Economics and business reporter David Warsh is getting much attention for suggesting that F. A. Hayek, far from being one of the two most prominent economists of the 1930s – the other being Keynes – is rather more like the woman who was thought to have won the Boston marathon in 1980 when in fact she had joined the race, mostly unnoticed, a half-mile from the finish line.

Hayek’s fans “have jumped a caricature out of the bushes late in the day and claim that their guy ran a great race,” Warsh writes. “. . . But the fact remains that Hayek just didn’t contribute very much to the development of technical economics,” he continues.

Warsh, whom we may judge by the fact that he calls The Road to Serfdom “an embarrassment,” nonetheless does have some positive things to say about the 1974 Nobel Prize laureate: “With the publication of ‘The Use of Knowledge in Society’ in the American Economic Review in 1945, he essentially won on the ‘calculation debate,’ conducted with Ludwig von Mises and Oscar Lange, concerning the possibility of central planning.”

Considering how many respectable economists favored central planning – essentially the abolition of spontaneous competitive markets — until fairly recently, that would seem to be no mean feat. And there’s more:

[I]t is pleasing to think that Hayek himself may yet turn out to have been a very great economist after all, far more significant than [Gunnar] Myrdal or [Joan] Robinson, when seen against the background of a broader canvas.  The proposition that markets are fundamentally evolutionary mechanisms runs through Hayek’s work. [Bruce] Caldwell, of Duke University, notes that, starting with the Constitution of Liberty, “the twin ideas of evolution and spontaneous order” become prominent, especially the idea of cultural evolution, with its emphasis on rules, norms, and decentralization.

These are today lively concepts in laboratories and universities around the world. ‘It could have been that Hayek was running a different race, and the fact that he didn’t do well in the [mainstream] Walrasian race was that he wasn’t running in it — he was running in the complexity race,’ says David Colander, of Middlebury College. Hayek may yet enter history as a prophet of evolutionary economics, a discipline dreamt of since the days of Thorstein Veblen and Alfred Marshall in the late nineteenth century but not yet forged, whose great days lie ahead. [Emphasis added.]

In other words, maybe Hayek’s critics judge him by an inappropriate standard. We’ll get back to this.

Krugman Pile-on

As Jacob T. Levy surmises, not everyone eager to dismiss Hayek as a lightweight read Warsh’s post to the end. Take Paul Krugman, ever ready to trash anyone who doubts that Keynes was the fount of all wisdom:

David Warsh finally says what someone needed to say: Friedrich Hayek is not an important figure in the history of macroeconomics.

These days, you constantly see articles that make it seem as if there was a great debate in the 1930s between Keynes and Hayek, and that this debate has continued through the generations. As Warsh says, nothing like this happened. Hayek essentially made a fool of himself early in the Great Depression, and his ideas vanished from the professional discussion. . . .

[T]he Hayek thing is almost entirely about politics rather than economics. Without The Road To Serfdom — and the way that book was used by vested interests to oppose the welfare state — nobody would be talking about his business cycle ideas.

Hayekians Strike Back

The Hayekian wing of the blogosphere (which really has nothing to do with the right wing) has responded in force, and properly so. A common theme is that Hayek furnished the grounds for a proper skepticism about macroeconomics, the branch of economics launched by Keynes that treats large statistical aggregates (demand, unemployment, and so on) as though  they were concrete entities that interact with each according to fixed quantitative rules rather than historical “summations” of individual purposeful actions in a particular institutional context. As Hayek wrote,  “Mr. Keynes’ aggregates conceal the most fundamental mechanisms of change.” (See Steven Horwitz’s “Mr. Keynes’s Aggregates.”)

George Mason University professor (and FEE trustee) Peter Boettke at Coordination Problem wrote:

Hayek’s influence in modern economics is ubiquitous, even if sadly modern economics is not as Hayekian as I would like it to be.  Information economics, theories of dynamic competition, equilibrium theory of the business cycle, and complexity theory all owe a debt to Hayek’s economic contributions.  The work on legal origins owes a debt to Hayek’s work on law and political-social philosophy as well.  Hayek impacts the DNA of economics and political economy to such an extent that many are unaware of the pervasive influence. . . .

The final problem I have with both Krugman and Warsh is that they don’t actually consult the historical record and the accounts of those who were there in the 1930s when the battle was engaged or the direct citation evidence from post-WWII thinkers. . . . Instead they rely on impressionistic accounts from their education and discourse communities, and cherry pick from recent journalistic histories of economics.

Back with a Vengeance

And there’s this from GMU professor Alex Tabarrok at Marginal Revolution:

It is true that many of Hayek’s specific ideas about business cycles vanished from the mainstream discussion under the Keynesian juggernaut but what Krugman and Warsh miss is that Hayek’s vision of how to think about macroeconomics came back with a vengeance in the 1970s. . . .

Hayek was an important inspiration in the modern program to build macroeconomics on microfoundations.

Tabarrok notes that “in an interesting exercise David Skarbek finds that Hayek is cited by other Nobel laureates in their Nobel talks more than any other Nobel laureate with the exception of [Kenneth] Arrow.”

GMU’s Russ Roberts responded this way at Café Hayek:

Was Hayek an important macroeconomist? I would argue that the macroeconomic skepticism of the later Hayek is more valuable than the macroeconomic theorizing of the early Hayek. But he wasn’t an important macroeconomist in the mainstream sense of the title. So what? That’s a badge of honor. He was merely a great economist, without any prefix.

Rejecting the Rules

There are others, but I will close with a post from New York University’s Mario Rizzo at ThinkMarkets, one of the most perceptive people I know. Remember the remark above that “It could have been that Hayek was running a different race”? That’s Rizzo’s take.

I think the real issue is this. Hayek’s approach attacks, root-and-branch, the macroeconomic way of thinking. It is not simply a challenge to a particular theory of the determinants of mass unemployment, inflation, business cycles and the like. Hayek is not accepting the rules of the game or the parameters of the sub-discipline of modern macroeconomics. . . .

In short, he does not want to focus on aggregate spending and aggregate consequences. Hayek’s approach says: Let us pierce the veil of aggregates and look at the distortive effects on relative prices and relative output produced by boom-time credit expansions. Let us look at the distortive effects that booms leave us as we work our way through a recession. . . .

Suffice it to say this greatly erodes the intellectual capital of a field of economics – although one not noted for its successes. It mocks the claim that Keynes was a true revolutionary in economic thought. It opens the possibility that he was muddled, inconsistent and unaware of the contributions to monetary and business cycle theory made by the “classical economists” on the eve of the General Theory.

(By cutting out many details, I have not done these blog posts justice. Follow the links for the particulars.)

Hayek was important politically for demonstrating the practical social necessity of individual freedom. But he is just as important for what he taught us about markets: namely, that they provide the only way for human beings to overcome their individual deficiencies in knowledge, which would otherwise keep them from flourishing through social cooperation and the division of labor.

These experts, armed with the most sophisticated methods available, gave the journalists what they needed. In turn the journalists—armed with what they uncritically accepted as good information—returned with coffee to their keyboards and reported.

