Austrian School’s interpretation of current economic problems: what they get right and where they go wrong

An Article by:

Russell Cole

Virtually every mainstream economist has consented to the veracity of the following proposition:

The current financial turmoil has been created by the deregulation of the housing mortgage industry.

Despite near consensus over the causation of America’s current hardships, there continues to exist one ideological camp that argues differently. This is not unexpected, however, because the mainstream understanding of the present economic conditions and the forces underlying them is fundamentally irreconcilable with the core tenets of their belief system.

I am referring to the School of Austrian Economics and their alternative explanation for the precipitants of the current collapse of the housing market and its devastating impact upon our financial systems. According to adherents of this ideology – what amounts to a Cult of the Laissez-faire – it was not deregulation that paved the way for this state of affairs under which we suffer; rather, it was the intervention of government upon economic processes; namely, the Federal Reserve’s manipulation of our monetary system, which is based upon a currency whose value is not backed by any commodity of intrinsic worth, but, instead, by fiat.

Through the Federal Reserve’s manipulation of the Dollar – as part of their attempt to render a condition wherein credit was artificially inexpensive, allowing for markets to bubble – they contributed to the ballooning of the subprime mortgage industry. In fact, it was Greenspan who intentionally bolstered the subprime loan industry by continuing to make credit cheap and accessible through the manipulation of interest rates.

In this essay, I concede that the Austrian School’s interpretation of events is fundamentally correct. Specifically, it certainly was the Federal Reserve and the stimulus that it provided to the housing market that created the housing bubble. However, I do take exception with the implications that the Austrian School draws from its explanation of market bubbles and the economic turbulence that bubbles incite through their collapse.

My argument is two-part:

First, I argue that bubbles in markets are not inherently undesirable. Rather, they are tool to be used by government in order to motivate the production and acquisition of the hardware, contributing to American infrastructure, that is often accounted for under the rubric, capital expenditures: investments in things that have a lasting value.

Secondly, I argue that the current despair in the American economy – and the massive bailout that was orchestrated by Congress – could have been prevented by an expanded definition and a more rigorous enforcement of anti-monopoly and anti-trust. These firms that are supposedly ‘too large to fail,’ should have never gotten to that point with which to begin. In short, anti-trust and anti-monopoly should have been imposed preventing these firms from procuring a corner on markets allowing for such corporate enormity. These firms have amassed such a presence that they are no longer competitors in a sector of the economy; instead, these overgrown monstrosities are themselves the economic subsystems, and, therefore, their bankruptcy entails systemic failures to the economy.

What is a matter with bubbles?

According to libertarians, who subscribe to Austrian economics, bubbles are disturbances to markets that are created through government tampering in monetary systems. Government, for instance, might elect to provide artificially inexpensive credit; subsequently, allowing for economic agents to obtain capital in order to purchase and consume. This extension of accessible credit might serve to propagate a sector of the economy. However, the particular market that expands due to this governmental intervention is unsustainable in that it will cease to exist after the economic stimulus is retracted and there is no longer a means for members of the consumer market to leverage the capital necessary to consume the commodity defining this inflated sector.

Libertarians – using this simplified model, or some version of it, as justificatory support – argue against the intrusion of governmental agencies who control and regulate economic activity. They insist that only government can create market distortions, and, therefore, if not for government, the economy would not exhibit the volatility associated with crashes and the recessionary periods that they can precipitate. Without the Federal Reserve, for instance, there never would have been the housing market crises from which American society currently suffers.

It is not my intention to argue directly against this picture of the economy and government’s relation to it. However, it is my position that this picture is incomplete. Libertarians fail to recognize that bubbles serve practical purposes. They can be used to accomplish projects that have enduring legacies, because these artificially supported market expansions contribute to the future functioning of the economy and the society that it serves.

A prescient example of the utility of bubbles is found in the 19th Century, during the period when the Federal Government attempted to bolster the development of the railroading industry by offering incentives. The vibrancy of the railroading industry, which was partially the product of governmental intervention, came to an eventual deceleration, as the artificial stimulus failed to continue to fuel its frenetic growth rate, causing some pronounced economic readjustment. Nevertheless, despite the economic slowdown that ensued, the Country was left with an enhanced infrastructure; one where the railroading system connected various population centers that were previously separated by vast distances that would have otherwise impaired commerce and travel. In short, the facilitation of the railroading industry – which was accomplished through governmental intervention – aided in America’s domestication of its capacious geography.

