Arnold Kling  

Rothbard on the Depression

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My Plans... Unchecked and Unbalanced

I started to read it. Should I finish? Some excerpts and my comments.


the timidity and confusion of Reagonomics make very clear what its choice will be: massive inflation of money and credit, and hence the resumption of double-digit and perhaps higher inflation, which will drive interest rates even higher and prevent recovery. A Democratic administration may be expected to inflate with even more enthusiasm. We can look forward, therefore, not precisely to a 1929-type depression, but to an inflationary depression of massive proportions. Until then, the Austrian program of hard money, the gold standard, abolition of the Fed, and laissez-faire will have been rejected by everyone...Perhaps, this present and future economic holocaust will cause the American people to turn away from failed nostrums and toward the analysis and policy conclusions of the Austrian school.

That is from the preface to the 1983 edition, written in September of 1982. What are we to make of this Jeremiad? To me, the prediction in hindsight seems embarrassingly bad. What followed was the opposite of an inflationary depression. Instead, we had the Great Moderation.

Or shall we say that the past five years are a vindication for Rothbard? Hard-core Austrians would say, "We told you so. The Fed distorts patterns of production, creates booms, and then--crash! Fits our model exactly."

The problem for me is that they always tell us so. They always predict horrible macroeconomic events, just as the Marxists always used to predict ever-worsening crises for capitalism. If crises are a refutation of orthodoxy, then periods of normal growth can be refutations of heterodoxy.


Suppose a theory asserts that a certain policy will cure a depression. The government, obedient to the theory, puts the policy into effect. The depression is not cured. The critics and advocates of the theory now leap to the fore with conclusions. The critics say that failure proves the theory incorrect. The advocates say that the government erred in not pursuing the theory boldly enough, and that what is needed is stronger measures in the same direction. Now the point is that empirically there is no possible way to decide between them. Where is the empirical "test" to resolve the debate?

I would say that paragraph (emphasis in original) is indeed genuinely prophetic.

It is the well-known fact that capital-goods industries fluctuate more widely than do the consumer-goods industries.

Emphasis in the original. However, contra Rothbard, this is not a point of distinction between Austrians and Keynes. Keynes also locates the source of business fluctuations in business investment--he posits "animal spirits" rather than monetary distortion as the cause. Interestingly, Ed Leamer is emphatic in Macroeconomic Patterns and Stories that business cycles do not originate in the investment sector. "It's a consumer cycle, not a business cycle," is his mantra. On the other hand, the consumer cycle does manifest itself in housing and consumer durables, which allows for interest rates to play a causal role.

My main problem with the Austrian theory is that it presumes that businesses are highly myopic. An entrepreneur should be able to tell when the central bank is keeping interest rates too low. In that case, he should not say, "Oh, boy. Let me commit to long-term production based on these low interest rates." Instead, he should say, "I'd better be careful. These interest rates are artificially low."

I would be the last person to insist on rational expectations. But it does seem to me that rational expectations would destroy the Austrian channel for money to cause the business cycle. On the other hand, if you get rid of rational expectations, then all sorts of other things besides money could cause the business cycle. Why privilege the central bank as the only source of bubbles, the only locus of mistaken beliefs by entrepreneurs?

[UPDATE: Thanks to commenter Rod Long for pointing to Gene Callahan, who looks at the rational expectations critique of Austrian economics. Obviously, I am not the first person to think of this issue. Callahan rejoinders,


Even if we somehow did know that on, for instance, July 12, 1995, the interest rate was at its natural level, how could we relate that fact to what the rate should be now? Fed watchers might be able to tell entrepreneurs that the Fed is easing. But is it easing toward the market rate of interest from some level above it, or further past the market rate from some level already below it? The idea that entrepreneurs are committing significant errors by not somehow divining where the rate ought to be is to criticize them for lacking superhuman capacities.]


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COMMENTS (31 to date)
MichaelM writes:

Bounded rationality Arnold, bounded rationality.

