A Libertarian's Library
Business cycles and market failure: Who can you trust?
May 14, 2013The 2008 housing collapse and the continuing discussion over the government's various policies of financial and regulatory intervention in the economy give Libertarians and Tea Party voters reason to look at two differing theories of the business cycle and how markets fail, i.e., the view of John M. Keynes and that of the Austrian School of economics, principally represented by Ludwig von Mises and Friedrich Hayek.
Keynes contended that supplies of unsold goods and high unemployment during recessions were evidence that markets did not always clear of their own accord. He proposed a theory where savings were seen as purchasing power withdrawn from the cycle of production and consumption. Savings were idle money, not fully reinvested in the economy, resulting in under-consumption, unsold goods and unemployed labor. Keynes proposed that fiscal stimulus could act as a substitute for investment lost to savings. His argument was stated in terms of aggregate supply and aggregate demand. He did not consider individual adjustments of pricing between particular producers and consumers of specific goods and services as being critical to the process of economic recovery. Rather, Keynes relied on government stimulus to float all boats on a rising tide of deficit spending. It was held that an increasing money supply would flow proportionally among buyers and sellers and that a general equilibrium would establish itself throughout the economy given that enough central bank money and deficit spending was put to use. As the liquidity in the economy increased, surplus inventories would find buyers. Goods and services that went unsold earlier would eventually appear to be bargains as inflation generally eroded real prices. It importantly assumed that union pay demands would be mollified by rising nominal wages while employers would respond to falling real wages with new hiring that would reduce unemployment.
The Austrian theory of the business cycle views aggregates as an oversimplification of the economy. It maintains that markets fail to clear because individual prices are first artificially misaligned and then prevented from correctly shifting back into a market determined relationship with one another because of extraneous influences, e.g., activity of central banks, tax policy, labor legislation, subsidies, trade barriers, etc. Basically, markets fail to clear because actions by government interfere with price discovery and create a misallocation of resources between individual producers and consumers of particular goods and services.
Austrians uniquely contend that central banks, by increasing currency in circulation and reserves available to commercial banks, systemically distort the supply and demand within the interrelated markets for specific goods. When currency and demand deposits expand, the increased money supply is put at the disposal of some individuals before others. Early recipients of newly created funds satisfy their unique spending preferences before later recipients are given the same opportunity. Those favored enough to be closest to the spigot drink first and most fully. These time-biased monetary actions by the central bank artificially lower rates of interest and change the relative spending patterns of respective buyers and sellers of particular goods and services throughout the economy; thereby, altering the price signals that had earlier directed the distribution of resources between producers and consumers.
Since the lower interest rates are not due to a shift of consumer preferences to more savings and less spending, consumers are not sacrificing current consumption of existing resources to fund new lending for increasing producer expenditures; therefore, consumer and producer spending, newly augmented by the central bank, compete with each other for the resources of an unchanged production possibilities frontier. In plain English, consumers and producers are both using newly created money in bidding up prices of both guns and butter. Although doubling the money supply does nothing to increase the quantity of wheat in a Wichita elevator, it does raise the price and while prices are generally rising, relative prices are being artificially distorted. For example, doubling the money supply might more than double prices of real estate in Phoenix or bank stocks in Manhattan while leaving pension checks unchanged in Cleveland. When the central bank eventually responds to inflation by withdrawing bank reserves, the amount of credit available to both producers and consumers shrinks, rates of interest rise and liquidation of unfinished or now unprofitable projects begins. The relative valuations and asset allocations created during the credit expansion must now be reconsidered during the contraction.
More specifically, when interest rates are artificially lowered by central bank action, long-dated capital-intensive projects of upstream producers have their present value greatly improved in relationship to down stream consumer projects requiring less time to develop. Long-term debt for factory construction gains a present value advantage over borrowing of a shorter duration for the purpose of carrying inventory at retail outlets. This strongly encourages "malinvestment" in production projects requiring lengthy development schedules as well as the goods and services supporting them; while giving less encouragement to the shorter-term projects that more directly target retail consumer demands.