Another obvious example of the usefulness of bubbles involves a more recent development in American history.  The technology boom, which was created during the Clinton Administration, crashed after the collapse of the Dot Com market. However, during the rapid expansion of the technology sector, large segments of the population acquired Internet service. Additionally, due to the increased demand for the Internet, investments were made in broadband; resulting in the materialization of an augmentation to society’s infrastructure that has provided immeasurable benefits to the economy, not to mention its contributions to other spheres of society; i.e., knowledge centers, such as academic libraries that now offer remotely accessible electronic reserves: repositories of hypertext that can be searched using adaptations of the programming applications associated with the more generally specialized Internet search engines, such as MSN and Google.

It is difficult to appreciate the full extent of the technological innovations that have been spawned – as subsidiaries – of the underlying platform, the Internet. However, one can feel confident in saying that the proliferation of digital artifices that transact with one another using available broadband – which enhance our abilities to communicate and exchange information – has had a transformative impact upon our habitual modes of social comportment. These communicative devices have changed the way in which we relate to others. They have generated a whole field of possibilities in the economy, civil society, and the political sphere; opportunities that might never have been disclosed if not for the Dot Com boom of the 1990s.

From these few examples, I hope that it is evident that the artificial inflation of economic markets by government can serve useful purposes. However, this is not to say that governmental interdiction in economic affairs is not fraught with dangers. Special interests might be favored by regulators; thus, amounting to a situation where it is not society that is benefited though government’s propagation of a market, but merely segments of the economy who directly profiteer from the market’s expansion.

In relation to considerations resulting from this line of inquiry, I have often heard the argument against the Austrian School and its insistence upon a return to a commodity backed monetary system that can be paraphrased as follows: In lieu of a Gold Standard, all that needs to be done is to do away with the extra-democratic Federal Reserve and, as a substitute, have Representatives in Congress make decisions affecting currency and its availability as well as other policies impacting financial markets. According to this counter to the Libertarian platform, it is the not the absence of regulation that is desirable; rather, it is the democratization of the regulatory fixtures that oversee economic activity.

Too big to fail?

We are often subjected to this argument when the Federal Reserve or Congress elects to save one of the economy’s larger corporations from impending bankruptcy. We are told that the economy as a whole would suffer from the ripple effects of such a formidable collapse. However, these appeals for government bailouts always appear hypocritical if not entirely insincere. It is always those who are the adherents of free-market economics, when it serves their interests, who are left making appeals for governmental intervention when their speculations do not pan out. One is left to suspect that the risks underlying their business decisions are made under the pretext that even if their investments suffer from a “black swan*,” catastrophe, they, ultimately, can rely upon government to prevent their dissolution because they are, after all, ‘too large to fail.’

If we look to the current situation in which we find ourselves, if we were to follow along the lines suggested by the Austrian School, we would simply allow these corporate monstrosities to go under.  In turn, our economy would enable competitors to enter the market; firms that would be structured according to a sounder business model, who would better understand risks and how they should impact their investments.

This approach to the current problems we face, however, is no assurance that this will not happen again in the future; where we are placed in a situation in which the failure of overgrown financial firms causes systemic reverberations, possibly resulting in recession or depression.

“Greed is good,” perchance, in an limited array of situations. However, when greed is allowed to compel men to act without any countervailing regulations designed to mitigate the adverse consequences that might result from the unleashing of this baser mental predicate, the Executives of the Financing industry will pursue their bonuses with temerity, because the paper salaries they receive will compensate for any loss they might suffer with respect to their stock options.

A more effective policy maneuver would consist of more robust anti-monopoly and anti-trust regulations that would compel regulators to thwart these types of firms from ever growing to a state where their failure would entail large scale economic repercussions. Therefore, the answer to our current woes is not be found in the Laissez-faire that is advocated by Libertarians, who follow in the tradition of Austrian economics. Rather, the best approach consists of smarter regulations that anticipate these occurrences and enable regulators to actively work against them.