The question refers to a school of economics. I argue that in the information age, Austrian economics has gained relevance in some respects but lost it in others.
(A) Imagine a restaurant in which the menu includes some items that can be cooked quickly, using stir-fry and microwave techniques, while other dishes such as stews and roasts require longer and more roundabout cooking methods. In a well-functioning restaurant, the extent to which consumers are hungry now or are willing to wait determines the mix of food that is prepared. The waiters deliver the right information to the chefs about how much of each type of meal to prepare. However, like a bad waiter, a central bank can enter the picture and deceive the chefs into thinking that people want more stews and roasts than they truly desire. This leads to a boom in long-term cooking, followed by a bust later on.(B) Imagine a restaurant in which the chefs have many new recipes to try. Most of them will not be popular, but some will represent successful gastronomic progress. When the chefs become optimistic, they try many new recipes, which means a boom. When the chefs become risk-averse, there is a slump.
For reasons that baffle me, the Austrians prefer explanation (A). Explanation (B) is closer in spirit to Keynes, the arch-enemy of the Austrians.
My experience both in business and in economics leads me to prefer (B). I have never been in a business situation where a decision boiled down to a choice between two projects with known, predictable rates of return, with one project short-term and the other project long-term. Instead, the typical challenge has been to guess whether a new business idea will be successful or not, given uncertainties about feasibility, marketing, technology risk, and other factors.
As an anarcho-Austrian, let me respond to your restaurant analogy illustration of a stylized boom and bust.
In (A), you pose a sharp dichotomy between two styles of cusiine, one of which requires less roundabout cooking methods, the other of which requires more. (Think of an economy in which two consumer goods are produced. One requires no [or very little] capital, but the other requires a lot of it.) The central bank is like a waiter that provides bad information about what the patrons want to eat. It gives excessively bullish information about the demand for food requiring longer and more intensive preparation, and too bearish data about demand for that taking a less roundabout method. There are only two choices in this scenario: food with more and less roundabout cooking. In effect, there are two fixed-stage methods in (A).
In (B), chefs try many new recipes and are not confined to cuisines requiring two fixed-stage cooking methods. There are dishes that take very little food preparation, some that require a long process, and different dishes with different ranges of roundaboutness. This is more like how the real world works, whereas the former scenario is--dare I say it?--a strawman.
Nevertheless, (A) is far better in describing reality than (B) because the latter is a kind of real business cycle that has the chefs waxing optimistic then pessimistic by turns, but with no causal adjustment mechanism and no explanation of why these cycles occur. Why should they become risk averse en masse after a period of booming prosperity fueled by optimistic expectations? Why did they become optimistic together in the first place? Is this a le Bonian theory? Just crowd behavior?
(A) implicitly recognizes the crucial role of the interest rate in allocating capital, which (B) does not. A central bank is like a bad waiter, who misinforms the chefs by telling them that there is more demand for dishes requiring more roundabout methods than there in fact is.
By pushing interest rates below the natural rate set by the supply and demand for loanable funds, it encourages entrepreneurs to invest in longer production processes than can be sustained by the actually existing demand for consumers' goods. Therefore its actions set the stage for the inevitable bust.
What happened in the internet boom of 1995 to 2000 (actually 1999, as the advance-decline line of the Nasdaq turned down in '99, thus marking the real end of the bull market), is that a combination of strong productivity growth (cited by Edmund Phelps in a WSJ op-ed article earlier this year) and easy money caused stocks to boom well beyond their intrinsic values, and led to a fall in the cost of capital (both debt and equity), which in turn fed a huge IPO boom (there were about 2,300 IPOs from August 1995 to early 2000). Phelps wrongly cited the productivity boom as the sole cause of the stock bubble, and criticised the Austrian theory of the business cycle, if memory serves. The productivity gain theory can't account for the low cost of capital, although it can account for at least some of the excessively bullish growth rates and profit margins investors used to value stocks.
The combination of overly bullish growth rates and expected cash flows, which were discounted with excessively low rates, caused the stock bubble. It was not "irrational exuberance" or "mass insanity," as Burton Malkiel calls it in his new book. (Thomas Szasz, call your office!)
Thanks to Tyler Cowen for citing this post at The Marginal Revolution, one of the most interesting blogs going.
Bill Stepp
Anarchist Antidefamation League
Fun quiz and inciteful argument about church vs. sect. Sect is a nice word... some of these things border on cult. What I love about the quiz and the analysis of answers provided for the quiz taker is that it pretty much divides the world into three groups: screwballs, squishes, and people who are right. Notice that all the Chicago answers are 90% in agreement with the Austrian answers, but have a touch of impurity to them. The biggest enemy of a cult is the person who is 90% in agreement, because he hasn't suspended personal judgement for the pre-made judgements of the cult.
As a movement, the Austrians seem more intent on growing the cult than having influence. I love listening to and reading Walter Williams, for example. But I wouldn't want him to be a Presidential economics advisor. The context in which he'd have to offer advice is not Autrian. There are necessary evils to deal with, because if they aren't dealt with by people who have the right motivations, there are people with the wrong motivations waiting to do serious harm.
I agree with Arnold. It's too bad they don't take a church view and let things sort out (and remain relevant to wider contexts which we may not like but have to deal with) in that market of ideas.
-Brad
Posted by Brad Hutchings on November 11, 2003 02:01 PM | Permalink to Comment91% Austrian (strong finish)