How does an entrepreneur know when the interest rate as set by the central bank is too low? The information necessary to come to that conclusion is costly, very costly. Most every entrepreneur in an economy is rationally ignorant about where the interest rate should be because, in order to no longer be ignorant, he'd have to put thousands of hours into studying millions of transactions, and even then he'd only have the slightest of ideas.

Not to mention that even being wary of interest rates requires that the entrepreneur in question have knowledge of and adhere to the Austrian business cycle theory.

AC writes:

Why would it take thousands of hours of study for a business to account for a scenario of higher interest rates in the near future -- they don't have to know any theory at all. All they have to be thinking is "hey, what if these good times don't last forever"? At least in the simplistic version of the Austrian story, they seem to be totally unconcerned about it.

andy writes:

"My main problem with the Austrian theory is that it presumes that businesses are highly myopic. An entrepreneur should be able to tell when the central bank is keeping interest rates too low. In that case, he should not say, "Oh, boy. Let me commit to long-term production based on these low interest rates." Instead, he should say, "I'd better be careful. These interest rates are artificially low." "

There are 2 problems with this objection:
* Market price is both 'result' of market forces and 'incentive' to do some things. If government starts influencing the rate, you may know that this signal is wrong. But you do not have a better signal. It's like driving an airplane with totally non-sensical speedometer. The fact that you know that some information is wrong doesn't mean you know the correct information.

* The lower interest rate *means* that money is more available. The whole notion is based on the fact that prices do not change instantly. More money available means that more people have incentive to invest. However, if we assume good investors decide not to invest, the bad investors get the money.

One of the reasons market works is that it directs money from bad investors to the good investors. If the good investors know about the problem, they will refrain from investing - and the money can go to bad investors. If it still doesn't work, the Central bank WILL lower the interest rate further to make them invest.

It's a kind of prisoner dilemma.

Ron writes:

"I started to read it. Should I finish?"

Yes, you should. The current government "solutions" are very similar to the disastrous Hoover-FDR new deal (credit expansion, deficit spending, public works, protectionism, etc.), with similar results to date. Is history about to repeat itself?

Your insights after finishing it will be welcomed.

Bob Layson writes:

The entrepreneur may think that low interest rates produced by a flood of expanded credit is making a bubble riding on a period of genuine growth brought about by cost-reducing invention and globalisation. It's a boom either way and I can always get out before the bubble part of it pops, he thinks. And it's true that anyone can sell up in time - providing that too many don't attempt to be the one.

RPLong writes:
Why privilege the central bank as the only source of bubbles, the only locus of mistaken beliefs by entrepreneurs?

Mises, for one, did no such thing. He lived in a world where banks themselves caused localized bubbles with some regularity. He also watched central banks gradually take on a bigger role in credit expansion and crack-up booms.

I think there is a cogent enough story from the early 80s to today that involves credit and regulatory expansion. Let's not forget the role of US investors in the Asian and Latin American crises.

Sometimes we as economists grow accustomed to seeing market events in isolation, but the reality is that - just like the market itself - each event is often intertwined with several others.

Brian Shelley writes:

Austrian economic believers are a lot like Texans. It's not that we're wrong about being the best, we just have a bad habit of exaggerating.

MikeP writes:

How does the old joke go?

Austrians have predicted seven out of the last four recessions.

Thucydides writes:

Predicted 7 of last 4?

Is that like saying a back seat driver criticizing a wild driver warned of some crashes that were somehow averted?

When most mainstream economists not only failed to predict the current crisis, but worse, insisted it would not happen, who would you take more seriously?

fundamentalist writes:

The main reason to finish Rothbard is the good history. Sometimes Rothbard's polemics are hard to swallow, but he was a darn good historian. Like Braudel, his history is great, his conclusions not so much.

I don't understand why most Austrians are so pessimistic all of the time. I just don't get it. Always prophets of doom and gloom. Yet as Kling points out, we have enjoyed some really good periods of growth. If the market works as well as Austrians think it does, then we should be very optimistic. Look at China. It has far more state intervention in its economy, yet it grows rapidly. What's left of the free market in the US has overcome enormous amounts of state intervention and it will do it again.