It is important to note that if interest rates had not been forcibly moved lower there would have been no reason to expect either buyers or sellers to significantly change their established behavior. In effect, producers are induced, by the manipulated time value of long term borrowing, into undertaking projects that are not supported by consumer wishes. This lack of consumer interest in the new undertakings of producers is the initial cause for the build up of unwanted production and under-consumption.
Austrians assert that goods are not homogeneous aggregates. Goods are more correctly seen as being heterogeneous. They have a specific purpose and must find a specific place in a structure of production where the sequence of time and place both matter. Farms sell wheat to flour mills and flour mills sell flour to bakeries. Combines harvest wheat before ovens bake bread. In a modern industrialized economy the arrangement of resources in time and space matters greatly. Square pegs cannot fit into round holes and A comes before Z. Thus, depending on the degree of specificity in their use, forced liquidation of heterogeneous goods may require steep discounts in price. Long dated projects are the first to suffer during the liquidation phase and they suffer the steepest price losses since capital equipment is more difficult to disgorge and reposition than consumer goods and because its price has increased relatively more than other goods during the credit boom. Austrians are concerned that grouping distinct assets into an aggregation of goods obscures the necessity of coordinating the opinions of individual buyers and sellers of assets having very different operating requirements, price behaviors and market niches, i.e., induction furnaces are not radial tires.
Once the recessionary contraction has begun, the use of renewed fiscal stimulus obstructs the liquidation process that would, otherwise, force individual buyers and sellers to re-examine the structure of relative values for the distinctive assets that were distorted by monetary action in the expansionary phase. If this process of recalculating and coordinating revised subjective valuations in the markets for specific resources is hindered by monetary and legislative intervention, then there is a continuing mismatch in the opinions of buyers and sellers. Buyers will not purchase what are now understood to be over-priced goods and services that are unsupported by consumer demand. Consequently, the liquidation of ill-fated projects is delayed and mispriced resources cannot be redeployed to produce new products that better suit the preferences of consumers. Therefore, under-consumption continues and unemployment persists until the sell off of bad investments can be completed.
There is reason to believe that having fiscal stimulus fail, as a recession remedy, is less of a problem than having it succeed. As the central bank further eases greater quantities of liquidity into the economy, inflation will erode the real value of surplus assets, lets say an induction furnace, and eventually a new producer will acquire it. However, by then consumers with swollen wallets and bloated checking accounts will have sharply bid up the prices of radial tires. Nothing will have been done to eliminate artificially misdirecting consumer and producer preferences and the economy then risks being fragmented into myriad of further mispriced markets by a rapidly depreciating currency, as was characteristic during the stagflation of the 1970's.
This has been a broad sketch of two theories of the business cycle by a non-economist. Each school has its own expert supporters and critics. So who are we to believe?
The Tea Party and Libertarians will note that the Keynesian view, by definition, requires a select body of central planners to direct the economy by regulating taxes and interest rates, while the Austrians would wish to reduce government's influence over the economy.
In regard to predictive value, the Austrian School has anticipated the 1970's stagflation, the savings and loan debacle of early1990's, the dot-com bubble in 2000 and the 2008 collapse in housing. Keynesian central bank policies have predominated throughout the 1970's stagflation, the savings and loan debacle of the early 1990's, the dot-com bubble in 2000 and the 2008 collapse in housing. Both, in their own way, are impressive achievements.
Citing high levels of unemployment in an economy threatened by deficit spending, unprecedented monetary expansion, bewildering taxation, subsidies to crony capitalists and trade barriers may well beg the question concerning the failure of markets. Using fiscal and regulatory tools that further distort prices might be less productive of wealth and liberty than allowing buyers and sellers to freely enter into mutually beneficial exchanges and bargain their own way to a balanced economy.
Gene Callahan and Roger Garrison
Ludwig von Mises