The Skyscraper Curse: And How Austrian Economists Predicted Every Major Economic Crisis of the Last Century

In 1993, Milton Friedman proposed his famous “plucking model”1 of the business cycle. To understand this theory, imagine a string or straight rising line on a graph that represents the potential growth of the economy. Also on the graph is another string that represents actual economic growth and follows the potential growth line except for when the second string is “plucked” downward by policy mistakes or external forces. In Friedman’s model, after the economy has been plucked economic growth quickly returns to the potential growth string. For Friedman it is important to explain the pluck and economic bust, but not the boom because in his model the boom is normal.

Friedman would recommend no special polices regarding the business cycle other than avoiding policy errors. If monetary policy is too tight, loosen it. In particular, money mattered for Friedman and the monetarists, and Friedman argued that a mistakenly restrictive monetary policy and high real interest rates were responsible for the Great Depression. Garrison2 provides an effective critique of the plucking model.

In the Friedman context, you could try to make an argument that policy makers made an error that brought on the financial crisis, but this would conflict with Friedman’s3 own vision. He appeared on the Charlie Rose show on December 29, 2005, the zenith of the housing bubble, and summarized his view of the US economy: “The stability of the economy is greater than it has ever been in our history. We really are in remarkably good shape. It’s amazing.”

He went on to praise Alan Greenspan and the work being done at the Federal Reserve. Not only did Friedman fail to see the housing bubble, but his recommended policy response of loosening the supply of money and credit did not solve the problem. In fact, a loose monetary policy of zero interest rate policy (i.e., ZIRP) and quantitative easing (i.e., QE), have all failed to get the economic-growth string back to the potential-economic-growth string thus far.4  

Another string theorist is Ben Bernanke. The former chairman of the Fed was a student of the Great Depression and Friedman’s work on that subject. More generally he is considered to be in the camp of the New Keynesian school, which assumes that people have rational expectations about the future but live in an economy with imperfections and market failures. Extending Friedman’s work, Bernanke found in his research that the collapse of the banking sector in 1933 was the main reason that the depression was “great.” The stock market crash and ensuing economic crisis weakened banks, and many of them failed. After FDR’s bank holiday in March 1933 the normal channels of credit turned into a market failure that held back the economy for many years to come. The bank failures were like a weight hung on the actual-economic-growth string preventing it from reconnecting to the potential-economic-growth string. Therefore Bernanke places a great deal of emphasis on protecting the large, systemically important banks and the credit-industry infrastructure. However, he also believes that loose monetary and fiscal policies are necessary for controlling the business cycle.

On the occasion of Milton Friedman’s ninetieth birthday, Bernanke delivered extensive remarks on Friedman and Schwartz’s5 work on the Great Depression, holding it in the very highest regard. Although some of his conclusions do differ from Friedman and Schwartz, Bernanke6 closed his remarks on the Great Depression with the following apology and promise: “Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression, you’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”

Bernanke was working at the Fed as vice chairman and then chairman during the housing bubble. He repeatedly denied the existence of the housing bubble and often suggested that if a bubble did exist and did pop, he would just lower interest rates. When it became evident that there was trouble in the housing market Bernanke moved aggressively in terms of monetary policy. He used both policies along traditional lines, such as reducing the federal funds rate and the discount rate, and aggressive, untried nontraditional policies, such as quantitative easing and zero interest rate policy. The overall policy response included radical decreases in interest rates, radical increases of liquidity in banks, a bailout of the systemically important banks and industries, and an enormous fiscal stimulus from the federal government, including multiyear trillion-dollar deficit spending. Bernanke soon began speaking of his ability to see “green shoots” in the economy, but many years later the actual-economic-growth string continues to lag badly behind the potential-economic-growth string.

Paul Krugman will here represent the Keynesian school of economics. The Keynesian view of the business cycle is based on social psychology. In the Keynesian view, periods of investment euphoria give way to periods of panic, retrenchment, and depression. If the actual-economic-growth string veers even slightly down from the potential-economic-growth string, then this sets up a potential scenario of dashed expectations, cutbacks, and diminished investment that can lead to layoffs, high rates of unemployment, and a significant decline in aggregate demand. This scenario is caused by what Keynes himself referred to as “animal spirits,” which is the irrational fear associated with investment.