Witness:

Mark Zandi, chief economist at Moody’s Analytics, is frequently the go-to guy for both parties when it comes to analysis of various jobs proposals. So, what did he think of President Obama’s speech last night? Here’s the report: “The plan would add 2 percentage points to GDP growth next year, add 1.9 million jobs, and cut the unemployment rate by a percentage point.” [Brad Plummer, “Ezra Klein’s Wonkblog,” Washington Post, September 9.]

And who are the willing consumers of this information? People looking for reasons to be hopeful. People looking for certainty. Who can blame them? Times are tough.

But this sort of reporting is just scientism on display. I’m not alone in thinking this. Economist Russ Roberts, reacting to similar reporting in the Financial Times, wrote at Cafe Hayek (September 13): “Really? That’s what they found? [The journalist] treats it like a discovery of fact. As in ‘[Alan] Blinder and Zandi weren’t sure of the distance between the earth and the sun but when they measured it, they found it was about 93,000,000 miles.’”

Roberts knows economists aren’t capable of auguring such things. Because when it comes to national-level prediction and forecast, economics has all the reliability of a Farmer’s Almanac. And that’s being charitable.

Certainty for Sale

Here’s the problem: People like Mark Zandi belong to a great power nexus that relies on scientism for its very existence. To repeat: People crave certainty. Politicians crave power. So the latter have to provide the former with at least the illusion of certainty to stay in office. But they can’t do it alone.

Economists—especially those who tend to get tapped by the media or by Washington elites—are the ones willing to strut around on the national stage showing their predictive plumage. Journalists, no experts themselves, report what they’re told. (And few try to spot the turkey behind all that peacocking.)

But as readers of this publication know, a nexus of politicians, economists, journalists, special interests, and a desperate lay public can hardly be virtuous. This industry enables peddlers of scientism to hock their wares in a world full of uncertainty. Indeed, a pseudo-certainty creates the circumstances under which great wishes can father great lies.

F. A. Hayek warned us about this, of course, when he said, “It seems to me that this failure of the economists to guide policy more successfully is closely connected with their propensity to imitate as closely as possible the procedures of the brilliantly successful physical sciences—an attempt which in our field may lead to outright error. It is an approach which has come to be described as the “scientistic” attitude. . . .”

Since Hayek, a growing movement of great minds, across disciplines, warns us to clip our wax wings.

Chaos Rules

In 1961 Edward Lorenz discovered the “butterfly effect.” Ironically, when he figured out that tiny changes in initial conditions could mean seismic shifts in the rest of a system, he was studying weather and climate. I won’t discuss the irony here. Suffice it to say Lorenz is the one who taught us that complex systems—whether the climate, an ecosystem, or an economy—can also be chaotic systems. “I realized,” said Lorenz of his then-obscure finding, “that any physical system that behaved nonperiodically would be unpredictable.”

Although “chaotic” eludes strict definition, the term usually refers to a system that is sensitive to changes in initial conditions, shows order without regularity, and is immune to prediction and forecast.

In his still-vibrant Chaos (1989), James Gleick tells Lorenz’s story—including the latter’s discoveries and the implications of chaos. “Forecasts of economic growth or unemployment were put forward with an implied precision of two or three decimal places,” writes Gleick. “Governments and financial institutions paid for such predictions and acted on them, perhaps out of necessity or for want of anything better. . . . But few realized how fragile was the very process of modeling flows on computers, even when the data [were] recognizably trustworthy and the laws were purely physical, as in weather forecasting.”

Little has changed.

Aggregates, Agents, and Ants

I think the failure of macroeconomics can be boiled down to this: Macroeconomics deals primarily with aggregates, or macro-level trends. But to be truly accurate the macro level would have to be explained in terms of the micro—that is, individual agent behavior. Micro behaviors give rise to macro trends. Another way of putting this is that macro trends are dependent on micro behaviors. The trouble is, individual agents interact with—and react to—one another in diverse, complicated ways.

Similarly, it’s impossible to predict exactly what an ant colony will do when confronted with two picnics at equal distances from the colony. In that famous experiment we might be able to predict a single ant’s behavior if we have lots of local information about its pheromone secretion algorithms and such. But relative to each food source it would be impossible to predict the behavior of the colony as a whole. Such is life at the edge of chaos.

A Blind Spot

Now of course we have processors that can crunch tons of data. We have a new breed of mathematical wizards in the tradition of Paul Samuelson who can write whole tracts with as many equations as words. And we have whole new constituencies of politicians, pundits, and people ready to believe. So are we finally living in a time when macroeconomics can tell us what we need to know about unemployment in a year—as Newtonian mechanics tells us when Halley’s Comet will arrive?

Alas no, says mathematician William Byers. In his excellent The Blind Spot, Byers makes an audacious argument for humility in the sciences—both hard and human: “Human beings have a basic need for certainty. Yet since things are ultimately uncertain, we satisfy this need by creating artificial islands of certainty. We create models of reality and then insist that the models are reality. It is not that science, mathematics, and statistics do not provide useful information about the real world. The problem lies in making excessive claims for the validity of these methods and models and believing them to be absolutely certain.”

Interestingly, Byers also picks up on the idea of selling certainty. Whether he’s talking about the complicated financial instruments that obscured the problems leading to the financial meltdown, or the schematics for all the Keynesian fixes that followed, models are the conduits of pseudo-certainty. “The more complex the package and the more arcane the mathematics, the better,” says Byers. “What was being sold was the faith that the complex, human, world of economics and finance could be made over in the image of science, could be made objective and predictable.”

Byers goes on to explain that there is a kind of quantification bias at work. That is, if you can describe things in mathematics, you are in some sense speaking the language of nature. But limning the world in numbers has its limits—especially since so many of the important aspects of science are subjective. And so many aspects of nature are, well, uncertain. Numbers, argues Byers, are our attempt to create the illusion of objectivity—where objectivity is thought to be the very stuff of certainty. But “science does great damage when it turns into ideology, when it begins to worship certainty.”

The (Other) Freeman

Eminent physicist Freeman Dyson is no libertarian. But his call for humility in science (“Heretical Thoughts about Science and Society,”) extends to economics, too:

The politicians and the public expect science to provide answers to the problems. Scientific experts are paid and encouraged to provide answers. The public does not have much use for a scientist who says, “Sorry, but we don’t know.” The public prefers to listen to scientists who give confident answers to questions and make confident predictions of what will happen as a result of human activities. So it happens that the experts who talk publicly about politically contentious questions tend to speak more clearly than they think. They make confident predictions about the future, and end up believing their own predictions. Their predictions become dogmas which they do not question. The public is led to believe that the fashionable scientific dogmas are true, and it may sometimes happen that they are wrong. That is why heretics who question the dogmas are needed.

So if Dyson is right about the need for heretics, are those skeptical of macroeconomics heretics or “market fundamentalists”?

People who understand markets know they can’t do everything under the sun. Yes, markets can and do work wonders. But most truly liberal thinkers start with a particular kind of skepticism:

• Knowledge is dispersed, not centralized. Planning or tweaking by central authorities is a fool’s errand and results in perverse effects. (Skepticism of grand designs.)
• Centralized power tends to corrupt people. Coalitions of interests, bureaucrats, and moralists form to transfer resources from the masses or from competitors to the pockets of coalition members. (Skepticism of power wielded for the “public good.”)
• Value is not objective but rather subjective. This not only makes market exchanges possible, but makes it difficult for any central authority to claim it is operating in the name of a universal good. (Skepticism of claims to objective value. [See my “The Relentless Subjectivity of Value.”])

