Investors Pessimistic about Europe

Those who expected the European crisis to be over by now (probably nobody outside of the European political elite) are in for a rude awakening. Not only does the Greek government press ahead with highly destructive austerity policies – together with the Spanish and Portuguese governments – but there is also growing discomfort among financial investors with Europe’s long-term direction. A new report from Fitch Ratings (no-cost subscription required) sends a chill down your spine:

55% of investors say fundamental credit conditions for sovereigns will deteriorate [in Europe], more than double the vote in the last survey (24%), reversing the more optimistic trend since Q212. The more circumspect sentiment was evident across all sectors, notably also banks.

This is bad news for the European Central Bank which has tried to prop up European treasury bonds with an endless commitment to buy them back from whoever wants to sell them, whenever and at whatever amount. Investors simply do not believe that the ECB can or will print that amount of money.

That is understandable. Theoretically, we are talking about 400 billion euros just to honor every Spanish treasury bond.

Then Fitch reports something rather interesting:

Recession Fears Spread Gloom: An all-time-high of 86% of respondents rate prolonged recession as a high risk to the European credit markets, up from 69% last quarter. Eurozone sovereign debt problems are ranked as the second-highest risk. … Only 9% of survey participants expect inflation to be a problem in the next 12 months. Deflation is seen as more likely, based on the 29% who voted this as high risk.

A continued recession combined with deflation is about the worst that Europe could face right now. Deflation is a highway to business depression, primarily so for the so called Keynes effect:

  • A business owner borrows $48,000 today and expects to pay the bank $1,000 per month for the next four years;
  • At a constant sales volume he earns $8,000 per month, pays $6,000 for his production costs and $1,000 to the bank, leaving $1,000 in profits;
  • He expects prices to rise with inflation, or  two percent per year, which with reference to the bank loan will reduce its cost by a small annual margin.

With a two-percent inflation rate his sales revenue – at constant volume – will rise to $8,160 per month in the second year. Given that his production costs go up by the same percentage he is left with a profit margin of $1,040, a four-percent uptick in one year.

Assume instead a two-percent deflation rate per year. With the same numbers and production-volume assumption his sales revenue decline to $7,840 in the second year. If his production costs fall accordingly he is left with $960 in profits.

In the first case inflation eases the cost of the bank loan; in the second case deflation makes it more costly. If this was a small business with no profit margins – the situation for a large number of small businesses in recession-ravaged Europe – the obvious decision would be not to invest in any expansion of production at all. But even larger businesses suffer from deflation and will be less inclined to expand during a period of price declines.

Before we return to Fitch, I also want to point out that the deflation fears come amid the large money-printing endeavor in the history of the European Central Bank. This is therefore yet more evidence that the transmission mechanisms that build a bridge from the monetary sector into the real sector are pretty much dormant at this point. There is in other words very little demand for liquidity because there is far too little activity in the real sector of the economy.

Back to Fitch and the backlash from the Cyprus Bank Heist:

A strong majority of 80% interpret the Cyprus bank resolution as a precedent which removes implicit sovereign support from bank senior debt.

How do the European political leaders expect their banks to attract savings in the future, when people know that the government can flip their savings into bank assets at the slightest glimpse of a new recession?

Overall there are signs that Europe’s investors have become more short-sighted in their strategic planning, which is an endemic feature of deep, long recessions. Fitch makes this point, though more techically:

Insatiable High-Yield Hunger: 27% voted high yield (HY) their most favoured investment choice, down from 29% last quarter, but still clearly ahead of runners-up emerging-market (EM) corporates (16%) and banks (15%). … In Fitch‟s view, there is a stark dichotomy between the continuing recession with rising unemployment across Europe and the rally in financial markets. If the latter is not validated by economic stabilisation and progress towards banking union, the danger is that market volatility will return with a vengeance over the summer, as it did in 2012 and 2011.

The combination of high-yield hunger and a financial rally in the midst of a deep recession is reminiscent of historic episodes of financial instability. The notion seems to be to make as much money in as little time as possible because the future is so dim that no one can even see it. But this combination also reinforces an important impression from the Fitch survey, namely that investor confidence in Europe’s economic future is getting weaker, not stronger.

