Here's Why the Fed Plan Is Failing: We’re All Austrians Now

It’s no accident that Austrian economics is newly popular. It provides the best explanation for the business cycle we just lived through.

Stockbyte | Getty Images

But the resurgent popularity of Austrian economics may actually be hampering the ability of the Federal Reserve to reflate the economy with low interest rate policies. Businesses, now aware of the dangers of a low inflation- sparked economic bubble, may simply be refusing to fall for the age-old boom-bust trap.

The Austrian theory of business cycles is rather straightforward:

1) In a market economy, lower interest rates are a sign that more wealth is available in society for new business projects. Either society is more wealthy—and therefore saving more without lowering spending—or its members are saving more—delaying current consumption in favor of future consumption, and incidentally providing loanable funds for projects that will be sold for future consumption.

2) In either case, the low interest rates are a sign of additional savings—and therefore a sign that more money will be available for future consumption. Businessmen respond to this by starting or expanding business lines aimed at future consumption—that is, projects that take time and larger amounts of money to complete.

3) Many of the projects seem profitable only because low interest rates make them cheap to fund and the assumption of future consumer spending out of increased savings promises demand for their products. For businesses, this is a kind of paradise: they get to borrow cheaply and sell to wealthier people in the future.

4) Low interest rate-fueled business expansion spreads through the economy. The cost of labor and materials goes up, which provides people with more money to spend or save. Retail businesses expand as well as the higher-order long-term manufacturing, investment and research & design projects. This creates what looks like a benign cycle: expansion fueling expansion.

5) When the low interest rates are caused by central bank intervention, however, this paradise turns out to be an illusion. The wealth that would have led to future spending does not actually exist—because the low interest rates aren’t caused by an increase in the amount of savings. Because we already know the interest rates weren’t caused an increase in the savings rates, it’s fair to assume that the additional wealth created during the boom mostly went to spending rather than increased savings. (Indeed, savings might actually have decreased as people anticipating future wealth rationally spend more now because they perceive less need for savings to finance future spending.)

6) As it is revealed that savings-fueled demand is lower than expected, many of the projects go bust. Investments in them need to be liquidated, some at a total loss. The investments in those long term projects now look like irresponsible speculation on an assumption of future growth. The Austrians call them “malinvestments.”

7) The liquidation of those malinvestments means the loss of value in the resources those investments would have used, including the loss of jobs in those businesses. This spreads the “bust” from the original speculative areas to cover the economy—in a reverse of the boom cycle.

8) A side note here: It’s sometimes asked why a consumer boom doesn’t follow a long-term project bust. After all, if the problem was an assumption by businesses of increased savings, shouldn’t learning the reality that people weren’t saving cause the retail sector to boom? Unfortunately, this doesn’t happen. In fact, the reverse is usually the case. The reason is straight-forward: the mistake wasn’t underestimating spending, it was overestimating savings. What’s more, the liquidation of malinvestments causes unemployment, often triggering consumers to start saving more and spending less.

9) The economy develops what looks like an output gap. It is producing far less than it once did and employment is at a far lower level. This is mainly because part of the old output was geared toward future consumption that is now understood to be impossible. The output gap is just a shadow of the old, unsustainable boom.

Okay. Let me say that this is a slightly modified version of the Austrian theory of business cycles. It’s been modified mostly to take out the shibboleths of Austrian economics—the kind of private language that people who have read a lot of Ludwig Von Mises use to talk to each other. No doubt they’ll strenuously object to one part of another of my description of what they like to call the ABC—Austrian Business Cycle.

Students of ABC will notice that I left out one crucial aspect of the Austrian theory of business cycles here: I didn’t mention the role of the central bank in sparking the bust by raising interest rates. Typically, Austrians say that the central bank inevitably raises interest rates to ward off inflation. But I don’t think any raising of interest rates is necessary to begin the bust cycle—all that is necessary is for the future spending to be lower than it was expected to be. (I think this explains the housing bust, for instance.)

The strongest critique of the Austrian theory of business cycles has always been that it makes businessmen out to be a bit foolish. Why are they always getting tricked by the low interest rates of central banks into making unsustainable investments? Wouldn’t a smart businessman take advantage of low rates to make investments that could withstand inevitable rate raises?

There are lots of possible responses to this. The Austrian economists have offered plenty, including the fact that low interest rates create a kind of calculational chaos that makes if very hard to figure out which projects are sustainable and which are too risky.

One of the favored responses, however, has just been that businessmen did not understand the business cycle very well. After all, Austrian economics has long been regarded as outside the realm of mainstream economics. Many MBA’s probably have nothing but a vague sense of the Austrian business cycle theory. So the reason businesses didn’t anticipate and respond to the boom-bust cycle is that they didn’t know much about it. Their errors were based in ignorance.

A conspiracy theorist might point out that this ignorance served the purposes of central bankers very well. It made it possible for central bankers to use interest rates to manipulate the economy. They could lower interest rates and count on businessmen to respond as they expected—by starting and expanding business lines.

This brings me around to my point today. I think that we may have entered a new era.

We may all be Austrians now.

Not since the New Deal has Austrian economics enjoyed the political popularity it does now. Austrian economists are awfully popular with the Republican Party, especially its Tea Party wing. Peter Schiff, the Austrian economics-inflected investment advisor, is a very popular guest on business television. Tom Woods' book “Meltdown”—which provided an Austrian economics explanation for the financial crisis—was a best seller. Congressman Ron Paul and Senator-elect Rand Paul are both devotees.

Perhaps more importantly, there has been widespread blame assigned to Alan Greenspan’s Federal Reserve for initiating the housing bubble with its low interest rate policies. I cannot remember when the last time was that there was widespread public appreciation of the role of central banks in causing the boom-bust cycle.

Top that off with the very public criticism of Ben Bernanke’s zero-interest rate plus quantitative easing policy. While much of this is centered on the dangers of inflation, it has also given rise to fears of “bubbles” in various assets.

All of which points to me to the possibility that Austrian business cycle theory has gone mainstream. I think it is very likely that businessmen are finally waking up to the dangers of malinvestment—and avoiding some of the errors that the critics of ABC theory always thought they should.

If I’m right about this, it could mean that Ben Bernanke’s plans to push along the recovery through further easing could be stymied—or at least delayed. I’m not sure how long business will be able to hold out against the lure of low interest rates—especially as investors push banks and businesses to put the money on their balance sheets to work. But the downturn could last much longer than history would suggest.

Don’t get me wrong. I don’t think the Fed has totally lost its power to create mischief for the economy. If the power of central bankers to manipulate businesses through lower interest rates was diminished, the economy would be far healthier. But interest rate manipulation still will be a source of calculational chaos that will make business planning more difficult and likely lead to clustered economic errors.

But as long as our Austrian moment lasts, we might be headed to a healthier—if slower—recovery than we would have had if Bernanke could get his way.


Questions? Comments? Email us atNetNet@cnbc.com

Follow John on Twitter @ twitter.com/Carney

Follow NetNet on Twitter @ twitter.com/CNBCnetnet

Facebook us @ www.facebook.com/NetNetCNBC


NetNet TV

Wall Street