I could go on. Suffice it to say that to be a classical liberal is to be a heretic. And for heretics skepticism is a prime virtue. Yes, we tend to admire the market process. But unlike those who prostrate themselves before the golden calf of Aggregate Demand or Government as God, we are skeptics first and foremost.

Soothsayers and Charlatans

When it comes to heresy in economics Arnold Kling comes to mind. Writing in The American, he says: “I think that if the press were aware of the intellectual history and lack of scientific standing of the models, it would cease rounding up these usual suspects. Macroeconometrics stands discredited among mainstream academic economists. Applying macroeconometric models to questions of fiscal policy is the equivalent of using pre-Copernican astronomy to launch a satellite or using bleeding to treat an infection.”

Kling says economists should be more honest about their limitations. He thinks the Congressional Budget Office, with all its scoring, can do little to predict the effects of various policy scenarios, such as taxing and spending: “The CBO adds value to policymakers by ‘scoring’ the impact of policies on the budget. However, the ‘scoring’ of policies in terms of GDP growth or jobs saved is of no value. The CBO should simply refuse to do it, and the consulting firms that purport to provide such estimates should be regarded as the charlatans they are.”

An Uncertain Constituency

Though the methods used by these macroeconomists are no more reliable than “soothsaying or entrail-reading,” they belong to that great nexus of power, which creates incentives for folks to “step right up” for more of the same elixir.

Sadly there is no competing power nexus. And yet people are growing increasingly suspicious of these nostra. Just as Americans have grown weary of intervention in foreign affairs, they’re growing weary of intervention in the economy, too. Call it what you like—stimulus bills, jobs plans, back-to-work schemes, or whatever—fiscal interventionism is not producing the desired effect. And people are getting wise to it. In the old days they ran the charlatans out of town.

SMUT

SMUT is the acronym I use in my classes to refer to the Subjective Marginal-Utility Theory of value.  A little crude perhaps but memorable, which is the point.  It says that the value to a person of any good or service, water for example, is the usefulness (subjective utility) of the last unit of it she obtains.

If she’s dying of thirst in the desert, the last or marginal liter of water probably (though not necessarily) has very high value to her because it is likely the first and only liter she commands and so would be useful in satisfying her most urgent want – presumably to sustain her life for another hour or so.  A second liter would also be very useful in this sense, though it would satisfy a want a little less highly ranked than the first and so less subjectively valuable to her.  And so on.

The idea here is that the value to her of water, not water in general but of the marginal unit, depends on how many units she already has command over.  Back in civilization, water would probably have much less value to her because she would have a lot of water at her fingertips (sometimes literally); so another liter of it would be useful only in satisfying a want that is very low on her scale of wants.

Note something else important here: Value is not something disembodied; it depends on the end to which a particular person puts the good or service, be it water or labor.

Modern economics is based on SMUT – price theory, capital theory, monetary theory – which arose as a result of its simultaneous and independent discovery in 1871 by the Austrian economist Carl Menger and the English economist William Stanley Jevons, and in 1874 by the French economist Leon Walras in Switzerland.

(For elaboration of SMUT, see Sheldon Richman’s “Value, Cost, Marginal Utility, and Böhm-Bawerk.”)

The Labor Theory of Value

In time, SMUT-based economics replaced the edifice of classical economics, which was based on the so-called labor theory of value.

In it’s simplest terms, the labor theory of value, or LTV, states that the value of any good or service depends on the amount of labor that goes into its production.  While it makes some intuitive sense – the more labor we put into something the more valuable the output seems to be – it encounters all sorts of problems.

For example, if the LTV is true, spending four hours digging a hole and then spending another four hours filling it back up would be worth eight labor hours of value.  It should therefore trade for, say, a wooden table that took eight hours of labor to manufacture.  But I’m guessing that it would be to very hard find anyone willing to trade the latter for the former, although as P.T. Barnum is credited with saying there’s a sucker born every minute.

Also, putting in a lot of hours in a job that doesn’t produce anything useful, such as building houses when housing demand is slack, doesn’t make those houses more valuable.  In fact, it makes houses in general less valuable.  No, we would work hard building houses only if we expected those houses when they’re finished to be subjectively valuable enough (to us or someone else) to cover the (subjective) costs of their manufacture.

Rejecting SMUT

The macroeconomics of mainstream pundits is essentially a rejection of SMUT.  Although not exactly the same, it’s still a throwback to the discredited labor theory of value.  Let me explain.

In simple terms, their theory says gross domestic product (Y) consists of three aggregate variables:  private consumption spending (C), private investment by businesses (I), and government spending (G).  This gives the widely used formula for the entire macroeconomy as

Y = C + I + G.

The problem, according to simple Keynesian macrotheory (and that seems to be the predominant version guiding public intellectuals these days), is that Y is in the doldrums because the private sector, C + I, just isn’t growing.  So it’s up to government to increase spending to raise G and stimulate Y.

(Actually, according to the data, C has been doing pretty well since the beginning of 2010.  See the Robert Higgs’s analysis of the data in “One More Time: Consumption Spending HAS Already Recovered.”)

Now, increasing G is supposed to “create” more jobs.  What kind of jobs are the best to do this “stimulating”?  The answer, according to one Nobel-Prize-winning economist, is that it doesn’t really matter (as this YouTube video strongly suggests): war, natural disasters, fighting space invaders, anything.  Creating jobs, any jobs, is an end in itself.

The Kind of Jobs Matters

From the point of view of SMUT this is all pretty nuts.  Remember, the value of anything, including labor and what it produces, is never disembodied: It is always valuable to someone for something.

For instance, unless you at least recognize that value issues from the subjective perception of individuals, the idea of economic efficiency goes out the window.  Economic efficiency depends on benefits being greater than costs, but again it’s never benefits and costs disembodied from purposeful action.  Benefits and costs are always benefits and costs for someone from doing something.

Likewise a job is a job for someone to do something.  Building a house or a bridge or a car has to have a value to someone, expressed in terms of a market price someone is able and willing to pay that will cover its cost. Otherwise building it is a pure waste.  Unfortunately, macro-pundits don’t care about efficiency or producing value in this sense.  It’s just jobs, jobs, jobs!

Really, it’s the modern equivalent of digging a hole and filling it back up again, the modern version of the LTV, and it’s just as wrong as the old one.

***

(If you’re wondering what a sound macroeconomics looks like, check out, among others, these books by Steve Horwitz, Roger Garrison, and Peter Lewin.)

One of the first things I have to disabuse my students of in introductory microeconomics is the belief that microeconomics is about the “little picture,” while macroeconomics is about the “big picture.” First, what self-respecting scientist would deliberately choose only to study the little picture? Even microbiologists believe they’re dealing with major problems such as the nature of life and disease. Beyond that, the prefixes “macro” and “micro” don’t refer to the scope of the subject but to, you guessed it, the unit of analysis.

(To be fair, those prefixes are unfortunate choices, but it seems for the time being we’re stuck with them.)

This confusion is understandable because traditionally at the undergraduate level macroeconomics courses do deal with economy-wide output, employment, inflation, and the like, all of which are indeed big-picture issues. And courses in microeconomics usually cover things like value theory, individual choice, and market demand and supply, which, while important, do seem smaller in scale than macroeconomic problems.