In all likelihood, they are all well aware of the most recent macroeconomic data. We will therefore review those numbers here in a day or two. In other words, stay tuned for more bad news on Europe…

Austrian Theory vs. Economic Freedom

My apologies for a long article, but this is a very important topic.

When someone titles his article “The Bankruptcy of Governments” it attracts interest from every friend of economic freedom. If the piece is well-written, it makes a valuable contribution to the intellectual battle over the future of Western Civilization. We need more of intellectually sharp contributions and less of ill-founded demagoguery. Our followers on the political side of the arena are inspired by us, bring our arguments and our analysis to the legislative hallways and try to get laws and budgets passed that will change economic policy and the role of government in the better direction.

If we get it right, all the way from good analysis to good policy decisions, we win – and more importantly: everyone else wins when we all benefit from more economic freedom. The wealthy can invest and improve businesses under more liberty; the poor and needy get more opportunities to improve their lives; creative, entrepreneurial people get more opportunities to build new businesses.

However, if we get our analysis wrong our cause is badly hurt. In theory, it does not matter where the mistake is made in the chain from analysis to legislation, but the closer the error is to the analytical starting point, the more serious the mistake is. Policies that are built on flawed legislative work will have repercussions that are limited to the legislative process; analysts and policy advocates can still do their work without having put their future credibility in jeopardy.

When the error is in the analytical foundation, the entire chain unravels. Bad analysis contaminates analysts, policy advocates, grassroots and activists, as well as elected officials. We who create the analytical foundation therefore have to hold ourselves to the standard that we can’t miss once.

In fact, as I explain in my book Ending the Welfare State, with the big welfare state we have today we will in reality only get one chance to restore economic freedom. If we stumble on the reforms or execute them in such a way that it causes a lot of hardship for many people, we will lose the battle for at least a generation. By that time there won’t be much of a prosperous, industrialized world to save.

For precisely this reason it is crucial that we freedom scholars and analysts do not waste our time – and other people’s time – on analytical constructs that lead to pain, suffering and a certain death for the cause of freedom. This is also why I engage other scholars and analysis whose ambition it is to promote economic freedom, but whose analysis I disagree with.

In the field of economics there is one school that meets all the criteria of purportedly supporting freedom but in reality doing a lot of harm to the cause. That school is, hardly surprisingly, Carl Menger’s Austrian tradition of economics. I have already on a few occasions written about the flaws in Austrian economics and I will continue to do so until its role in the freedom movement has been marginalized to the point of no influence.

This side of Marxism, Austrian economics is the most ill-conceived theory currently at use in the public policy arena. When it was put to work in Russia after the collapse of the Soviet Union, the result was a decade of economic waste, deprivation, abject poverty and collapse of almost every social institution except the Orthodox Church. The demise of a bankrupt government did not automatically, through some spontaneous order, give rise to a well-ordered society with a minimal government. When big government disappeared chaos, anarchy and mob rule took over.

With this experience in mind we have to know exactly what we are doing when we lay out a path to limited government. The article mentioned earlier, “The Bankruptcy of Governments”, has a promising title but unfortunately turns out to be yet another example of flawed Austrian thinking. It is an important example to discuss, though, precisely because it so well illustrates the fine line between good and bad analysis.

The author, Alasdair Macleod with the British think tank The Cobden Centre, starts off well:

For a long time governments have been redistributing peoples’ income and wealth in the name of fairness. They provide for the unemployed, the sick, and the elderly. The state provides. You can depend on the state. The result is nearly everyone in all advanced countries now depends on the state. Unfortunately citizens are running out of accessible wealth. Having run out of our money, Governments are now themselves insolvent. They started printing money in a misguided attempt to manage our affairs for us and now have to print it just to survive.

That is not entirely true. The excessive money printing did not start until the Great Recession broke out in 2009. Up until that point EU governments in particular were very good at maxing out taxes on their citizens. But Mr. Macleod’s point about governments printing money just to survive financially is a good one, and falls well in line with my analysis.

However, this statement…

The final and inevitable outcome will be all major paper currencies will become worthless.

…is a bit on the excessive side, to say the least. Austrians have been crying about American monetary inflation for years, yet it has not happened. The reason is that their analysis does not recognize the existence of transmission mechanisms between the monetary and the real sectors of the economy. In order for newly printed money to drive up prices in the real sector there has to be some movement of activity in the real sector to motivate price setters to mark up their prices at hyper-inflation rates. In a recession like the current one those transmission mechanisms are weak – consumer credit demand is weak and it is tough for small businesses to get bank loans for investments. As a result, the newly printed money stays in the monetary sector of the economy, where it has no contact with prices.

