McCully Praises, But Misunderstands, Austrians
PIMCO bond manager Paul McCulley's recent commentary, A Kind Word for the Austrian School, contrasts the Austrian and Keynesian views on macro-economics. After reading it several times, I am still slightly puzzled about whether McCulley understands, or accurately represents, the Austrian view. McCulley writes:
And the concept of a "neutral" real rate is a very Austrian notion: there exists some unobservable interest rate (called the "natural" rate by Austrians) that perfectly matches the time preference of lenders and borrowers and in the absence of fiat currencies, free markets would find this rate (as if by Adam Smith's invisible hand), bringing about just the right amount of investment and savings.
In turn, Austrians argue that if fiat currencies do exist and if policymakers peg rates below the natural rate, there will be an excess of investment relative to that level which would generate returns consistent with the natural cost of borrowing, producing an investment bubble, which will be revealed when policymakers lift rates to or above the "natural" rate, generating an investment bust.
This is where the Austrian School is in direct opposition to the Keynesian School. For Keynes, investment was not a function of savings, but rather savings was a function of investment, which drives income, from which savings flow. Yes, after the fact, savings and investment must, as an accounting matter, equal each other.
But there was no a priori reason, Keynes argued, that savings and investment would ex post equal each other at full employment. For Keynes, what mattered was ex ante investment desires, which were driven by the state of confidence in long-term return expectations, summarized as animal spirits.
Thus, for Keynes there was no magical natural — or neutral — rate of interest. Indeed, Keynes actually put more emphasis on the role of stock prices than interest rates in eliciting the ex ante desire to invest. Yes, the great James Tobin found his Q in Chapter 12 of Keynes' General Theory!
Which brings us back to the ironic crossover between the Keynesian School and the Austrian School: if investment is a function of animal spirits and if animal spirits get their mojo from asset prices, then boom and bust in investment is endemic to the capitalistic system. That doesn't mean that it's not the best system ever devised for allocating resources. It is. But it is also inherently given to cycles of euphoria followed by doom.
For the Austrians, the solution to this problem was to kill fiat money systems and in the absence of that prescription, to resist using fiat money systems to soften periods of busts. For Keynes, writing at a time when the Austrian "solution" was de facto being applied, called the Great Depression, this made no sense at all. If investment and savings were equaling each other at 25% unemployment, then it was the duty of the sovereign to incite animal spirits with monetary ease, while even more important, boosting public investment.
I find this passage slightly misleading. McCulley's reading of Keynes is accurate: Keynes did believe that boom and bust cycles were inherent in the capitalist economic system, and that unemployment was likely to exist in the labor market even when capital markets were in equilibrium.
Austrian economists do not deny that boom and bust cycles are a recurring feature of the world that we live in. The question is whether the causes are endogenous, as Keynes thought, or exogenous, driven by central bank mis-regulation of the credit markets. Austrians believe the latter.
McCulley is correct in describing the Austrian solution to actual boom and bust cycles, but not if he meant "the Austrian solution to the problem of endogenous boom and bust cycles in the capitalist system". Since the problem of inherent instability in a market economy does not exist in the Austrian view, no solution is necessary. The "Keynesian problem" that McCulley refers to in the last quoted paragraph is only a problem for those who agree with Keynes.
I would also dispute the claim the the "Austrian" solution was being applied during the Depression. In particular, with regard to labor markets, there were efforts by policy makers to prevent labor markets from clearing by keeping wages at pre-depression levels when the money supply had collapsed significantly. The Keynesian "solution" was to divert more real savings into wasteful government spending, which lengthened the process of capital restructuring that was necessary in order for labor to find employment that would reflect actual consumer preferences and resource constraints. According to Austrian economic historian Robert Higgs, the threat of nationalization of the private sector depressed investment. Austrian scholar MacKenzie discusses the role of tarrifs and high taxes in prolonging the depression.
Later, in another passage which again leaves me slightly puzzled, McCulley writes:
Yes, it [a low and stable CPI] can work for a time. But precisely because it can work for a time, it sows the seeds of its own demise. Or, as the great Hyman Minsky declared, stability is ultimately destabilizing, because of the asset price and credit excesses that stability begets. Put differently, stability can never be a destination, only a journey to instability.
Keynes knew that. The Austrians knew that. On that, they agreed. What they disagreed about was whether instability was caused by fiat money makers holding real rates away from the natural level. For Keynes there was no ex ante natural rate level, only an ex ante imperative for policy-makers to pursue full employment. And the key to that was maintaining investment — private and public. For Keynes, there was no natural rate of interest at which that would happen, because investment is inherently the product of animal spirits, which fluctuate in animal-spirited ways.
What exactly did the Austrians know? It is a standard Austrian observation that a low and stable CPI is compatible with a high rate of bank credit expansion, so long as the credit expansion works mostly to distort relative prices within capital markets and between capital goods and consumption goods and not to raise the prices of consumption goods. So McCulley would be correct if he if his point is that a period of expansion with a low CPI can eventually result in a cycle bust. To "stability...is only a journey to instability...the Austrians knew that" is confusing at best. What Austrians knew is that phony stability — an artifact of the way that the CPI is measured — can mask real instability.
McCulley's discussion leaves out the possibility of true stability, which occurs under a sound monetary system, when the interest rate is set by the supply and demand for real savings. In this type of stability, economic growth only to the extent that there are real savings available to fund it. This mode of economic growth does not contain the seeds of its own destruction.
In the end, the point that McCulley is making is that the Austrians provide a bit of wisdom in advising the central bank not to ignore booms in asset prices. His conclusion:
Yes, I am a Keynesian. But more precisely, I'm a Keynesian wearing Minsky clothing, and doffing Austrian shoes. In the fullness of time, I expect Chairman Bernanke, a brilliant Keynesian, to rediscover that the Austrians were not all wet in their diagnosis of the potential for maldistribution of investment, even though they were soaking wet about what to do about it. The Austrians said let the asset price and credit excesses purge themselves. A much better way, I believe, is to lean against the excesses preemptively, using all available tools, including regulatory tools.
Yes, inflation targeting is fine. Myopic inflation targeting is not. Asset prices matter, and not just in the context of their influence on aggregate demand relative to aggregate supply and, thus, inflation. Asset prices matter in their own right, because wild swings in asset prices, even in the context of "stable" goods and services inflation, are a source of both volatility and maldistribution in investment.
Are we making progress at getting out accurate understanding of the Austrian school? You decide.