Mukti

Austrian days

Posted in economics by jrahman on August 10, 2007

Some time ago, I read this joke that, quite scarily, I found funny.  In addition to the real business cycle — negative technological shocks — and Keynesian — fall in aggregate demand — stories of why recessions happen, there is also the ‘hangover theory’.  The story of recessions in this theory goes like this: in the beginning, there is loose money that leads to bad investment, at some point the easy money runs out and the day of reckoning arrives, and the painful adjustment process is what we call recession.

A major proponent of this theory is Friedrich von Hayek, the doyen of Austrian school of economic thought.  Listening to the school’s ideas in his iPod (yes, he is a very disturbed young man), my brother thought the Austrians were a cult who believed in the god of market called the invisible hand.  Well, Paul Krugman compared Austrian macroeconomics with phlogiston theory of fire in the late 1990s.  But as De Long notes here, Krugman had a sort of change of heart after the 2001 US recession.

Perhaps I should start a bit further back.  Once upon a time, there was chairman of the Federal Reserve called Alan Greenspan.  When the unemployment rate in the US fell to 6 per cent in the mid-1990s and everyone feared a break out of inflation, Greenspan held steady and didn’t raise rates.  In the event, joblessness fell further, to 5 per cent and then to 4 per cent.  And there was no inflation.  What happened?  It was the beginning of the new economy — the IT and globalisation inspired productivity pick up.

Stronger productivity growth led to rallying share prices, and before long, there was a full-blown bubble in the share market.  Even though inflation was moderate, many crypto-Austrians, but not Krugman, thought there was too much money in the system, and Greenspan should prick the bubble.  Greenspan did nothing.  The bubble ran its course and burst in April 2000.

Then for the next 30 or so months, share prices fell steadily.  By 2002, there were talks of a Japanese-style deflationary slump in the US.  Bush administration cut taxes heavily and Greenspan slashed interest rates sharply.  The economy was flooded with liquidity.  Consumers borrowed, and spent, heavily.  And the 2001 recession turned out to be one of the mildest on record.  Greenspan became a legend.

Tax cuts and cheap money fend of a deflationary slump — sounds like textbook Keynesianism.  And it seemed to have worked.  Or did it?  There were doubters, of the Austrian kind, but also a reformed Krugman, who thought that the tax cuts were poorly designed and money became too cheap.  They argued that Greenspan merely replaced the bubble in the tech stock with one in the housing market.  And sooner or later, that bubble would burst, leaving Greenspan’s successor to with a mess.

The housing bubble burst last year.  It appears that there were a lot of bad loans to the sub prime mortgage market.  Other financial institutions had link with these bad mortgage loans.  And now it appears that the rabbit hole is much deeper than what anyone thought.

The general view it seems is that it’s Greenspan’s fault (here’s what Stiglitz says).  It seems that we are all Austrians now.

Or are we?  The first reaction of the central bankers seem to be to pump more money into the market, exactly the opposite of what the Austrians would suggest.  Hmmm… stay tuned for what happens next.

And oh, if you have lost money in the last few days, oh well, remember, money can’t buy you love.

Originally posted at A-A-A.

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