In Michael Pollaro’s otherwise excellent Mises Daily, “The Bernanke Bust” Michael writes, “To Austrians, all [emphasis original] economic “booms” founded on monetary largesse always [emphasis original] end in economic busts, roughly equal in size and intensity to the preceding booms[emphasis mine].” Such a phrasing often leads to a misrepresentation of Austrina Business Cycle Theory which is often used by critics to discredit it. Over 10 years ago in a Forbes article, “L is for Layoffs”, Peter Brimelow and Edwin S. Rubenstein made such a misrepresentation. Brimelow and Rubenstein classified their statement as “Hayek’s Law”. These authors argued that Austrian business cycle theory implies that a long period of credit expansion will be followed by a long recession or period of stagnation.
In 2001 I attempted to clarify this aspect of Austrian Business Cycle Theory (ABCT), in a Mises Daily, “Hayek’s Law or Rothbard’s Wisdom” I wrote then:
The authors’ [Brimelow and Rubenstein] source for Hayek’s Law is Mark Skousen, who is quoted as saying, “Hayek’s Law states that the economy takes a long time to recover after an unsustainable boom (1995-99). The excesses of the previous boom create an investment structure that cannot be easily dismantled and transferred to new uses.”
What exactly do Hayek and other Austrian business cycle theorists, particularly Murray Rothbard, have to say about the relationship between the boom and the length of the bust? Actually, correctly interpreted, nothing.
The chief conclusion I want to demonstrate is that the longer the inflation [the increase in the effective quantity of money] lasts, the larger will be the number of workers whose jobs depend on a continuation of the inflation, often even on a continuing acceleration of the rate of inflation—not because they would not have found employment without the inflation, but because they were drawn by the inflation into temporarily attractive jobs, which after a slowing down or cessation of the inflation will again disappear. (Hayek, Unemployment and Monetary Policy: Government as Generator of the “Business Cycle,” p. 13)
Rothbard comes to a similar conclusion when he states, “The longer the inflationary distortions continue, the more severe the recession-adjustment must become.” [Rothbard’s America’s Great Depression, p. xxvii] Notice that both of these are statements about the severity of the maladjustments, not statements about the length of the recession/depression [and subsequent recovery]. It is an inappropriate jump in logic to go from the conclusion that the greater the length of the period of artificial credit expansion the greater the degree of malinvestment and, thus, the greater the necessary reallocation of resources, to a prediction about the length of the adjustment period.
The restructuring of the economy requires a realignment of relative prices and wages. The crisis and the period of recession are the “necessary corrective process by which the market liquidates the unsound investments of the boom and redirects resources from capital goods to consumer goods industries,” says Rothbard (p. 12). How long this adjustment takes, however, is more a historical problem than a theoretical one.
As Rothbard (p. 14) explains, “Since factors must shift from the higher to the lower orders of production, there is inevitable ‘frictional’ unemployment in a depression, but it need not be greater than unemployment attending any other large shift in production” (emphasis mine). The adjustment can be quick and the unemployment temporary if markets are allowed to work during the necessary period of liquidation and restructuring.
What, then, causes or leads to a prolonged depression? Here again, Rothbard (p. 14) provides a clear answer: “Unemployment will progress beyond the “frictional” stage and become really severe and lasting only if wage rates are kept artificially high and are prevented from falling. If wages are kept above the free-market level that clears the demand for and supply of labor, laborers will remain permanently unemployed.”
In the current slow (worst recovery since the Great Depression?) what is needed for a speedier recovery and one which does not sow the seeds for the next bust? (For a more in depth discussion see Capital in Disequilibrium: Understanding the “Great Recession” and the Potential for Recovery). Recovery, like growth and development, requires forward-looking planning. Austrian capital theory implies that a significant portion of current economic activity is directed not to current, but to future consumption. Planning and calculation include decisions on reinvestment to maintain current levels of production into the future as well as new investment for expansion and new enterprises, all of which are future oriented. Recovery, like sustained growth, requires an environment that facilitates the planning and development of projects which create current jobs, most of which will be directed toward future consumption.
It is true that ABCT emphasizes impediments to adjustment caused by the non-homogeneous nature and varying specificity of many capital goods and some human capital. These impediments plus any capital consumption generated by the cycle are unique to each crisis.
Where some proponents (and critics) of ABCT go wrong is to use these capital structure impediments to recovery to imply (or to have been interpreted as implying by critics) that longer credit expansion induced booms and the correspondingly greater degree of distortion on the market makes necessary a longer and more severe correction/recession/recovery period. While malinvestments caused by credit creation cause losses and impede reallocation, there is no necessary connection between the length of the boom, the degree of misallocations, and the actual severity of the recession and the length of the recovery process. One also has to take into consideration whether markets are being allowed to work and if the “regime” is not only certain, but stable, predictable with a policy environment conducive to entrepreneurship and prudent risk taking. Policies that impede competition and impose excessive tax burdens—or that in any way simply add to costs, reduce expected returns, or increase the uncertainty of business activity—are seen as the most important factors in forestalling recovery and turning economic corrections into stagnation, stagflation or depression.” Historically, policies and actions that threaten property rights create “regime uncertainty.” Garden variety recessions become depressions (or sustained periods of stagnation or stagflation) only if markets are prevented from correcting by bad policy and not just regime or policy uncertainty, but more explicitly by threats of “regime worsening”; threats of higher taxes, burdensome regulations, enhanced labor market rigidities or other policies that threaten property rights and reduce expected rates of return on investment – the key to recovery and potential sustained growth.
Marcus Nunes at Historinhas provides interesting data on recovery from 4 boom-bust periods in U. S. history which provide some support to the above argument in his commentary “Three panics and a nonevent”
Nunes, an advocate of nominal GDP targeting concludes, “I don´t know why Austrians decry the 1873 contraction a myth. From their perspective they should be searching for reasons why it didn´t happen despite all the malinvestments that, according to them, are a root cause of all the other ‘Panics’.
In 1873 and in 1893 there was no Central Bank. In 1929 and 2008 the Fed was there to minimize the effects of such ‘panics’. Apparently, Central Bank or not, it surely doesn´t help to let nominal spending crash! And Bernanke should note that in the 1870s and 1880s the economy performed robustly in spite of a drawn out fall in prices, an ingredient of his worst nightmares!”
Relative to the more recent crisis, John Taylor at Economics One provides some evidence that policy uncertainty has increased and is a primary influence on the slow pace of the current recovery.
“Of course something is now interfering with the usual economic response, because our current recovery is certainly not springing back to normal. I have argued that economic policy is holding the economy back, and I think recent research by Ellen McGrattan and Ed Prescott (on increased regulations) and by Scott Baker, Nick Bloom, and Steve Davis (on policy uncertainty) supports this view. Their work is part of a forthcoming book (Government Policy and the Delayed Economic Recovery) edited by Lee Ohanian, Ian Wright and me.”