This does not mean that a modern economy in a recession cannot succumb to high inflation pressure. We know numerous examples from Latin America where government has used its own spending to push newly printed money out in the economy. This is in part how Venezuela under Hugo Chavez got stuck with 30 percent inflation. So far this has not happened in the United States, but that is no guarantee it won’t happen. While the simplistic Austrian prediction is wrong, the facts on the ground are not sufficient to completely dismiss their argument. More evidence is needed, especially on the nature of the transmission mechanisms.

Alasdair Macleod disagrees. True to the Austrian school he dismisses the use of empirical evidence and quantitative reasoning in economics:

Modern economists retreat into two comfort zones: empirical evidence and mathematics. They claim that because something has happened before, it will happen again. The weakness in this approach is to substitute precedence for the vagaries of human nature. We can never be sure of cause and effect. Human action is after all subjective and therefore inherently unpredictable.

Does this mean that Macleod never drives? After all, he apparently cannot be sure that his fellow Brits will drive on the left side of the street tomorrow just as they did today.

Macleod’s statement about the “inherently unpredictable” nature of human action is of course rather silly. It is, however, typical for the Austrian school. One of its key tenets is the denial of empirical analysis, which of course begs the question why they even bother with economics. But by taking the attitude that human action is inherently unpredictable they also suggest that we as humans are not rational. Rationality means, among other things, repeating successful behavior in order to assure your own survival. In terms of economics this means repeating successful trade and other exchange relations with other rational individuals.

I should not have to explain this to someone who is in the game to change public policy. But Alasdair Macleod appears to be one of those activists/analysts who have been seduced by the supposedly refined nature of Austrian theory without seeing its public-policy consequences. If he did he would realize that a theory that starts out with suggesting that human action is inherently unpredictable will have a hard time convincing legislators that they can trust people to make the right decisions on their own. Quite the contrary, in fact: if we all behave unpredictably there is no chance for a society with a minimal government to survive, let alone thrive; the only way to create a stable, predictable society would be to have government organize and regulate it.

Macleod is of course wrong on the fundamental nature of human action. So is the Austrian theory. May I recommend some reading on the role of uncertainty in economic analysis. Austrian theorists might also want to disseminate Armen Alchian’s classic but very dense essay on uncertainty, evolution and economic theory.

Because of their disdain for empirical evidence and quantitative reasoning, Austrians have a hard time constructing workable analytical arguments on their own. Instead they often spend their time producing pure rhetoric, often directed at competing theories. Mcleod is no exception, going after the man Austrian theorists dislike almost as much as Karl Marx:

Keynes was strongly socialistic. In the concluding remarks to his General Theory, Keynes looks forward to the euthanasia of the rentier (or saver) and that the State will eventually supply the resources for capital investment.

This statement is not only false, but also very telling of the difference between Austrian theory and Keynesianism. Austrians prefer the armchair as the foundation of their analysis, while Keynesians work inductively to constantly evolve and enhance the proficiency of their theory and their ability to interact with the public policy arena. The statements by Keynes that Macleod has cherry-picked are from chapter 24 of the General Theory, where Keynes has left his theoretical work and is speculating about what role economic policy could play, and how government would fit in to that role.

It is important to note that in the preceding 23 chapters of his General Theory Keynes barely even touches upon government, even as a subject of conversation. Already for this reason, Macleod’s statement about Keynes being a socialist is false. But there is also a deeper and from a policy viewpoint more important reason. When Keynes got to the end of his book he had examined the “mechanics” of a modern industrialized economy – he had in effect laid the groundwork for what we now know as macroeconomics. With this pioneer work Keynes challenged a great many prejudices held by Classical economists, but he also opened for the potential of an entirely new era of economic policy.

First and foremost, Keynes’s work allowed for a new understanding of what brings about recessions – and, even more importantly, depressions. Never before had anyone systematically proven that when you try to starve an economy out of a recession, you make matters worse. But to produce and explain this proof, Keynes had to spend almost the entire volume we know as his General Theory; as he was finishing it, he only had time for brief, speculative thoughts about what role government could play in defending or restoring full employment.

