”
Instead, the shock came because complex mortgage-related securities minted by Wall Street and “certified as safe” by rating agencies had become “part of the effective liquidity supply of the system,” he says. “All of a sudden, a whole bunch of this stuff turns out to be crap. It is the financial aspect that was instrumental in the meltdown of ‘08. I don’t think housing alone, if it weren’t for these tranches and the role they played in the liquidity system,” would have been a debilitating blow to the economy.
Mr. Lucas believes Ben Bernanke acted properly to prop up the system. He doesn’t even find fault with Mr. Obama’s first stimulus plan. “If you think Bernanke did a great job tossing out a trillion dollars, why is it a bad idea for the executive to toss out a trillion dollars? It’s not an inappropriate thing in a recession to push money out there and trying to keep spending from falling too much, and we did that.” (emphasis added)
Unfortunately, this falls into the “Say what?” category. Part of the problem is that the rational-expectations views that permeate Chicago also hinder any belief in how and why a financial bubble forms. (In this interview, Eugene Fama of Chicago questions even the presence of a bubble.)
Instead, according to this way of thinking, people react immediately to market dislocations that occur within a boom, so those dislocations do not grow very much, and so there is little or no “malinvested” capital, because rational people would not create malinvestments in the first place — and they certainly would not march over the cliff. To extend the Chicago viewpoint on the macroeconomics side, Milton Friedman’s work in monetary theory employed the quantity theory in which the transmission mechanism for new money really does not matter, nor is it really discussed. Instead, new money tends to force prices up in uniform percentages so that Chicago School economists never look at the inside workings of an economy being hit with inflation, and they don’t see the changes in relative prices that help fuel the malinvestments. (But, if there are no malinvestments, then there is nothing to see and the quantity theory of money works just fine.)
Lucas clearly does not see the actions by the Fed, not to mention the Bush administration and its infamous TARP bailout of 2008, as being harmful in and of themselves, and in that viewpoint, he has the company of most academic economists, both “salt water” and “fresh water.” That makes sense at Chicago, because if there is no systematic creation of malinvestments, then the only thing the government and central bank were doing was making sure that the nation’s finance system remained secure.
By rejecting the possibility that the injections of new money and the government’s directive to put as many people into homeownership as possible also created massive malinvestments, Lucas is unable to make sense of the continuing debacle. True, as Jenkins writes, Lucas can see how the present policies are creating uncertainty, which at least gives him a tenuous tie to the Higgs thesis of regime uncertainty:
But that was then. In the U.S. at least, the liquidity problems that manifested themselves in 2008 have long since been addressed. To repeat the exercise now with temporary tax and spending gimmicks is to produce the opposite of the desired effect in consumers and business owners, who by now are back to taking a longer view. Says Mr. Lucas: “The president keeps focusing on transitory things. He grudgingly says, ‘OK, we’ll keep the Bush tax cuts on for a couple years.’ That’s just the wrong thing to say. What I care about is what’s the tax rate going to be when my project begins to bear fruit?”
However, uncertainty about the future, no matter how rational the actions, explains only why investors and entrepreneurs are failing to do long-term investments. There is nothing in the Lucas interview that explains why the economy is moribund now, which brings us to the malinvestments issue.
I have heard a number of Chicago School and affiliated economists critique Austrian business-cycle theory (ABCT) by saying that artificially low interest rates should not fool rational business owners and investors, so that there is no way that people would be “tricked” into making massive malinvestments, not to mention irrationally bid up assets into bubbles. That viewpoint is both shortsighted and unfortunate.
Bubble behavior can be seen as rational, even if market participants know they are seeing a bubble. After all, as long as one catches a bubble on the way up, buying low and selling high, one can make money. Furthermore, bubbles burst precisely because investors recognize that the asset prices at the top of the bubble are out of balance with market fundamentals; it is just that these things do not happen with the mathematical precision and smoothness of the mathematical models, so many academic economists simply turn away from looking at things as they really are.
Second, investors and entrepreneurs generally do not look at the economy from a universal viewpoint, instead looking at their particular opportunities. For example, during the housing bubble, a number of new mortgage firms came into being. From the ABCT viewpoint, this was throwing gasoline onto the fire, but to people entering the market, it seemed like a good and quick way to earn a lot of money. Moreover, there were plenty of people on the squawk box and elsewhere claiming that the housing market could sustain a lot more new money than it actually could.
In other words, people, even large groups of people, can be wrong. Their wrong decisions can be construed as rational or making sense at the time, but that does not mean that in the long term, they were correct decisions. Austrian business-cycle theory, after all, does not say that profits cannot be made in the short run via malinvested assets, but declares instead that over time the investments are revealed as not being sustainable, and that clearly is what happened in the housing bubble.
Without capital theory and without a good explanation as to how capital can be malinvested, Lucas is left holding to the regime-uncertainty viewpoint. There is no problem with that view, but it does not by itself explain the current economic downturn and why things likely will become worse.
Lucas also is theoretically helpless in explaining why the Keynesian schemes are bound to fail. When Krugman, for example, declares that the stimulus “is supposed to put resources that would otherwise be unemployed to work,” can Lucas explain why that often does not happen, and why a stimulus, even one big enough to satisfy Krugman, cannot and will not give an economy “traction” to move on its own?
Furthermore, how does Lucas answer an editorial that recently appeared in the New York Times defending the Obama administration’s huge loans to the failed solar firm Solyndra? Can he explain that no government can subsidize the economy into recovery, despite the claims from the NYT that it can and should? Furthermore, why is it impossible for the government to be able to do such a thing?
The Austrian theories can explain all of these things, even if the theories are unpopular. For example, Austrians want to know why the resources are unemployed in the first place and, for another, Austrians recognize that the lack of demand for such resources is not a cause of their idleness, but rather an effect. The cause can be found by examining patterns of malinvested resources — and how and why those resources were malinvested in the first place.
Modern mainstream academic economics simply is not geared to asking relevant questions, nor are its practitioners interested in finding answers. Instead, economists claim that Austrian business-cycle theory “fails the market test,” not because it fails to explain things, but rather because the conclusions that one must draw from the ABCT do not include economists pulling magic economic rabbits from hats — not even economists who have won the Nobel.
