Another metaphor on the causes of recessions

I’ve previously presented thoughts on the causes of recessions, the bust part of ‘boom and bust’. Understanding the causes of recessions is crucial in order to help prevent them, and to return to growth.

The mainstream Keynesian view (named after the economist John Maynard Keynes) is that there has been a fall in ‘aggregate demand’ – a reduction in the overall amount of spending in the economy. Keynes was somewhat vague on why this happened across the economy rather than there being reductions in one area and perhaps increases in another. He blamed ‘animal spirits’. The usual explanation of this is that there may be a loss of confidence, people get worried and spend less.

It is this belief in a reduction in aggregate demand that leads to ‘stimulus’ packages – increases in government spending to make up for the shortfall in the private sector – that typically result in government deficits. The other key policy prescription is to lower interest rates to encourage more borrowing and hence in turn, more spending.

These actions however only make sense (and indeed will only work) if the recession was actually caused by a reduction in aggregate demand. It is not right to argue that we must do whatever is necessary to end the recession and worry about the causes later. Both stimulus spending and lowering interest rates can in fact make things worse if the cause of recessions is that as proposed by the Austrian school.

The Austrian school of economics, that’s been featured numerous times on this blog so far, is so named as the key proponents of these ideas at the turn of the 20th century all happened to be Austrian. Nowadays, Austrian economists are found the world over.

The Austrians see the recession as inevitable consequence of the boom phase and hence the key policy prescription is to avoid the boom in the first place. The boom is viewed as a period of unsustainable growth that is set in motion by an artificial increase in the money supply. In the modern era, this is usually caused by central banks lowering interest rates.

As I argued previously, this artificial lowering of interest rates set off unsustainable business ventures that would not have happened otherwise. These are ‘malinvestments’, projects that do not reflect the true supply and demand in the economy. In that post, I presented an analogy from Ludwig von Mises, one of the early Austrian economists, in which he described this malinvestment as a house builder who believed he had more bricks that he actually had. When he realises he has too few bricks to complete his half-finished house, he has to cancel his project and a recession ensues. In this picture, the problem is not a lack of aggregate demand, but a mistaken use of resources.

Another analogy that is useful to understand the Austrian view, is one from Robert Murphy:

To illustrate what’s wrong with the typical Keynesian view of the economy, in the debate I told the spectators to imagine that one night, mischievous gnomes decided to rearrange all of the capital goods and skilled laborers in the country. The next morning, brain surgeons who were supposed to report to a hospital in Albuquerque would wake up in Miami. Factory owners in Trenton would open their doors and see that their assembly lines were gone, replaced by defecating cows. Farmers in Iowa, for their part, would be baffled to see drill presses and computer servers sitting in their empty fields.

In this rather exaggerated scenario, there is no overall lack of demand, but rather a complete mismatch between the supply and demand of both capital and labour. Increasing demand will not solve the problem, instead, workers and machinery need to find their way back to where they belong. Austrians argue that Keynesian economics tends to focus too much on aggregate data (such as unemployment figures, GDP etc) and neglect to focus on the heterogeneous nature of the economy. Not all workers are the same, neither is capital. Murphy again:

Once we understand the Austrian diagnosis of the cause of a recession — namely, that the preceding boom period allowed the economy to reach an unsustainable configuration — then we can also understand the “function” of so-called idle resources.

After the collapse of a boom, it takes time and genuine search for displaced workers and owners of capital goods to discover their best niches in light of the new information. In an unhampered market, the bulk of this readjustment would probably be over within six months. But with the government and central bank doing everything in their power to prevent this dreaded “liquidation” process, the alleged recovery churns along at an agonizing pace.

Hopefully these two analogies help to understand the Austrian perspective, and to shed light on why increasing government spending during a recession will only make things worse if the Austrians are correct.

Of course, the best way to understand this is to watch the awesome rap videos I’ve posted on the Resources page 🙂

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