This is what Austrians do not get. Keynes’s analysis was systematic. He built a macroeconomic theory, induced from evidence, that allowed him and anyone else who takes it seriously to do an open-ended analysis of what role government might play. Unlike closed systems like Marxism or Austrian theory, the Keynesian analysis is open in that its conclusions are not deductively produced – or, to be blunt, dictated – by the theory.

Herein lies the problem with Austrian theory. Because it refuses to recognize the role of evidence, it refuses to open itself to the probable – as opposed to uncertain – nature of human action. Because there is no room for probability, there is no open end to the analysis an Austrian produces. His conclusions are dictated beforehand.

This leads to major problems when theory is brought in to the public policy arena. More on that in a moment. First, let me wrap up Macleod’s point about Keynes being a “socialist”. In chapter 24 of the General Theory Keynes suggests a death tax as one possible policy measure to help build economic policy in favor of full employment. The tax would be used to fund investment activity when private-sector activity is unable to reach full employment. Keynes speculates on the possibility of having government be a permanent agent in this way, which he suggests would mean that the economy would be operating at or very close to the point of full employment.

Keynes’s theory of investment equates full employment to a point where the so called marginal efficiency of capital is virtually zero. The practical meaning of this is that there is no more profit opportunity left in expanding the economy’s capital stock – it is operating at its economically viable maximum. This is accomplished, Keynes suggests (but does not firmly conclude), when private-sector investment is supplemented by government investment, funded by a death tax

Obviously, a death tax, even at 100 percent, would never lead to government replacing private investment funding. Yet Macleod makes the critical mistake of thinking that the point where the marginal efficiency of capital is zero is also the point where private credit is eliminated. He misreads Keynes’s idea about “euthanising the rentier” as the elimination of privately funded investment. In reality, this statement means that funding for investment is so abundantly available that it ceases to be scarce. Thereby no one can make money on credit in response to systemic uncertainty. Individual risk factors still remain, though, as Keynes makes clear in his elaboration of his theory of investment and the concept of the marginal efficiency of capital.

In short: government eliminates systemic uncertainty while the private sector handles uncertainty and risk at the market level.

I disagree with Keynes’s speculation about the death tax. But I do agree with him that the free market is unable to incorporate and manage systemic uncertainty. How that is best done is a matter for further scholarly work; my own doctoral dissertation was devoted entirely to finding the demarcation line between the roles of government and the private sector in managing uncertainty. What I learned from Keynes is that there is indeed a role for government to play there; the exact nature of that role is still an open question, especially because the attempts made thus far at organizing government to eliminate systemic uncertainty have had a lot of side effects.

I apologize for the wordiness of this article, but it is important to understand the depth of the problem with Austrian theory. One good way to do that is to contrast it toward its arch enemy, Keynesianism.

Speaking of which, it is almost amusing to witness the obsession that many Austrian theorists have with Keynes. As Alasdair Macleod demonstrates, this obsession sometimes gets so bad that they throw out the only analytical tool they themselves cherish, namely logic, just to get another chance to go after Keynes:

The misconceptions of Keynesianism are so many that the great Austrian economist von Mises said that the only true statement to come out of the neo-British Cambridge school was “in the long run we are all dead”.

Let’s put this in its proper Austrian context. In December last year one of the Cobden Centre’s academic advisors, Phillip Bagus, applauded the shrinking GDP that some European countries were experiencing. Bagus was jumping up and down with joy over the fact that Greece had lost a quarter of its GDP and suggested merrily that this elimination of economic activity would free up resources that would create new investments and new jobs. He suggested that it was a home run for the economy that people were laid off from jobs right and left and forced to scavenge for food because an austere government was not providing the poverty relief people had been promised.

Bagus is a prime example of what Austrians do when they enter the public policy arena. They are completely locked in to their theory, without a single open window to the outside world and its empirical evidence that when they are confronted with the worst economic crisis since the Great Depression they suggest that the world needs more of the same. To them there is no such thing as hesitation and caution among private entrepreneurs and consumers. Their static and rigid theory says that consumers and entrepreneurs fail to produce full employment for the economy because government takes away resources from them. There is a great deal of truth in this part, but what the Austrians forget is that there is a second leg to this analysis: they conclude that all you need to do is fire government bureaucrats and  they will all get jobs in the private sector. All you need to do is shut down a government agency and someone else will take over their office.

