Austrian Business Cycle Theory and the Global Financial Crisis: Confessions of a Mainstream Economist

Abstract

ABSTRACT: Austrian business cycle theory has a legitimate claim to being the most authoritative explanation of the recent global financial and economic crisis. Indeed, many mainstream economists have begun to analyze the crisis, perhaps unwittingly so, in terms that sound as if they were derived directly from the Mises-Hayek-Garrison theory of macroeconomic fluctuations. Even advanced economic research into financial leverage and liquidity does conceptually little more than develop the framework of Austrian business cycle theory. Milton Friedman used to say that there is no such thing as Austrian economics-or Chicago economics, or Keynesian economics for that matter. Instead, he noted, there is only good economics and bad economics (Vaughn 1994, p. 105). What makes an economic theory good, Friedman (1953) argued, is the empirical accuracy of the predictions it generates. He rejected Austrian business cycle theory because he did not believe it was an accurate explanation of economic recessions as they actually occurred in practice (Friedman 1993). Not all economists agree with Friedman's criterion for the validity of an economic theory-indeed, many Austrians do not. Nonetheless, one wonders whether Friedman, who passed away in November 2006 shortly before the onset of the recent global financial crisis, might have felt differently today about the explanatory power of Austrian business cycle theory in light of that crisis. This mainstream economist's understanding of Austrian business cycle theory is roughly as follows. An economic expansion is sustainable if it is the result of an increase in investment that is funded by an increase in saving. In contrast, an economic boom that is merely the result of credit expansion is not sustainable. 2 When credit creation by monetary authorities exceeds a society's structural saving rate, financial intermediaries end up lending money at interest rates that are below the rate where supply and demand clear in the market for loanable funds. As a result, the information embedded in market prices (including interest rates) is distorted, affecting entrepreneurial decisions and causing a misallocation of capital across the economy. Specifically, too many capital goods and not enough consumer goods end up being produced relative to ultimate consumer preferences. Eventually, as the lack of underlying demand for these capital goods becomes apparent, production capacity is idled, and the boom that was fed by the credit expansion turns to bust. Thus, credit expansion during an economic downturn will not help bring about a sustainable boom but will merely postpone it, as it causes a delay in the structural adjustments, such as business closures and other eliminations of unproductive uses of capital, that need to be made to bring about a sustainable economic expansion. With the benefit of hindsight, the preceding paragraph would appear to be a summary description of what has happened to the financial system and the macroeconomy in recent years. The 2002-2007 expansion was characterized by both monetary accommodation and a boom in residential real estate. The boom proved unsustainable, and was followed by a spectacular bust in both the financial markets and the broader economy. Indeed, predictions by Austrian or Austrian-inspired economists such as William R. White, Economic Adviser and Head of the Monetary and Economic Department of the Bank for International Settlements from May 1995 to June 2008, have been uncanny not just in their accuracy but in their specificity. Just before the onset of the crisis, White (2006, p. 1) pointed out that persistently easy monetary conditions can lead to the cumulative build-up over time of significant deviations from historical norms-whether in terms of debt levels, saving ratios, asset prices or other indicators of 'imbalances.' To be sure, a financial crisis of sorts had also been forecast by many non-Austrian economists, such as Nouriel Roubini and Stephen Roach. …

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