However, my colleague Roger Garrison captures the relevance of making the right choice in the unit of analysis in his phrase, “There are macroeconomic problems, but only microeconomic solutions.” To understand the “big picture,” you’ve got to begin with the microfoundations.

Macroeconomic Problems

One of the great differences between, say, a contemporary Keynesian economist like Paul Krugman and a modern Austrian macroeconomist like Garrison is that Krugman sees the current recession as chiefly a problem of aggregate spending: If only economy-wide spending by consumers and especially businesses would increase, the economy would wake from its doldrums. Because Krugman doesn’t think it’s helpful to look behind these aggregates – to the fact that not all labor is substitutable or that residential construction is significantly different from bridge building – it doesn’t much matter what people spend their incomes and savings on. For him the problem is that for whatever reason people aren’t spending voluntarily.

Government spending via stimulus packages or “quantitative easing” is a blunt instrument, but because in standard Keynesian macroeconomics the variables to be manipulated are themselves pretty blunt – aggregate demand and aggregate supply – these policy tools are entirely appropriate for the task at hand. You wouldn’t think that having only a sledgehammer in your toolbox is a problem if you think your job is only to pound giant spikes. But when the job actually requires a crosscut saw or a Phillips screwdriver, then you’ve got a problem.

Microeconomic Solutions

From the Austrian viewpoint, while the recession and persistently high unemployment are indeed macroeconomic problems, that doesn’t mean the sources and the solutions are also at the macroeconomic level. In the field of public health, epidemiologists are beginning to understand something similar.

If there’s a threat of a flu epidemic, the best solution is not to spend resources inoculating everyone in sight. The social-network theorists Christakis and Fowler report that it would be more sensible to find out how flu spreads, that is, who are the most likely carriers and spreaders – say, those who come into contact with a lot of potential victims: doctors, nurses, and teachers – and make sure that they get the vaccine first.

Similarly, for an Austrian, just increasing aggregate demand is not only ineffective, it’s potentially dangerous. For example, government spending to re-stimulate the housing market, which is a sector within the macroecomy that isn’t doing too well right now in some (but not all) places, is from this perspective a bizarre remedy for a recession whose immediate cause was a housing bubble. Yet, guided by Keynesian thinking and the aggregate unit of analysis, this is precisely what Congress and the President are trying to do.

So just because national unemployment or declining cities are pressing problems, that doesn’t mean that you can solve it by spending more at the national level to get the aggregate numbers down. You need to ask what are the choices people make – the poor, the unemployed, as well as those who could help or employ them – that create these problems and what are the knowledge and incentives at the individual level that result in that aggregate outcome.

Micro-foundations of Cities

In the case of cities the great urbanist Jane Jacobs relentlessly and effectively attacked the urban-planning orthodoxy of the 1950s for imposing someone’s ideal bird’s-eye, macro-urban vision on the micro-fabric of great cities. Rather than try to understand from the ground up how cities’ spontaneous processes work – the informal neighborhood networks, the diverse knowledge and skills and tastes that both attract people to, and themselves generate the opportunities found in, great cities – the planners sought to directly shape the macro-urban landscape, gardener-like, according to their own ideal, usually rationalistic central plan. It is just like saying, “Wow, these 500-year-old quadrangles at Oxford University are lovely; let’s build some in Las Vegas!”

As Robert Caro documents in The Power Broker, his great book about New York’s city planner, Robert Moses, too often the results were massive highway and urban-renewal projects that tore apart living neighborhoods, disrupting and destroying lives and the economic vitality of once-thriving city districts.

Choosing the right unit of analysis is more than an academic exercise. It’s a matter of poverty and prosperity, even of death and life.

This makes perfect sense. If banks don’t engage in risky lending again, how ever will the government be able continue “rescuing” them.

FEE Timely Classic:
“Economic Fascism” by Thomas DiLorenzo

He has since repeated this bon mot in a number of columns and television appearances. Like Keynes, Krugman lets his fondness for flippant, pithy sayings get in the way of regard for long-run economic prosperity. (Keynes famously remarked that “In the long run we are all dead,” ignoring the fact that in the long run others are alive.)

It is true, as the graph shows, that the country’s gross domestic product rose sharply during the war.

But GDP measures only the total monetary value of production while ignoring what is actually produced. It is just a number, a number that would be no different if consumer goods were produced and sold or if the government set the workforce to making mud pies and then purchased those pies for a like sum. Yet what is produced makes all the difference. The point of an economy is to improve people’s lives by producing goods and services they want and need.

During the war the P in GDP largely consisted of the munitions needed to defeat the Axis powers. While these weapons were necessary to win the war, they did nothing to provide food, clothing, and shelter. Despite all the production increases that came with the war, the American people were materially worse off while it lasted. Some 15 million American men and women, over 10 percent of the population, served in the armed forces. Living, and sometimes dying, in a foxhole was not an improvement over stateside life—even life during the worst of the Depression. Back in the States living standards also dropped (though not as dramatically) as consumer goods, including food and gasoline, were rationed.

Bridges to Nowhere But Recovery?

Krugman, however, is interested in jobs rather than production. He wants the government to spend massive amounts of money and is relatively indifferent as to how the money is spent: “Let the government borrow money and use the funds to finance public investment projects—if possible to good purpose, but that is a secondary consideration—and thereby provide jobs, which will make people more willing to spend, which will generate still more jobs, and so on.”

This indifference is a logical outcome of his belief that the war ended the Great Depression. If, as Krugman thinks, the economy was rescued then by expending huge amounts of resources to build weapons that disappeared overseas, then we would be that much better off now if the government spent a similar amount of resources on things that have even marginal utility—say, bridges to nowhere. If the bridges provide any long-term economic benefit at all, that would just be icing on the cake.

Economically, however, World War II did not spark a recovery so much as it created a financial bubble—not in Internet stocks or housing but in

munitions. Once the war was over, the bubble collapsed along with the demand for aircraft carriers and B-17 bombers.

The war’s outbreak necessitated two policy changes, though, that did aid the postwar recovery. First, President Roosevelt stopped his incessant attacks on business. As Amity Shlaes points out in The Forgotten Man, FDR needed big business to produce the tanks, planes, and ships required to defeat Hitler and his allies. Second, he ended his erratic, trial-and-error experimentation. Before the war the stated strategy of FDR and his Brain Trust was to try one program after another until they found something that worked. This resulted in perpetual market churn that made long-term planning and investment especially risky if not impossible. Another result was the creation of myriad tiny, short-lived bubbles. Jobs were created in various locations and in various crafts only to disappear when the government lost interest and shifted its gaze.

Yet Krugman elsewhere prescribes this same strategy of experimentation for today’s financial woes: “The point of all this is to approach the current crisis in the spirit that we’ll do whatever it takes to turn things around; if what has been done so far isn’t enough, do more and do something different, until credit starts to flow and the real economy starts to recover.”

The Don Ho School

World War II forced Roosevelt to concentrate on a single area of production: weapons. This focus was maintained for the duration of the war and resulted in a sustained economic bubble. Without a similar attention-focusing crisis, however, current government attempts at stimulus will simply result in economic effervescence—tiny bubbles inflating and bursting as the winds of politics shift lawmakers’ attention. Call it the Don Ho School of Economic Thought.