The Austrian business cycle has two components - the boom and the bust. Why do Austrians fixate only on the bust? Why can't they enjoy the boom while it lasts? The Great Moderation was quite an achievement and Rothbard got it wrong. Why? He didn't factor in all the variables. Yes, Reagan had massive budget deficits, but he also enjoyed the deregulation under Carter and subsequent massive tax increases.

In several ways, paleo-Keynesian economics and Austrian economics are much more alike than Austrian econ and neo-Keynesian and neo-classical econ today. Keynes was not wrong about every single thing, just a few important things.

As for why businessmen don't respond to low interest rates there are several answers. As MichaelM wrote, bounded rationality is one answer. Another is that they follow mainstream econ theory, if they follow any theory, because it dominates in the schools and media. They are not Austrian. However, Hayek and Mises thought in the 1930's that businessmen would ignore the Fed's low interest rates as Austrian thinking became more widespread. Keynes nipped that in the bud.

(I know. Get my own blog.) Keep marginal theory in mind. Every businessman in the country does not run out and borrow money when the Feds reduce interest rates. Only a few do so. And if a few didn't, the Fed would continue to reduce interest rates until someone did borrow money. The Fed depends upon the weak wills and minds of the businessmen at the margin, those whose businesses can't survive or whose project can't get funded except at very low interest rates.

Also, I prefer the Hayekian version of the business cycle theory, which says that businessmen don't pay attention to interest rates. They respond to profits. Reduced interest rates change the profit structure of production in consumer goods and capital goods that reverses itself through time because of the Ricardo effect.

RPLong writes:
I don't understand why most Austrians are so pessimistic all of the time. I just don't get it. Always prophets of doom and gloom. Yet as Kling points out, we have enjoyed some really good periods of growth. If the market works as well as Austrians think it does, then we should be very optimistic. Look at China. It has far more state intervention in its economy, yet it grows rapidly. What's left of the free market in the US has overcome enormous amounts of state intervention and it will do it again.

Who's the greater optimist - the one who believes that people will naturally make the market function in spite of forces conspiring to overrule us, or the overlords themselves who insist that the economy requires constant tinkering to protect us from the "unfettered" effects of our own actions?

The single most appealing thing to me about Austiran economics is its undying optimism. Maybe you should give Mises another glance.

Jeff Haymond writes:
Look at China. It has far more state intervention in its economy, yet it grows rapidly. What's left of the free market in the US has overcome enormous amounts of state intervention and it will do it again.

Your assessment may be correct, but call me skeptical. The Chinese gov't is systematically directing capital to those industries that specialize in exports. This central planning leaves China highly vulnerable if and when exports are no longer cost effective. Could be for a multitude of reasons: no more US consumer able to buy, other nations w/even cheaper labor, rising costs in China, Renminbi rising, etc. When others see the muscle bound China, I see the same thing, only I think a see a large steroid needle back in the corner and wonder what the true state of those muscles are when the underlying consumer preferences are really known.

8 writes:

Businesses serve customers. Customers (and shareholders) are myopic.

Remember Jeff Vinick? He got fired from Fidelity Magellan for buying bonds in the late 1990s.

If you sell houses and lots of customers want to buy houses, here is your choice: sell them houses while rates are artificially low, or let your competitor sell them. If you're smart you'll mitigate the damage by not expanding production.

But what happens if the boom goes on a year longer than you expected? And then it turns into 2, 4, 6 years? By then, your shareholders have either fired you or accepted a takeover offer.

Greg Ransom writes:

Hayek explicitly identifies housing as a long term capital good.

It does fit Leamer.

In any case, this is an issue of contingent history, not theory.

Greg Ransom writes:

Housing and consumer durables are lon period non-permanent production goods -- exactly the material of Hayek's boom bust story. See hayek' Pure Theory of Capital.

Chris Lemens writes:

Professor:

You say --

An entrepreneur should be able to tell when the central bank is keeping interest rates too low. In that case, he should not say, "Oh, boy. Let me commit to long-term production based on these low interest rates." Instead, he should say, "I'd better be careful. These interest rates are artificially low."