When aggregate demand does not keep up with aggregate supply, this leads to lower prices, or price deflation. This can plunge an economy into what Krugman describes as an economic “black hole” from which the economy will never recover. As such, Keynesian economists and mainstream economists more generally have a phobia of deflation, or “apoplithorismosphobia,” which is the irrational fear of price deflation. However, much has been written about why deflation is not to be feared.7

Krugman has been very vocal since the financial crisis, calling for aggressive fiscal stimulus — that is, for the government to borrow vast amounts of temporarily unused savings and spend it. What the government spends the money on is less important than how much it spends beyond its means. It is important that consumers get money in their pockets, that businesses are put back to work doing something, and that the spending has the biggest possible impact on increasing aggregate demand. Certain important industries should receive bailouts if necessary, and public works programs should be begun in hard-hit areas. In order to guard against the possibility of deflation Krugman also recommends a stimulative monetary policy. Krugman has even argued that a Martian invasion hoax would fix the economy:

If we discovered that space aliens were planning to attack and we needed a massive buildup to counter the space alien threat and really inflation and budget deficits (concerns) took secondary place to that, this slump would be over in 18 months. And then if we discovered, oops, we made a mistake, there aren’t any aliens, we’d be better off.8

Krugman even later congratulated Japan for adopting the “moral equivalent of space aliens” in the form of Abenomics (i.e., aggressive monetary and fiscal stimulus), and for rejecting the “austerian orthodoxy” (i.e., balanced budgets).

The problem for Krugman is that with the exception of the fake Martian invasion, all of these policies have been implemented in the United States at unprecedented levels since 2008. In Japan, they have been implemented at higher levels for a longer period of time, to no good effect. Of course Krugman might object that these policies were still not large enough or quick enough to solve the problem. However, that just means his approach is untenable: Keynesians cannot predict a crisis in advance, because their analysis of the economic crisis starts with an unpredictable shock to social psychology; similarly, in the case of RBCT (real business cycle theory), the analysis starts with an unpredictable technological shock, or some other exogenous change.

These theories of the business cycle start with stylized facts that describe business cycles. From this, economists develop a hypothesis concerning what causes the business cycle. From this hypothesis, they develop a policy recommendation that agrees with their ideological perspective. Conservative economists — for example, those of the Chicago school — typically recommend no or limited remedial policy actions when faced with an economic downturn, while liberal economists from Ivy League universities are much more likely to recommend significant government intervention when faced with the same crisis. The most general problem with these approaches is that all of these recommendations have been tried since the beginning of the financial crisis and they have all failed.

• 1Milton Friedman, “The ‘Plucking Model’ of Business Cycle Fluctuations Revisited,” Economic Inquiry 31, no. 2 (1993): 171–77.
• 2Roger Garrison, “Friedman’s ‘Plucking Model’: Comment,” Economic Inquiry 34, no. 4 (1996): 799–802.
• 3Milton Friedman, Interview on Charlie Rose, December 29, 2005.
• 4Ryan Murphy, “The Plucking Model, the Great Recession, and Austrian Business Cycle Theory,” Quarterly Journal of Austrian Economics 18, no. 1 (Spring 2015): 40–44.
• 5Milton Friedman, and Anna J. Schwartz, A Monetary History of the United States, 1867–1960 (Princeton, NJ: Princeton University Press, 1963).
• 6Ben S. Bernanke, “Remarks by Governor Ben S. Bernanke,” Speech at the Conference to Honor Milton Friedman, University of Chicago, November 8, 2002.
• 7See Philipp Bagus, In Defense of Deflation (New York: Springer, 2015); Jörg Guido Hülsmann, Deflation and Liberty (Auburn, AL: Mises Institute, 2008); Greg Kaza, “Deflation and Economic Growth,” Quarterly Journal of Austrian Economics 9, no. 2 (Summer 2006): 95–97; Mark Thornton, “Apoplithorismosphobia,” Quarterly Journal of Austrian Economics 6, no. 4 (Winter 2003): 5–18; Joseph T. Salerno, “An Austrian Taxonomy of Deflation—with Applications to the U.S.” Quarterly Journal of Austrian Economics 6, no. 4 (Winter 2003): 81–109, and “Deflation and Depression: Where’s the Link?” Mises.org, August 6, 2004.
• 8Paul Krugman, “Krugman Calls for Space Aliens to Fix U.S. Economy?” Global Public Square, August 12. 2011.