The inability of the Obama administration’s deficit spending to spark economic recovery may be masked for a time by the Fed’s continued expansion of the money supply. Inflation could resurrect the housing bubble, providing a brief uptick in the economy, but such policies cannot be maintained for long.

What the country needs is not more economic bubbles—tiny or otherwise. It needs sustained economic growth. That will come by strengthening the private sector, not by strengthening government. The best way to do this is to reduce government spending, which crowds out the private kind, and to enact long-term tax cuts.

Contrary to popular belief, the “public works program” known as World War II did not end the Great Depression; it ended the New Deal. The end of the war brought federal spending and tax cuts and the repeal of the Smoot-Hawley tariffs. All these changes combined to pull the nation’s economy out of its long and painful slide, and all could have been made without the war. Similar changes made now could restore the world’s economy without the massive human suffering that, in their absence, is all but inevitable. Inevitable, yet so avoidable and so unnecessary.

Lewis poses excellent questions and gives fairly good answers. His questions include: Should prices in general be stable, fall, or rise? and Should the stock of money grow continuously, never, or sometimes? He conducts a dialog with himself over these questions, first defending a “yes” answer, then a “no,” and then offering additional replies and counter-replies. His sympathies lie with what he describes as “the Austrian, laissez-faire, or free-market point of view,” but he endeavors to represent the alternative Keynesian view fairly.

Lewis is to be applauded for presenting the case for letting prices fall in a growing economy. Unfortunately he appears to have overlooked some of the strongest previous presentations of that case. We must distinguish between a harmless deflation, where technological progress or other sources of improved productivity lower costs and thereby gently draw prices down, and a harmful deflation, where shrinkage in the stock of money or its velocity brings unsold inventories and thereby painfully forces prices down. Lewis recognizes a distinction between gentle and painful, but oddly claims that, in the view of its defenders, “deflation is always good,” even when “quite painful.” Claiming that deflation is always good is absurd because there is no benefit from deliberately creating a deflation by shrinking the money stock. Auric Goldfinger’s plan, in the James Bond story, to nuke the gold in Fort Knox, thereby raising the purchasing power of his own gold, was the plan of a villain not a hero. Just as a central-bank-engineered monetary expansion disrupts the economy and causes misallocation of resources—something Lewis recognizes—so too does a central-bank-engineered monetary contraction.

To his credit Lewis identifies the error of monetary expansionism: “If you have four apples and a dollar, the dollar may help you price and trade the apples. But adding another dollar will not increase wealth; it will simply raise the price of the apples.” Unfortunately, he fails to identify the corollary error of deliberate contractionism.

In the second half of the book, Lewis discusses what he calls “the problem of banks,” meaning the question of fractional-reserve banking. Here Lewis—following and citing Murray Rothbard’s The Case Against the Fed—offers the view that fractional-reserve banking is prone to runs, “inherently destabilizing” for the broader economy, and should be outlawed as fraudulent. Uncharacteristically, he neglects to consider the other side: the historical studies indicating that free banking with fractional reserves is not run-prone but robust, the theoretical arguments for the efficiency and economically stabilizing character of free banking, and the jurisprudential arguments for the legitimacy of voluntary fractional-reserve arrangements based on freedom of contract.

Defenders of fractional-reserve free banking (the present reviewer included) would reject the claim that, like a central bank, “a fractional reserve bank can also ‘print’ new money” arbitrarily. Any bank in a competitive system issuing gold-redeemable notes and deposits is tightly constrained, unlike a monopoly central bank. Contra Lewis, the money supply in a fractional-reserve free banking system is neither “over elastic” nor “generally expanding.” Lewis might have consulted Mises’s The Theory of Money and Credit and Human Action more closely on these points.

Lewis does a good job of sketching the Austrian theory of the boom-bust cycle resulting from a central bank’s cheap-credit policy. And he sagely notes that when a central banker promises to inflate the economy and bail out financially troubled firms, “then it becomes more rational to speculate, to take excessive risk, and not at all rational to save, to take precautions, to be prudent. In this respect . . . so-called stabilization is actually de-stabilizing.”

The book contains three appendices, respectively concerning the Federal Reserve System and its operations, the gold standard and other international monetary arrangements and institutions, and nonmonetary cycle theories. The appendix on the Fed unfortunately gives an incorrect account of how the money multiplier and open-market operations determine the money stock.

The academic economist-reviewer cannot resist noticing some other errors. For example, no sensible view holds that a period of inflation typically or automatically leads to a period of deflation in a fiat money economy. A determined central bank can issue enough money to keep the price level rising continuously, as almost all have since the fiat era began in earnest in 1971.

Despite its shortcomings, this book is an interesting and useful introduction to the important question posed in its title.

DeLong blithely rejects the Austrian account. In his lecture delivered January 5 in Singapore, “The Financial Crisis of 2008–2009: Understanding the Causes, Consequences—and Possible Cures,” he fabricates a “Marx-Hoover-Hayek axis” (complete with adjoined photos of this unlikely trio) and then offers a brief and ill-informed critique under the heading “The ‘Austrian’ Story in a Nutshell.”

A true-to-Hayek nutshell version of the Austrian theory is not difficult to produce. The central bank is central to our understanding of the current crisis. The Federal Reserve under the leadership of Alan Greenspan kept interest rates too low during 2003 and 2004 and then ratcheted the rates steeply upward. Time-consuming investments that were initiated while cheap credit made them artificially attractive were then made prohibitively costly to carry through. Macroeconomically, that sequence translates into an Austrian-style boom and bust. The background against which the story unfolded was a long-running, politically motivated sequence of housing policies whose dubious goal was to increase home ownership beyond what mortgage markets themselves would allow. The actual effect of the various policies was to desensitize both lenders and borrowers to the risk of default, causing mortgage markets and hence housing markets to play leading roles in this particular boom-bust episode.

The Austrian theory couldn’t be more tailor-made for understanding our current situation. Dealing with the unfortunate consequences of artificially cheap credit, a memorable passage in Mises’s Human Action (3rd ed., 1966, p. 560) alludes to an overbuilt housing market:

The whole entrepreneurial class is, as it were, in the position of a master builder whose task it is to erect a building out of a limited supply of building materials. If this man overestimates the quantity of the available supply, he drafts a plan . . . [that cannot be fully executed because] the means at his disposal are not sufficient. He oversizes the groundwork and the foundation and only discovers later in the progress of the construction that he lacks the material needed for the completion of the structure.

The foiled plans in Mises’s parable represent the upper turning point of the business cycle. The subsequent compounding of the downturn in the form of a downward spiral into deep recession should not distract attention from the underlying problem of the credit-induced misallocation of resources. The solution must entail, in the first instance, a reallocation of those misallocated resources.

If credit creation by the central bank was the cause of the problem, it is doubtful that still more credit creation is the solution. Similarly, if investment activity was overstimulated by cheap credit, it is doubtful that a stimulus package will hasten recovery. Why, then, isn’t there a general recognition of the implausibility of these textbook solutions? And why don’t mainstream macroeconomists see the direct applicability of the Austrian theory and the appropriateness of a market solution to the crisis?

Votes Now, Bust Later

For the economist-turned-policymaker, the answer is simple. Policies based on mainstream thinking—cheap credit and stimulus packages—are politically attractive, a circumstance that makes any other theory, particularly as it might apply to the long run, wholly irrelevant. Attempts to rekindle the boom also satisfy the “don’t-just-stand-there” criteria for political viability. In the long run a boom will get you a bust; but in the short run, a boom will get you votes. No doubt, many elected officials are oblivious to the first part of this long-run/short-run distinction. And virtually all those not so oblivious see the second part as trumps.

For academic macroeconomists, especially for those trained and employed by top-tier universities, we need a two-part answer to our question. For Part I we must recognize that economists who were trained at Harvard or MIT and hold a faculty position at Berkeley or Princeton have trouble grasping the Austrian theory. They learned their (short-run) macroeconomics and their (long-run) growth theory in two different sets of courses. The capital theory that unites these two subject areas in the Austrian literature was effectively out of play in both sets. In mainstream macro, where business cycles were discussed, capital is assumed to be fixed. In mainstream growth theory, where cyclical movements are assumed away, capital is allowed to grow or to shrink, but it enters the theory as a holistically conceived capital stock.

By contrast, the inherent time dimension in the economy’s capital structure makes capital theory a natural common denominator for Austrian macro-economics and Austrian growth theory. Capital is a sequence of stages of production; its temporal structure is a key macroeconomic variable. Interest rates that reflect people’s preferred tradeoff between consuming now and consuming later guide capital creation and allow for sustainable growth. Almost as a corollary, interest rates that are distorted by central-bank policy misguide capital creation and give rise to unsustainable growth. The inevitable bust (in the recent and earlier episodes) is a dramatic manifestation of the growth rate’s unsustainability.

To mainstream macroeconomists, the mix of cycles, growth, and the temporal allocation of resources makes Austrian theory appear as a disorienting mishmash. The mainstreamers are not won over; they are simply flummoxed. At best, they will try to fit piecemeal the various propositions put forth by the Austrians into an otherwise mainstream theoretical framework. Distortions of the capital structure get translated into unwarranted changes in the size of the capital stock; the plausibility of entrepreneurs being misled by cheap credit gets judged in the light of presumed “rational expectations.” The unemployment of labor during the period of capital restructuring gets questioned on the basis of the efficient-market hypothesis. Individually, the pieces don’t fit, and so collectively the Austrian propositions are rejected wholesale. (Notice that the Austrian theory is better received by Wall Street analysts trained in finance and attuned to the real economy than by academic macroeconomists.)

Part II of the answer to “Why don’t the mainstreamers see the Austrian theory’s relevance?” actually deals with a follow-on question. “Why don’t they at least make the effort to learn what the Austrian theory is?” After all, economists who study and teach at top-tier universities are intelligent people who could learn the Austrian theory. A little reflection suggests that while they surely have the ability, they lack the motivation. For a seasoned member (or even an upstart member) of the Berkeley or Princeton faculty, studying Austrian economics is just not a career-enhancing activity.

Theories that they do know, which include New Keynesian, New Classical, and Real Business Cycle Theory, fail to incorporate capital theory in any meaningful way. And although advertised as “new” and “real,” none of these theories have more than a tenuous link to current economic reality. Further, these mainstream theories have now begun to merge together into technically demanding and other-worldly constructions called Dynamic Stochastic General Equilibrium (DSGE) models. For mainstream macroeconomists, the DSGE models are the wave of the future. They are the vehicles for publications and professional advancement. (Googling “Dynamic Stochastic General Equilibrium” yields more than 80,000 results.) Any attention to the Old Austrian theory, then, can only divert their careers in an unrewarding direction.

When the mainstreamers are called on to make a public statement about the current economy or to make a policy recommendation, they find their DSGE models wholly unserviceable. And so they simply fall back on the simplest, principles-level version of these complex formal models—which, not surprisingly, is the Old Keynesian theory. Their policy positions are based on the decades-old textbook construction in which earning and spending are locked into a spiral-prone circular flow—and in which countering a downward spiral requires a deficit-financed stimulus package.

Austrian Theory in a Mainstream Straitjacket

The short final section of DeLong’s Singapore lecture, his nutshell rendition of the “Austrian Story,” presents us with a particularly significant case study of the mainstream perspective on Austrian theory. During the several months before his January lecture, DeLong had multiple encounters with the Austrian theory as applied to our current financial crises. The Cato Institute’s 26th Annual Monetary Conference (held in November 2008) was titled “Lessons from the Subprime Crisis.” Among the dozen or so papers presented at that conference, the Austrian school was well represented. Although DeLong was not a conference participant, he reacted on December 8 to an online version of Lawrence H. White’s conference paper, “What Really Happened,” with a critique titled, “Liquidity, Default, Risk.” White responded on December 10 with an insightful defense of the Austrian theory. This exchange of ideas was then followed by still more contributions to “The Conversation” stemming from the White paper and including four additional comments by White. (The DeLong-White exchange is accessible through www.catounbound.org, and all the conference papers appear in the winter issue of the Cato Journal.)

So what effect did this virtual immersion in Austrian theory have on DeLong’s understanding? The answer: little or none. Although his January “nutshell” is just too small to contain much understanding at all, it does contain evidence of the continuing fundamental misunderstandings typical of mainstream critiques.

DeLong’s explanation of the Austrian view makes reference only to “the economy’s capital stock”—that phrase from mainstream macroeconomics that treats capital holistically. Willful or not, DeLong has distorted the Austrian theory by force-fitting it into his mainstream macroeconomic framework. And in DeLong’s rendition of the Austrian view, we see that the “overinvestment” that characterized the boom implies that “the economy’s capital stock needed to shrink.” A two-panel diagram showing “boom” and “crash” is used to depict the sequence of overinvestment and shrinkage. The demand for risky assets first rotates up producing the boom and then rotates back down precipitating the crash. The Austrians themselves would claim, instead, that the malinvestment (Mises’s term) that characterizes the boom implies the need for a capital restructuring. In other words, the allocation of resources within the capital structure has to be brought in line with post-boom market rates of interest. This restructuring takes some time and is best achieved, in the Austrians’ view, by the market itself.

From the Time Dimension to the Moral Dimension

Turning a blind eye to the notions of malinvestment and capital restructuring, DeLong quickly shifts ground from economics to ideology and from F. A. Hayek to Herbert Hoover. (We will take DeLong’s inclusion of Marx in his discussion as pure hyperbole.) DeLong takes the Austrians’ call for a market solution (capital restructuring) rather than a government solution (rekindling the boom) as justification for denigrating the Austrians as “liquidationists,” a label popularized by DeLong himself in earlier articles and associated in his own thinking with Hayek, Hoover, and Hoover’s treasury secretary, Andrew Mellon. The specific recommendations that Mellon supposedly offered for dealing with the 1929 crash and its aftermath are, by themselves, almost enough to call this association into question:

Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate. It will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder, live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people.

