In a recent conference held at the IEA, there was much discussion of the Great Recession. How can we interpret the recent recession and how can George Osborne’s Autumn Statement help us get out of it?
Firstly, how do the monetarist and Austrian schools differ in their explanation of recession? There are at least two important differences between the approaches. In the period of monetary expansion, the distortion of investment and consumption decisions caused by interest rates that are too low is the key problem for Austrians; for monetarists, this is secondary. Secondly, Austrians argue that a recession must follow a monetary boom.
Austrians argue that recession must follow a period in which monetary policy has been mismanaged by holding interest rates lower than the level necessary for saving and investment to be equal. This is because investment projects are started in the boom at low interest rates and cannot be completed: resources have been misallocated as a result of interest rates being held down. Similarly, consumers will spend more on durable goods at low interest rates than could really have been afforded. A price has been distorted and resources misallocated; changing the allocation of resources in an economy is not a process without costs and frictions – Keynesians themselves remind us of this. Eventually, the misallocation of resources that happens in the boom has to be reversed. This reversal is the process of recession.
The key objection to the Austrian explanation of boom and bust comes from the neo-classical camp. It argues that the process outlined by the Austrians violates the efficient markets hypothesis and rational expectations. If market actors can see that a monetary boom is causing a rise in asset prices and that the boom will eventually come to a halt and reverse, then why do fund managers not simply ignore the monetary boom and refuse to invest in the rising stock market? Why do entrepreneurs not respond to artificially low interest rates by making rational predictions about the future path for interest rates and inflation?
The answer to these objections lies in Austrian micro-economics: market participants are not perfectly informed. If it were possible for market participants to be perfectly informed, it would be possible for central planners to be perfectly informed. Market participants respond to the particular information sets that they believe are relevant to their situation. Lower interest rates, rising company profitability, reduced risk premiums because of the perceived rise in the value of collateral that is backing lending and so on, all make it very difficult for private sector actors (entrepreneurs, company managers and fund managers) to distinguish between real factors and monetary factors. If I am running a bus franchise in Guildford and want to expand at today’s low interest rates, then I – and my bank manager – will be looking at the specific information that is relevant to me as an entrepreneur. All the people buying buy-to-let properties do not get their Fama and French out before applying for a bank loan. The greater the extent to which real and monetary factors point in the same direction – as happened in the early twenty-first century due to the Asian savings expansion reducing real interest rates - the more difficult it is to distinguish between real and monetary factors. There is a large amount of ‘noise’ amongst the information that investors need to use in order to make sound, long-term investment decisions. Indeed, even academics, using data gathered after the event, dispute whether real or monetary factors are responsible for changes in asset prices, credit booms and recessions in particular situations. Individual entrepreneurs are therefore highly unlikely to be able to untangle the sources of the price signals that they are receiving.
Because Austrians believe that recession inevitably follows artificial boom it has been said that Austrians have something to contribute to the understanding of a boom but nothing to the resolution of a crash. That sort of reasoning is wrong as well as not coherent logically. It is true that Austrians argue that there is a lot of misallocation during the boom and that this causes a lot of pain. They argue further that simply increasing aggregate demand through fiscal policy prolongs that pain. But, arguing that the Austrian explanation is not a good theory because its messages are somewhat uncomfortable does not make it wrong.
Secondly, there is something important in Austrian economics that comes from the understanding of the relationship between the real, financial and monetary sectors. Specifically, supply side reform will help make adjustment much easier. Some costs are sunk – one only has to wander round Dublin to see the huge and under-used capital investment projects that involved wasted resources during their boom to see this – but others are not. This is a point that New Keynesians should be able to understand because an explicit account of frictions is part and parcel of New Keynesian models.
In this context, it is worth noting that supply-side conditions in the UK in 2008 were particular grim and the coalition government has largely made them worse by increasing regulation and not liberalising in key areas such as land-use planning. This contrasts with the period from 1933 after the Great Depression in the UK when, with no substantial increase in government borrowing, national income grew very rapidly with a small government sector, the absence of land-use planning controls and so on. Indeed, by 1938, national income was back at levels which would have prevailed at trend growth rates had the great depression never happened.
So, this is the lesson from Austrian economics. A proper recovery from recession as well as an improvement in the long-run sustainable growth rate requires a smaller government sector, lower taxes and less regulation. It is to be hoped that this will be the message of the government’s Autumn Statement next week – it will be if the Chancellor has learned the right sort of heterodox economics.