We are very privileged to have Steven Horwitz as a guest blogger today. Dr. Horwitz is the Charles A. Dana Professor of Economics at St. Lawrence University in Canton, NY. He is the author of two books, Microfoundations and Macroeconomics: An Austrian Perspective (Routledge, 2000) and Monetary Evolution, Free Banking, and Economic Order (Westview, 1992), and he has written extensively on Austrian economics, Hayekian political economy, monetary theory and history, and macroeconomics. He is a frequent guest on TV and radio programs, particularly on the Great Recession and monetary policy.
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I appreciate the time and care with which Lorenzo has read my paper and his willingness to engage as a serious and fair-minded critic of Austrian economics. His long post of April 24th raises a whole host of important issues, all of which I would like to respond to. However, I may not get to all of them in what follows, so omission should not be interpreted as agreement. With that said, let me try to tackle some of his claims in the order that he offers them.
1. I don’t think any Austrian believes heterogeneity is “all there is.” In the paper in question, that was the focus because I do think it’s the most important difference between the Austrians and Keynes, or at least the difference that explains the most in terms of why they end up at such different places. Austrians have written a fair amount on capital in the last decade or two and Lorenzo might wish to read some of that work to see the bigger picture. The place to start is Peter Lewin’s Capital in Disequilibrium, which can be found for free at that link.
2. Lorenzo notes that Austrians don’t have much to say about the heterogeneity of labor. This is a fair point, though more is being said about it, including in Lewin’s book and some work of my own. However, this claim very much misunderstands the Austrian argument:
Conversely, heterogeneity of labour would suggest that labour markets also have adjustment delays and constraints, which sits rather poorly with Austrian confidence in fully flexible wages if there were no regulatory interventions.
Austrians do not believe wages would be “fully flexible” in a free market. In fact, we don’t believe that about any prices in a free market. From the very beginning of the Austrian school with Carl Menger in 1871, the market has been understood as an iimperfect discovery process, subject to error all the time, thanks to the imperfect knowledge of human beings among other things. The case for getting rid of such interventions is not that markets would be perfect and prices and wages “fully flexible” without them, but rather that markets just work “better” without intervention. Less imperfect if you will. The Austrian case for the market has, for almost 150 years, not rested on a belief in market perfection. (And Lorenzo’s later claim that I make such a claim myself reflects a misreading.)
One other element of this claim: often critics of markets leap on the cases when markets produce less than perfect outcomes as if they were ipso facto cases for government intervention without ever asking whether the intervention will be even more imperfect than the imperfect market. Critical thinking demands that we engage in a comparison of the “real” to the “real:” real markets are imperfect and so is real government intervention. Austrians have reasons, both theoretical and historical, to believe that markets will be systematically less imperfect than government. We can argue about those, but let’s avoid thinking that any evidence that markets are less than perfect somehow condemns the case for markets and ipso facto justifies government intervention.
3. Lorenzo takes my phrase “fitting those pieces [of capital] together as correctly as possible” to be the same as believing there is “single correct outcome.” I think that’s a misreading. Again, the phrase “as correctly as possible” suggests that neither perfection nor a “single correct outcome” is the goal here. “Correctly” in this context does not refer to some objective pattern that the economy strives for, but rather its ability to meet the wants of consumers as well as possible (hence “correctly as possible”). Austrians have been very critical of the equilibrium orientation of modern economics and have, instead, tried to understand markets as open-ended evolutionary systems. There’s no objectively correct pattern of resource allocation out there. Rather, as James Buchanan put it, “order is defined in the process of its emergence.” Just as biological evolution doesn’t produce the “perfect squirrel” but one well-adapted to its environment, the same is true of markets.
4. Lorenzo’s points 4 and 5 about prices, inflation, and deflation, are preaching to the choir at least on his point 5 about the damage of deflation. He might wish to read my Microfoundations and Macroeconomics: An Austrian Perspective, in which I talk about the dangers of monetary disequilibria, devoting a chapter each to inflation and deflation. That book was explicitly written (in 2000 I might note) to reject the sort of characterization of the Austrian position that Lorenzo lays out: “But the Austrian view of business cycles is so focused on finding reasons for busts in the previous booms (those money over-supplying central banks) that it, in effect, blames the effects of deflation on previous inflation. Yet inflation and deflation are equally monetary phenomena, one is not causally dominant over the other.” The last sentence is precisely the argument I make in the book, which I would love for him to read and comment on.
Two other thoughts:
a) Austrians emphasize inflation more because it has been and will be far more the real-world problem in a world of government central banks that have a strong incentive to err in the direction of inflation as a way to reduce the burden of government debt and raise revenue. After all, historically, that’s where central banks came from: governments created them when they could not raise revenue, especially for wars, through other means such as taxation or bond issues. Lorenzo is right that in theory inflation and deflation are “equally” important phenomena, and my book argues that case, but in practice? Not so much.
b) Much of Lorenzo’s perception of Austrian economics, particularly on this issue it seems, is colored by who he’s reading. There are lots of “internet Austrians” who are really consumers of Austrian economics not producers. He finds me refreshing, which I appreciate. But there are dozens of scholars like me producing serious nuanced work in the professional journals. I’m not so unique. We don’t cover the internet with our work in the way some folks do, but in passing the test of peer-review, we are way ahead of the game. Critical thinking advocates might wish to consider which sources on what constitutes “Austrian economics” would be the better place to learn about it.
