Sunday, May 2, 2010

Critical Note on the Austrian View of the Financial Crisis

A Critical Note on the Austrian View of the Financial Crisis

Austrian economist Roger Garrison writes that “a true-to-Hayek nutshell version of the Austrian theory is not difficult to produce. . . The Federal Reserve under the leadership of Alan Greenspan kept interest rates too low during 2003 and 2004 and then ratcheted the rates steeply upward. Time-consuming investments that were initiated while cheap credit made them artificially attractive were then made prohibitively costly to carry through.”

Garrison goes on to cite Mises’s master builder parable, “the whole entrepreneurial class is, as it were, in the position of a master builder whose task it is to erect a building out of a limited supply of building materials. If this man overestimates the quantity of the available supply, he drafts a plan . . . [that cannot be fully executed because] the means at his disposal are not sufficient. He oversizes the groundwork and the foundation and only discovers later in the progress of the construction that he lacks the material needed for the completion of the structure.”

Reading this, I can only conclude that Mises’s “master builder” must be rather dim-witted. Why wouldn’t the Austrian master builder recognize that the Fed had pushed the interest rate below the “natural rate,” that the supply of artificially cheap credit couldn’t last, and that the rational course of action would be to avoid undertaking too many “roundabout” projects? Alternatively, when interest rates were artificially low, why wouldn’t the master builder borrow heavily at fixed interest rates (selling long-term bonds) and then hold onto the borrowed funds to assure he had “the material [funds] needed for the completion of the structure” after credit tightened?

It’s interesting to note that if firms took this last course of action, prices wouldn’t rise with the credit expansion because of the increase in hoarding. In fact, holding money as a store-of-value is precisely the aspect of a money economy that Piero Sraffa pointed to in explaining why Hayek's account of saving and investment was only relevant to a barter economy.

Keynes was once asked about his low opinion of the average business intellect, “If businessmen are so stupid, how do they get rich?” To which Keynes replied, “By competing against other businessmen.” I think Mises’s parable, and the whole Austrian theory of the boom-and-bust cycle, only work if Keynes’s quip is on the mark. Otherwise, they could discern when interest rates were below "the natural rate" and either circumscribe their investment plans or lock-in the prevailing low interest rates by selling lots of bonds.

Of course, the Austrians could argue that no one knows whether prevailing interest rates are above or below the natural rate. But, in this case, it's hard to criticize central banks for pushing interest rates below a natural rate the level of which no one knows.


  1. Insightful observations indeed.

    John Quiggin has his own criticism of Austrian business cycle theory:

    Hayek's business cycle theory went through several incarnations too, in response to attacks by Nicholas Kaldor in his articles "Capital Intensity and the Trade Cycle" and "Professor Hayek and the Concertina-effect."

  2. P.S.
    My own blog is here if you are interested: