What we learn from recessions

Posted: Jan 29, 2002 12:00 AM
All business cycles are different, and economists learn something new from every recession -- or rediscover something old that was forgotten. The current recession is no exception. This time, what is being rediscovered is something called the "Austrian" theory of the business cycle. The Austrian theory was developed in the 1920s by two Viennese economists, Ludwig von Mises and Friedrich Hayek. Their idea was that business cycles were caused primarily by the central bank. Through monetary policy, central banks lowered the interest rate from what would exist under free-market conditions. This set off a chain reaction that ultimately led to an economic boom, followed by the inevitable bust. To the Austrians, the interest rate is the central price for the entire economy, because it establishes the discount rate used for all investment decisions. Following the great Swedish economist Knut Wicksell, the Austrians believe there is a "natural" rate of interest, which ensures that saving and investment are appropriately matched. If the market interest rate should be below the natural rate, due to government regulation or monetary policy, then people will save too little and businesses will investment too much. If the market rate is above the natural rate, then people will save too much and businesses will invest too little. Monetary policy can easily affect market interest rates. When the Federal Reserve injects money into the financial system, it has the same effect as if people suddenly increased their saving, causing interest rates to fall. Because of supply and demand, more saving will lead to lower interest rates, all other things being equal. When the Fed withdraws money from the financial system, by selling government bonds, it has the opposite effect. In the Austrian view, therefore, business cycles result mainly from businesses making bad investment decisions that are caused by Fed interference with the interest rate. This inevitably creates misallocation of resources, so that factories are producing too many widgets and too few gizmos. Moreover, in the Austrian view, two wrongs don't make a right. The central bank cannot undo its mistakes by reversing course. A period in which the interest rate was too low cannot be fixed by raising the market rate above the natural rate. There is nothing to do, Austrians say, except stop fiddling with interest rates, allow the natural rate and the market rate to come together, and wait for the economy to reallocate its resources properly. In this process of readjustment, unemployment and bankruptcies are unavoidable. It is the only way that scarce resources, such as labor, can be reallocated from where they are not needed to where they have greater value. Unfortunately, labor and capital are not homogeneous, making this reallocation very painful and costly. Workers trained for one purpose cannot immediately be used for another, and machines built to make one type of good may not be able to be used to produce another. Anything government does to prevent this reallocation process only postpones it, delaying the time when full employment returns. This is a neat theory and was very popular until the Great Depression. At that time, the problem did not appear to be overinvestment, but underconsumption. Moreover, the Austrian view left no room for government action. If nothing else, this was politically untenable. Politicians were not going to just stand by and do nothing while the economy worked things out. After World War II, the Austrian business cycle theory was largely forgotten. Lately, however, Austrian theory has gotten a new lease on life. Economists studying the current business cycle have taken note of the fact that it is almost entirely caused by fluctuating investment. Heavy capital investment in the Internet and high technology fueled the boom. When market conditions could not sustain this investment, it collapsed. Since the end of last year, real nonresidential fixed investment has fallen 6 percent, explaining almost all of the decline in economic growth that we have seen. By contrast, real consumption has risen. This fact has rejuvenated interest in Austrian business cycle theory, as an explanation for the current recession. This month the International Monetary Fund published a paper on the subject by economist Stefan Erik Oppers. And articles mentioning Austrian theory have popped up recently in prominent business publications such as Forbes, Barron's and the Financial Times. There has also been renewed interest in Wicksell's work. It may be too soon to predict vindication for Austrian theory. Getting one recession right doesn't necessarily mean that the Austrian view can be taken as a general explanation for all recessions. Moreover, politicians have not changed their stripes -- Republicans are just as eager to pass "stimulus" legislation as Democrats these days, differing only on its form. Thus, even if economists accept the Austrian explanation for this recession, the Austrian "do nothing" cure still won't fly.