The Booms and Busts of Austrian Economics (Part II)

January 3rd, 2013

nullThis week and last I have been traveling to Austria. Following from this trip, I am writing this two-part blog series on Austrian economics, its successes, failures, and application to current dilemmas in economic theory and policy.

In the past few years the world—and the United States in particular—has witnessed a resurgence of the term “Austrian economics.”  Last week I wrote a post about the academic history and resurgence of Austrian economics in the last few years. I wrote that the reason for this is that the school of thought actually does a fairly good job of both explaining and predicting the financial crisis of 2007-8.[1] Yet while the Austrians have enjoyed a boom in their theories as they are able to explain the sources of the world’s crises, their proposed solutions are a bust. In fact, the evidence, politics, and most mainstream economists have summarily rejected its prescriptions for our ills. The logic behind this rejection is the topic I’ll take on this week.

Whereas before the crisis the Austrians might have gotten a thing or two right about its sources and determinants, the school of thought leaves a great deal to be desired when it comes to proposed solutions. In the 1930s, following the Great Depression, the world’s most severe economic contraction of all time, the Austrians argued that the only “cure” for such a contraction is to prevent it from occurring in the first place. That is, during an expansion: recognize economic bubbles, keep credit on a tight leash, and don’t let the economy expand at too rapid a pace. In the event of a contraction, like the one in the 1930s or the one in 2008, the Austrians would have argued to let everything be liquidated—that is to just let it all go bankrupt. The Austrians would have let the banks fail; they would not have passed a stimulus package and would have let unemployment rise unabated; and they certainly would not have bailed out the American auto industry. They would advocate this is necessary no matter how painful the economic repercussions.

Mainstream economists in the 1930s, even those who were very conservative, did not find this line of reasoning particularly compelling. Mass bankruptcy along these lines would have sunk our economy into a depression so deep we would not have been able to claw our way out of for many years. Moreover, much of the “bad” investments that would have gone bankrupt in the wake of the crisis would have brought down many still “good” investments in an implosion of a general economic collapse.

Excluding a few notable libertarians like Ron Paul, most politicians and economists did not advocate this extreme of a position after the financial crisis of 2008. In many countries it was the Keynesian economists who provided most of intellectual firepower for the fiscal and monetary economic fixes post-crisis. The Keynesian school of thought is a bit like the yin to Austria’s yang (for a pretty hilarious “rap video” explaining the differences, see here). Keynesians, named after John Maynard Keynes who put forward the school of thought in the 1930s, argue the best way out of a recession is to expand aggregate demand by boosting government spending. Paul Krugman, today’s surrogate for Keynes, has forcibly argued for stimulus going far beyond what the United States government passed in 2008. “The whole thing was underpowered from the start,” Krugman argues.

In reality, the disagreements between mainstream economists both in the United States and in Europe lie somewhere between these poles. Of course there are intelligent people on both sides of the debate, but political realities often confine our choices to a much narrower, more conservative set of policy options. On both sides of the Atlantic, while we have seen very different approaches to resolving the Great Recession and the fiscal crises, we have not seen anything as radical as Krugman’s approach or as conservative as Hayek’s.


[1] There are plenty of credible economists who disagree that the Austrian school of thought accurately predicted the sources of the financial crisis. For example, see Paul Krugman’s article in Slate “The Hangover Theory.”

Written by Ann Hollingshead

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