Significantly, DeLong’s broad-brush use of the term “liquidationism” was criticized by White in a 2008 paper titled, “Did Hayek and Robbins Deepen the Great Depression?” (Journal of Money Credit and Banking, June issue). In arguing the absence of a Hayek-Hoover connection, White is convincing on two key points. First, sheer chronology precludes the possibility of Hayek having a timely influence on Mellon and/or Hoover. Hayek’s first English-language statement of the Austrian theory was not published until 1931. Besides, a much more obvious basis for Mellon’s thinking was the fallacious Real Bills Doctrine, which was written into the legislation that created the Federal Reserve System. Second, there is no evidence that the above quoted passage can actually be attributed to Mellon. It comes from Hoover’s Memoirs (1952) and reads like a caricatured rendition of Mellon’s views—a rendition that sets the stage for Hoover’s rejection of those views.

For the Austrians the liquidation of malinvestments is essential to the economy’s recovery. Resources need to be reallocated. Hence, any government spending program that serves to rekindle the housing boom or even to keep resources from leaving the housing industry is counterproductive. It locks in the misallocated resources. Similarly, restoring macroeconomic health requires the liquidation of many other long-term or early-stage investments whose expected profitability depended on artificially low borrowing costs.

This needed liquidation does not imply that “a panic would be not altogether a bad thing,” a judgment that DeLong also attributes—via Hoover—to Mellon. What Mellon (or Hoover) called a panic, Hayek called a “secondary contraction,” meaning a self-reinforcing spiraling downward of economic activity that causes the recession to be deeper and/or longer-lasting than is implied by the needed liquidation of the malinvestment. Hayek argued, in effect, that the “ideal” policy would be one that allows the needed liquidation to proceed at market speed while the monetary authority curbs the secondary contraction (the panic) by maintaining a constant flow of spending. In terms of the equation of exchange (MV=PQ), Hayek argued that the ideal policy was to keep MV—and hence PQ—constant by increasing the money supply (M) just enough to offset declines in money’s velocity of circulation (V). Hayek used the word “ideal” in recognition that the monetary authority may lack both the technical ability and the political will actually to implement that policy. (It would lack the technical ability because it would have no way of getting timely information on the changes in money’s circulation velocity; it would lack the political will because pulling money out of the economy when eventually the velocity begins to rise is a politically unpopular thing to do.) But in any case, Hayek and the Austrians generally regarded the secondary deflation as “altogether a bad thing.” (In Hayek’s later writings, he favored a decentralized monetary system—in which market forces, rather than an ideally managed central bank, would govern changes in the money supply.)

Mellon is charged (by DeLong and many others) with having a “moral objection” to curbing even the secondary contraction. This moral dimension to Mellon’s supposed liquidationism tends to get imputed to the Austrian view as well. DeLong quotes Martin Wolf (Financial Times, Dec. 23, 2008) at some length on this point. Wolf insisted (with a bow to Keynes) that “we should approach an economic system not as a morality play but as a technical challenge.”

It is worth noting here that characterizing the Austrian Story as a morality play is not original with Wolf—and certainly not with DeLong. Most likely, this particular putdown comes from Paul Krugman, whose understanding of Austrian theory rivals DeLong’s. Krugman’s introduction to the 2006 printing of John Maynard Keynes’s General Theory of Employment, Interest, and Money contains the following passage:

Keynes’s limitation of the question [about a depressed economy] was powerfully liberating. Rather than getting bogged down in an attempt to explain the dynamics of the business cycle—a subject that remains contentious to this day—Keynes focused on a question that could be answered. And that was also the question that most needed an answer: Given that overall demand is depressed (never mind why), how can we create more employment? A side benefit of this simplification was that it freed Keynes and the rest of us from the seductive but surely false notion of the business cycle as morality play, of an economic slump as a necessary purgative after the excesses of a boom. By analyzing how the economy stays depressed, rather than trying to explain how it became depressed in the first place, Keynes helped bury the notion that there’s something redemptive about economic suffering.

The Austrian Story is not a morality play. It is a piece of economic analysis. Nor is it just some variation on a theme that can be understood in terms of the analytical framework of mainstream macroeconomics. Rather, Mises and Hayek offered a more encompassing macroeconomic framework, one that illuminates the market mechanisms that allocate resources among the temporally defined stages of production and traces the intertemporal misallocation of those resources to misguided or politically motivated policies of the central bank.

It is important to see that the whole focus of mainstream macroeconomics, and certainly DeLong’s focus, is fundamentally different from the focus of the Austrian economists. The difference, fully recognized by White in his response to DeLong, is captured in Krugman’s introduction to Keynes’s General Theory. Keynes suggested remedies for the ongoing depression without bothering himself about just how the economy came to be depressed in the first place. Throughout the Singapore lecture, DeLong, following Keynes, argues as if it is simply in the nature of capitalism that there are waves of speculation followed by a collective quest for liquidity—for more liquidity than can be readily accommodated in a modern capital-intensive economy. The central bank comes into play only to counter the economy’s wealth-destroying gyrations.

Hayek focused on the dynamics of the preceding boom, thinking that the question of how the economy came to be depressed was the most interesting and challenging question, and believing that a satisfactory answer to that question was a strict prerequisite to figuring out how (and how not) to deal with the depressed economy.

An Austrian Perspective on Suffering

There is nothing “redemptive about economic suffering.” Krugman, Wolfe, and DeLong are right about that. There is also nothing redemptive about the suffering of the Austrian school in the wake of ill-informed criticism. But the Austrian ideas will continue to suffer as long as mainstream macro continues to develop along its current path. And the suffering of the economy will continue—and intensify—as long as policymakers, following their political instincts and enjoying the support of mainstream economists, opt for ever-bigger stimulus packages to be financed by mushrooming debt.

Things have gotten so bad that no dissention can be tolerated. The German Chancellor Angela Merkel was harshly criticized for not going along, at least to the requisite degree, with the stimulus consensus. She stood out as “Frau Nein” until she went along with a “moderate” package.

I am not a macroeconomist. I am not even a financial economist. So much of my reaction to the current financial and economic problem may seem out of step with what most commentators are saying. Yet I think it is important.

Collective Irrationality

The macroeconomic frame of mind is quite peculiar. In the name of the emergency, this way of thinking dismisses most concerns about the efficient allocation of resources and throws almost total emphasis on maintaining levels of expenditure and employment. The implicit assumption is that the central problem is a collective irrationality that inhibits people from spending on consumption or investment. The root of the central problem, conceived in this way, is the initial financial meltdown. This involved a kind of domino effect in which the collapse of the housing market and of mortgage-backed securities, packaged in many complex ways, undermined the liquidity and even solvency of many financial institutions. The system’s ability to provide credit and thus expenditure was compromised, although at this writing the reduction in bank credit available has been relatively small.

Thus the solution, we are told, lies in returning to the status quo ante. Restore the condition of the financial institutions—perhaps by buying toxic assets or perhaps by infusing capital into the institutions. Restore the conditions of the housing market by getting the Fed and/or Treasury to buy Fannie and Freddie mortgage securities, thus sending capital into housing and lowering mortgage rates. Restore the condition of industries with large numbers of employees and others indirectly dependent on them. (So far, the automobile industry qualifies.) In general, restore the pattern of expenditure that prevailed before the crisis.

I realize that no economist believes that complete restoration to the previous situation is possible, but the basic philosophy is clear. Once economic agents believe something like this will take place, confidence will be restored.