I am a businessman. How do I know that interest rates are too low? None of the business publications I read say so. The government doesn't say so. The only economists who say so are the ones that the other economists call crackpots. So, how do I know that the price of money is wrong?

Moreover, assuming that I don't need external financing to pursue my investments, how do I know that the opportunities in which I am investing are ones that will disappear when interest rates move towards the unknowably right price? That would require me to know my customers' sensitivity to interest rates, and their customers' sensitivity, and so on in an endless regression of unknowables.

You seem to have missed Hayek's point that business people respond to prices because the obtaining the information leading to the price is so expensive to obtain. And, in any case, that information often cannot be formally known until conditions change and people respond to the change. Before then, it is just speculation.

Chris

Chris writes:

"My main problem with the Austrian theory is that it presumes that businesses are highly myopic."

Are the businesses being myopic, or are they rational in assuming the government is myopic?

Peter G. Klein writes:

Arnold, with respect, these are Austrian 101 questions. a) Austrian and Keynesian approaches to capital couldn't be more different -- the issue isn't volatility, but heterogeneity; b) Leamer is wrong; and c) the myopia issue has been covered extensively in the Austrian literature (knowing interest rates are artificially low doesn't tell you when they're going to rise). Keep reading, and consult some of your GMU colleagues who are supposed to be experts in this stuff.

fundamentalist writes:

Rplong, I think you misunderstood my post. I'm an Austrian economist, and yes I think Hayek and Mises were optimists. I was writing about the current crop of Austrian econ writers on the current crisis, who are unrelenting pessimists. If the ABCT is correct, and I'm convinced it is, at least Hayek's version, then the economy will recover from the current depression in spite of what the state does and we will enjoy several years of boom. We should let people know that we can expect several boom years.

Of course it will end badly; every boom has ended badly for the past 300 years. We have endured depressions every 6-8 years for the past three centuries. But we have also had 6-8 good years in between.

I think the quote from Rothbard emphasizes the pessimism of modern Austrian economists.

fundamentalist writes:

Jeff, check out this:

"The final panel at the Dow Jones Private Equity Conference included Carlyle Group co-founder David Rubenstein.

"Most of the questions by the moderator were directed at Rubenstien and he provided a long string of reasons why he thought China was the best place in the world to invest.

"He likened the present state of China to the United States in 1910.

"He said there were three types of Chinese companies to invest in:

"Embryonic companies that are providing services for domestic Chinese consumers.

"Larger companies that focus on the export market.

"State owned companies that are in the process of privatizing.

"He indicated that all three types made good investments.

"His enthusiasm for China did not stop there. He said that China encouraged Private Equity investments more so than any other country, including the U.S.

"I feel more welcome there than in the halls of Congress," he said.

"He said China will be the largest economy in the world by 2035. India will be second, the U.S. third and Brazil fourth."

http://www.economicpolicyjournal.com/2010/09/david-rubenstein-on-china-oligarchs-and.html

My main problem with the Austrian theory is that it presumes that businesses are highly myopic

Gene Callahan addresses this concern here:

http://mises.org/daily/2121#4

Rebecca Burlingame writes:

@fundamentalist,
Couldn't resist: Why do Austrians always focus on the bust? For the same reason Keynesians focus on the boom! It's that black and white world we live in...

ChanceH writes:

I don't think the "embarrassingly bad" prediction was really all that embarrassing. It was all conditioned on assumptions about the nature of response to the recession that turned out to be incorrect.

So it was a bad political prediction, but as an economic prediction it wasn't that much more than "if you print more money you'll get more inflation", was it?

Noah Yetter writes:

If the businessman is cautious, he will be outcompeted by the businessman who is reckless. He is trapped. The only way to win is by knowing the timing of the bust, which is impossible.

Vangel writes:
My main problem with the Austrian theory is that it presumes that businesses are highly myopic. An entrepreneur should be able to tell when the central bank is keeping interest rates too low. In that case, he should not say, "Oh, boy. Let me commit to long-term production based on these low interest rates." Instead, he should say, "I'd better be careful. These interest rates are artificially low."

