Letter sent to WSJ:
Edmund Phelps’s (”False Hopes and False Fears,” June 3) mischaracterization of the Austrian business cycle theory as one of “overinvestment” is doubly curious. For one thing, the Austrian theory has not been hidden under a bushel. F.A. Hayek shared the 1974 Nobel Prize, in part, for building on the pioneering cycle theory of Ludwig von Mises. And, the theory has enjoyed a renaissance since the financial debacle in Japan, especially among practitioners. The mischaracterization is all the more curious because the Austrian view of the boom-bust cycle stems from an insight analogous to that of the Friedman-Phelps analysis.
Mr. Phelps and Mr. Friedman claim that unemployment cannot be held below its “natural” rate by increasing aggregate demand through monetary and fiscal policy. While in the short run, they argue, production may be artificially stimulated and unemployment lowered by such policies, in the long run, the market adjusts to the additional spending by pushing up all prices commensurate to the artificial increases in aggregate demand and thereby, removing the stimulus. The normal functioning of the market returns production and unemployment to their “natural” rates.
In a similar way, the Austrian theory of the cycle argues that an investment boom cannot be forever sustained by central-bank monetary inflation and credit expansion. For a time, artificial credit expansion can push the interest rate below its “natural” level and stimulate a build up of some capital projects, but only at the expense of others. Credit expansion results in malinvestment, not in overinvestment. The market reacts to the distorted capital structure by restoring the “natural” rate of interest and setting in motion a reversal of the capital boom by which the capital structure of the market is returned to one that can be sustained by normal demands. Given his belief in the self-correcting nature of the market, it is odd that Mr. Phelps rejects this conclusion and holds that the “high performance of the boom” can become the “norm rather than the exception.”
In the Austrian theory, the self correction that takes place after a boom is not, as Mr. Phelps claims, a reduction of the present rate of investment to compensate for the previous “overinvestment.” Instead, it is the liquidation of the malinvestments made during the boom as a result of the artificial credit expansion. The recession is the period of liquidation and must last until liquidation is complete. Only then can recovery begin.
Mr. Phelps’s denial of the recession is an apt coda to his mischaracterization of Austrian cycle theory. Investors in the “towering investment boom of the 1996-2000” may have a less sanguine view on whether or not the resulting malinvestments brought on “the nightmare of interwar Austrian cycle theory” in the massive liquidation of 2000-2003.
Jeffrey M. Herbener, Professor of Economics, Grove City College, Grove City, Pennsylvania