The critical issue is this: Has the current situation—triggered by unsustainable levels of mortgage credit and production in the housing industry as well as in other interest-rate-sensitive areas—gone so far beyond its cause that we no longer need to worry about these previous misallocations of capital? In other words, is the correction of the cause now irrelevant to the cure?

Stimulus ex Machina

To discover the answer to this question, let’s step back a bit. We must understand the respective roles of causes and feedback effects. This is the “Keynesian” argument. Suppose a fall or collapse in markets X, Y, and Z causes F (a financial meltdown). Then F itself causes X, Y, and Z to fall further. Some of this is deleveraging, and some is the result of falling confidence in, say, the creditworthiness of counterparties. There is a general lack of clarity about what resources and financial instruments are worth. The future begins to look radically uncertain rather than simply risky. A collapse of confidence thus contributes to a fall in production and employment in areas far removed from the initial bubble-burst. The process is not dampening but explosive in the absence of the deus ex machina—that is, fiscal or monetary intervention.

Now let us imagine a cure that ignores the original misdirection of resources to the degree that it treats the collapse in these markets as mainly due to some exogenous loss of confidence. The Federal Reserve decides, as it actually has, to buy mortgage-backed securities, causing credit to become available in the housing market at lower interest rates. This also causes the prices of homes to stop falling and to begin rising. When will the Fed stop this infusion of newly created money, and hence a relative rise in resources, into the housing market? Presumably it should stop when the sector is brought back to a level that is simply a correction of the previous excess. In other words, the Fed should prevent the additional, “irrational” decline due to “feedback” effects.

Where is the feedback-sanitized point? I doubt anyone knows. Consider what it means to know. The planners would have to know the array of housing prices corresponding to the normal fundamentals of the housing market. This would be the prices that prevailed when the market was not overexpanded. However, it would not correspond simply to the average of recent values because the housing market has been overexpanded for so long. Recently, two economists have attempted to estimate these prices. (“First, Let’s Stabilize Home Prices,” by R. Glenn Hubbard and Chris Mayer, Wall Street Journal, Oct. 2, 2008.) Unfortunately their attempt is marred by the same extrapolation of historical experience that seems to have gone terribly wrong in the assessment of the risk associated with derivatives and mortgage-backed securities. More importantly, however, it seeks to determine normal market prices in the absence of a freely functioning market.

Suppose, however, the Fed is realistic and admits it doesn’t know. It will then simply try to get the housing market (and other similar interest-sensitive markets) to such a point where general production and employment are considered non-recessionary. The standard, practically speaking, will be the status quo ante. This is because of the lack of theoretical-empirical guidance discussed above and because the various sectors, bolstered by various politically powerful pressure groups, will not be satisfied until they are made whole. At this stage we would be left with the unsustainable direction of resources more or less back in place. The direction is unsustainable because, as the original bubble revealed, it was not consistent with the preferences of consumer-saver-investors.

Why it Won’t Work

Therefore the conventional macroeconomic diagnosis and proposed cures ignore many important structural or microeconomic factors, including the following:

1. The “irrationality” is not primarily in the system’s response to the initial financial impulse but in the unsustainable expansion of the housing and other capital markets in the first place. Proposals to prop up the housing market as if its contraction is some kind of unfortunate overreaction are not credible. Too many resources went into the housing market due to the low-interest-rate policy the Fed followed for too long. While housing prices have fallen recently in many markets, they need to fall further. Markets should be allowed to equilibrate.

2. Equilibrium in the housing market would provide greater transparency to the value of mortgage-backed securities. Lack of certainty about housing prices and the ultimate extent of foreclosures only adds to the problems surrounding the illiquidity of these securities.

3. Government infusion of capital with the purpose of restoring the status quo ante ignores the facts: Fannie and Freddie were overexpanded, the domestic automobile industry is a destroyer of scarce capital, some financial firms did a poor job of allocating risk, banks extended loans under the pressure of the government to people who should not own homes, and so forth. Resources were misallocated.

Confidence Follows Correction

Recessions are not simply crises of confidence or of insufficient demand (due to increases in the demand to hold money). They also have their allocational—or microeconomic—aspects. I suggest that these systemic distortions have an important role in creating the aggregate phenomena we are witnessing. To treat these distortions and their cure as relatively unimportant is a mistake. Lasting investor and consumer confidence follows the correction of the underlying causative distortions and does not precede them. In fact, the dominant macroeconomic policy framework does not leave room for correcting distortions at all because its basic theme is to restore, prop up, and maintain the current direction of resources.

The hastily approved macroeconomic schemes of the Bush and Obama administrations will not succeed in promoting lasting recovery because they ignore the microeconomic fundamentals. The direction of spending and hence resource allocation they generate are fragile—they are not consistent with the preferences of consumers, savers, and investors. Therefore, once the putatively temporary stimulus is complete, the corrective forces that are now trying to undo previous resource misallocations will reassert themselves.

In the longer term, the threat of significant inflation looms large. After the U.S. Treasury has incurred the additional trillions of dollars in national debt (at least one trillion in George W. Bush’s response to the crisis and a minimum of one more in Obama’s response) and the Federal Reserve has completed expanding its balance sheet (thus creating new money) by some trillion or more, what will happen? Will the federal government abolish the stimulus programs, raise taxes to pay off the increases in the national debt (or even to service the debt), and cut entitlement programs? The constituencies that will be formed by the stimulus spending will resist. Will the Fed begin a contractionary monetary policy to absorb all the excess money it created in the name of the emergency? That would raise interest rates and the cost of servicing the huge national debt. What is probable is that we will see an effective repudiation of part of the national debt through inflation. The temptation will be all but irresistible to inflate ourselves out of this mess. The economic consequences of the “cure” will be worse than the disease.

You’d hardly know this by reading mainstream economics, but economic phenomena happen on the ground –- where human action and interaction take place –- and not on the blackboard amid statistical aggregates and averages that no real person ever encounters.

Say the Federal Reserve created bank credit and lowered the interest rate. And say aggregate investment increased. This would be hailed as good thing by many economists. The Keynesians and others (monetarists included) look at capital as one large aggregate quantity (as thought it were a pile of Play Doh). It either goes up, down, or stays the same. But the Austrians realize that the economy has a structure of production that exists in many distinct stages through which inputs pass in various degrees of completion over time. In a truly free market, consumers communicate their preferences — through prices, including the interest rate — to entrepreneurs. The natural interest rate tells entrepreneurs how present- or future-oriented consumers are. Entrepreneurs then respond appropriately (but of course never perfectly) by allocating capital among the various stages, further from or closer to the final consumer level.But when the Fed creates credit and lowers the interest rate, investment shifts from later stages of production, near the final consumer stage, and toward earlier stages, for example, mining and R&D. This happens because the lower interest rates says consumers are more future-oriented. The problem is they really are not. So the fiat money will set off a race for scarce resources that cannot be in two or more stages at the same time.Notice how the multistage structure existing through time is papered over by aggregation. All the macro theorists see is an increase in Investment and Capital.The point is that macro aggregates and averages take our eyes off the ball: human action and interaction. Individuals confront market prices, resource constraints, and tradeoffs while trying to coordinate their plans with others in order to achieve their ends. There is no interaction, much less constant mathematical relationships, among total employment, total income, total investment, total output, GDP, etc.So, the short answer to your question is: Making policy decisions based on macroeconomic aggregates will not lead to good decisions.