There is a problem with this view. Because bubbles can last a long time businesses are often forced to make a choice between being prudent and reckless. If the bubble last long enough the reckless businesses will show much greater profits and be able to buy up those businesses who saw the bubble forming and decided to take the prudent course.

Imagine being the president of a bank that chose to have strict lending rules and ensure that appraisals were accurate and that incomes were verified. You would lose market share to your idiot competitors who chose to do what they must to stay in the game without regard to consequences. Your shareholders would be angry and would take the first opportunity to dump you or to sell to the reckless bank that is using its inflated shares as currency.

It is also clear to Austrians that many managers who chose to be very reckless and go after the massive rewards that came from short term thinking were right to do so. Imagine being the 52 year old CEO who worked his way to 750K per year after 25 years of working. If you choose to go all out and take massive risks you could earn $50 million a year for two or three years that would be yours to keep even if the bank went under in the forth year after the decision was made. If you play your cards right you would still be around at 55 to take a huge retirement package and go take a long trip around the world waiting for the crisis that you see coming. Yes, you might wind up with a low reputation for a time but several hundred million is a good payment for that loss of reputation and far more profitable than staying the course and wind up with two or three million before your board fired you for not performing.

What is true for the bank president is just as true for our local entrepreneur, who needs to weigh the risks of being prudent and being driven out of business by the reckless players with being cautious and hoping that he would still be around to profit when the bubble bursts. Is it better to be very rich and wind up with a failed business in a failed economy or to be poor with a solid business that cannot generate profit because the economy collapsed?

Vangel writes:
Most every entrepreneur in an economy is rationally ignorant about where the interest rate should be because, in order to no longer be ignorant, he'd have to put thousands of hours into studying millions of transactions, and even then he'd only have the slightest of ideas.

I do not think that this has to be true for the entrepreneur to find himself in trouble. Even if interest rates are too low many who chose to be careful will wind up being driven out of business by their reckless competitors if the conditions last a long period of time.

Vangel writes:
I don't understand why most Austrians are so pessimistic all of the time. I just don't get it. Always prophets of doom and gloom.

Austrians understand incentives and know history and human nature. For most of the past century the incentive for politicians was to intervene in the markets and to hand out goodies to voters. To expect that they would do otherwise is to ignore human nature.

That said, I do not believe that Austrians are pessimistic about the long term or about their own personal futures. By being able to see the problems that were developing better than most of the population Austrians are in better position to thrive during crises as well as during the good times. And theirs is the optimistic position because they trust human beings to progress if governments stay out of the way. The pessimists are those who do not trust people to do the right thing when governments get out of the way.

Doc Merlin writes:

'housing and consumer durables'

Bah! Stop treating housing as a consumer good. Its been treated as an investment good for decades now. Its also the main form of savings for most americans.

Colin k writes:

To extend on Chris Lehman above, I have been running my own company since 2004, and the interest rate has never once been a topic of discussion for me. The only things we talk about are prices and sales volumes, and occasionally the macro-economy, though that is more water-cooler talk than a guiding factor for us. FWIW, we've grown about 20% in 2009 and 2010 thus far.

Greg Ransom writes:

I've never understood how this argument is persuasive to anyone who understands Hayekian macro or follows the business world:

"My main problem with the Austrian theory is that it presumes that businesses are highly myopic."

Read Michael Lewis's book _The Big Short_ and read about just how hard it was to bet against the housing boom / securitized mortgage market. And note well that those who see what is happen are often people with very little money or the reputation and contacts to leverage the masses of capital required to bet against the boom -- and then of course there is the massive and impossible problem of market timing.

ivan writes:

"Instead, he should say, "I'd better be careful. These interest rates are artificially low." "

Why should he? Consider a car maker. The FED artificially stimulates demand of cars by setting intrest rates very low. That increase in demand is unsustainable. Suppose the car maker knows that. Should he not try to meet that demand? Of course he does, because he also knows that when things goes wrong he will almost certainly be bailed-out. He can reap the profits now and socialize the losses later, when the bubble burst.

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