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John Phelan: The hills are alive with the sound of praxeology

Picture 10 John Phelan is a Contributing Editor of The Commentator and fellow of The Cobden Centre. He blogs at TheBoyPhelan.

When I told a friend of mine three years ago that I was interested in Austrian economics she asked “Isn’t that just selling cuckoo clocks and lederhosen?” True, she wasn’t the brightest, but Austrian economics was fringe stuff. An influential school originating in Vienna in the late nineteenth and early twentieth century it was largely buried under the Keynesian avalanche of the 1930’s. That’s changing.

The Austrian school survived in America where émigré economists escaping the turmoil of 1930s Europe inspired a new generation. Perennial presidential candidate Ron Paul is an advocate of Austrian economics and the Ludwig von Mises Institute dominates the field.   

But the economic crisis has seen the school gain new popularity in Britain. Radio 4 broadcast one show, "Yo Hayek!", which examined the ideas of one of the leading Austrian school economists, and a debate between Keynesians and "Hayekians" (the Austrians won). The Economist, bastion of conventional economics, recently carried a complimentary piece. The Institute of Economic Affairs has produced or reproduced a number of works in and on the Austrian school and Eamonn Butler has written an excellent short introduction for the Adam Smith Institute. In The Cobden Centre the UK now has its own Austrian-minded think tank and in May last year the first (to my knowledge) Austrian MP, Steve Baker, was elected.

Much of this newfound popularity is down to the ability of Austrian Business Cycle Theory (ABCT) to explain the current mess. The Marxist theory of economic cycles with its declining rate of profit is clearly useless as businesses were making record profits on the eve of the bust. There was no shock to Total Factor Productivity which a Real Business Cycle explanation would require. Keynesian ‘animal spirits’ are also unsatisfactory. The liquidation of certain enterprises was a totally rational response to the Federal Reserve raising interest rates between 2004 and 2007. 

ABCT, by contrast, fits the facts rather well. Briefly put, ABCT says that when a credit expansion occurs, say, as a result of lowering interest rates in response to the bursting of the dot com bubble in 2000, ever more marginal investment projects begin to look viable. Entrepreneurs borrow to finance them or businesses and individuals borrow for current consumption.

But eventually, even in a world with dodgy inflation figures and, thanks to the vast productive capacity of countries like China, prices which should be falling, the inflation caused by this credit expansion starts to show even in the central bank’s figures as when inflation went above 4 per cent in the US in 2006. Interest rates are raised; the Fed Funds rate went above 5 per cent the same year. Those marginal investments that looked viable at 1 per cent are now scuppered.

This is the recession. Over the previous boom period, capital has been allocated to investments, more properly called malinvestments, which have no hope of ever producing a return above their borrowing costs unless interest rates are kept low and credit is kept flowing. The recession is the liquidation of these unviable credit positions and it will not be over until this process is complete.

Even though this grim diagnosis seems to be coming true daily the reputation of Austrian economics as a council of despair remains a potent repellent. But truth is truth even when it is unpleasant.

And this reputation is undeserved. Seeing the problem as one of fluctuations of credit Austrians focus on the sources of that credit, banks and central banks, and several lively schools of thought, including Free Bankers and hard money advocates, draw their ideas for reforming the financial system from Austrian thinking. That Austrians zero in on the causes of the slump is hardly a reason to ignore them. 

But there is more to Austrian economics than ABCT. Indeed, it is a fairly comprehensive critique of much of modern mainstream economics.

Austrians reject the notion that there is something called "the economy" which can be stimulated or cooled at will. Instead they see economics as rooted in the behaviour of individuals. This makes Austrians generally rather dismissive of the aggregate values which make up macroeconomics and the obscure quantitative mathematics which ties them together.

For Austrians the economy isn’t a thing but a process, one of discovery and coordination of dispersed knowledge. In its rejection of equilibriums and embrace of information asymmetries Austrian economics pre-empts many of the criticisms of neoclassical economics.

Austrian economics is a rich field of the study of human beings, their actions and interactions, what Ludwig von Mises called praxeology. Because it is based on the study of individuals, the only agents in economics, its model has produced a robust interpretation of recent events. It also indicates the way out. Painful, yes, but we are learning that that’s unavoidable. The Austrian school's time has come.

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