5. Austrians do not deny the role of risk in interest rates. Real world rates include a variety of factors beyond time preference, but the reason there is interest at all is due to time preference, and rates still say important things about time preference. In his discussion of these issues (his #6), Lorenzo once again seems to suggest that sticky prices undermine the Austrian argument. I think that criticism goes nowhere because Austrians have not argued that perfectly flexible prices are a necessary or sufficient condition for the market to be the preferred resource allocation process.
6. Lorenzo’s thoughts in his 7 and 8 are appreciated. But let’s be clear: no Austrian has ever said the depths/lengths of the bust depend on the size of the boom alone. The argument has always been a ceteris paribus claim: imagine two booms in which the only difference was the height/length of the inflation. In that case we would expect a worse bust from the bigger boom. Historically, of course, ceteris is never paribus. The Great Depression was awful not because of the size of the boom, but because of the intervention of the Hoover Administration, especially trying to prop up nominal wages as prices were falling, the Fed for allowing a destructive 30% decline in the money supply, and FDR for prolonging matters with both the actual content of his Hoover-like interventions and the uncertainty generated by his constant experimentation. There is ample historical evidence for all of these claims and this Austrian economist, at least, has written about the Great Depression invoking all of them. The same is true of the Great Recession. Yes, easy money was a factor, but so were a whole bunch of other things, especially housing policies and the government backing of Fannie and Freddie. I have written about this as well. Again, no serious Austrian makes the argument Lorenzo seems to attribute to them. I am not exceptional in this way.
7. In his 8, Lorenzo once again accuses Austrians of being subject to “strong equilibration” thinking. In fact, it is the Austrians who have been the most critical of equilibrium modeling in economics, and have been so for decades. Yes, Austrians believe markets have self-correcting forces in them, but those do not lead to equilibrium because: a) exogenous change is constant, preventing any actual move toward equilibrium and b) endogenous change can, in the short run, push us away from equilibrium. Yes, markets are excellent epistemological ecosystems in which people can learn from their mistakes. But the case for markets is only that they are better at this than the alternatives, not that they do so in the ways many economists talk about with respct to equilibrium.
8. Lorenzo writes: “But, in keeping with the Austrian approach being overly systematic, there is too strong a presumption that a monopoly provider of money will oversupply.” As I noted earlier, there are very strong theoretical and historical reasons to do so as an empirical matter. Central banks were born in the crucible of inflation – it is their raison d’etre. They do make systematic errors in that direction because virtually every incentive they face is to do so. I think Lorenzo’s mistake here is, as also noted earlier, to not take the internal processes of politics seriously enough. Central banks are political institutions and political actors face knowledge and incentive issues just as market actors do. Yes, deflation can cause real problems and can’t be ignored (I’ve taken heat from other Austrians for paying too much attention to deflation), but Austrians are living in the real world more than Lorenzo by recognizing the historical fact that central banks are almost always inflators, not deflators. Their mistakes are not random; they are in fact systematic because the incentives are there to make one type of error and not the other.
9. Austrians do not deny the possibility of a “general glut.” Like J. B. Say, we recognize that a general glut, meaning a general oversupply of goods, can happen if there is an undersupply of money combined with less than perfectly flexible prices. We deny that such a glut can happen without a monetary cause, but should the monetary system fail to produce enough money, then goods and labor will not get sold because prices cannot adjust immediately. The result is a “general glut.” This is why avoiding deflation is so important – it helps avoid such gluts in the real world of imperfectly adjusting prices. I would point Lorenzo to my book or to this paper of mine on Say’s Law from an Austrian perspective.
10. Finally, Lorenzo writes near the end: “For example, it was the deflationary policies of the Fed and the Bank of France that caused the 1929-32 Depression not some mythic inflationary boom.” I would first note that there’s no reason that the Great Depression considered as a whole could not be the result of both an inflationary boom and the Fed’s deflationary policies. I have written extensively on the Great Depression, as noted above, and have taught a senior seminar on it for several years. I know the drill. Let me suggest thinking about any “bust” with the following three questions:
a. What caused the turning point toward the bust, i.e., why is there a bust at all?
b. Why did the bust get as deep as it got?
c. Why did the bust last for as long as it did, or why was recovery so fast or slow?
This allows us to separate the cause of the bust per se from the factors that explain why it was so bad. With the Great Depression, any explanation of its severity and length will, as I argued earlier, have to invoke the deflation and other policy errors. But that does not exclude the possibility that the 20s involved an inflationary boom that produced the original downturn in August of 1929 (which precedes the stock market crash of course).
The problem with saying that the Fed’s deflation that caused the Great Depression is that the recession/depression is dated from August of 1929, which is before, even by Friedman and Schwartz’s narrative, the Fed started making its deflationary errors. Austrians are interested (though not exclusively) in explaining why the turning point happens in the first place. The typical Austrian business cycle story is sufficient, but not necessary, cause of a bust. But saying that other factors were in play, such as in the Great Depression, does not, by itself, exclude the possibility that the origins (though not depth and length) of the bust are to be found in prior inflationary boom. Let’s go look and find out!
And with that I will leave matters. Again, I appreciate Lorenzo’s serious engagement with my work and with Austrian economics in general. I am always happy to respond to criticisms of this sort. I would simply close by encouraging Lorenzo and readers here to look for the best work in Austrian economics, not the easiest to find. Critical thinking demands no less of you.