The problem is, as we witnessed in Russia during the 1990s, the private sector may hesitate to step in and absorb idle resources formerly employed by government. The one tiny detail that Austrians forget is that an entrepreneur will not make an investment unless he has reasons to believe that he will be able to pay off the loan he funded the investment with. Furthermore, the banks won’t lend him money toward the investment unless he can make a good case for the profitability of that investment.

Keynes knew of this problem very well. That is why he speculated that government should supplement private investment in times of uncertainty, in order to eliminate systemic risk factors. While I disagree with Keynes’s particular suggestion, I am wholeheartedly with him on the nature of the problem. Individuals can be held back by uncertainty and thereby, in the aggregate, hold back the entire economy.

Austrians do not believe in uncertainty. They recognize its existence but they do not incorporate it into their analysis. Instead, they assume that all that needs to happen for the economy to be perpetually in full employment is that the so called “natural” rate of interest can prevail. They assume the existence of this “natural” interest rate without ever providing proof of its existence. This assumption, again entirely theoretical, allows them to create a perfect intertemporal allocation of resources – in other words, to eliminate uncertainty.

When you ask an Austrian theorist when this natural interest rate will come about, he will give you an answer that resembles something like “in the long run”. In other words, in the long run the economy will always be in a perfect state of equilibrium and full employment.

Keynes always criticized Classical economists for relying on the long run to fix all sorts of problems. When Austrian theorists take the same view on the long run as Keynes did, they jeopardize the very foundation – flawed as it is – of their own theory. Either they have to resort to illogical reasoning or they have to make up their mind: do they agree or disagree with Keynes on the role of uncertainty in the economy?

Alasdair Macleod, needless to say, does not see this lack of logic in Austrian theory. He marches on like nothing happened. The rest of his analysis is unfortunately as simplistic as the Austrian theory he relies on. He echoes a commonly held belief among Austrians that there have never been economic crises before big government:

The misallocation of economic resources which is the result of decades of increasing government intervention cannot go on indefinitely. Businesses have stopped investing, which is why big business’s cash reserves are so high. Money is no longer being invested in production; it is going into asset bubbles. Dot-coms, residential property, and now on the back of zero interest rates government bonds and equities. These booms have hidden the underlying malaise.

Although I disagree with John Kenneth Galbraith on virtually everything under the sun, I have to give Galbraith credit for his book A Short History of Financial Euphoria. There, Galbraith takes the reader on a journey through speculative bubbles that have occurred throughout history – the ones we know of – and done so at times when there was no big government.

I have discussed the nature of today’s crisis at length in other articles. Very briefly, I do agree with Macleod that government has played a bad role in exacerbating this crisis – my conclusion is that our banking system would have absorbed the shock from the real estate crisis were it not for the fact that those same banks had also invested heavily in government bonds. During 2011 and 2012 more and more of those bonds turned into bad assets, effectively destroying an otherwise sound balance on banks’ balance sheets.

The implication of a sound analysis of today’s crisis is that we need to get government out of the economy, but that we need to do it in a structurally sound way and by showing great respect for two groups of citizens:

  • Those who already live on the dole because they have lost their jobs and been let down by government;
  • Those who still work but have become dependent on government to make ends meet.

The true challenge for freedom-minded public policy scholars is to design a path for our economy out of the welfare state without causing undue hardship for either of these two groups. It can be done. The problem is that we are not getting much help from Austrian theorists here: all they suggest is the destruction of the welfare state so that Phoenix may rise from the ruins.

Macleod is no exception. He makes a good observation about the role of government…

Take France. Government is 57% of GDP. The population is 66m, of which the employed working population is about 25m, 17m in the productive private sector. The taxes collected on 17m pay for the welfare of 66m. The taxes on 17m pay all government’s finances. The private sector is simply over-burdened and is being strangled.

But then, instead of helping pull the economy out of this entitlement quagmire, Macleod resorts to the favorite Austrian pastime, namely to bash the printing of money:

The progressive replacement of sound money by fiat currency has destroyed economic calculation, and has destroyed private sector wealth. These policies were deliberate. We have now run out of accessible wealth to transfer from private individuals to governments. That is our true condition. Governments will still seek to save themselves at the continuing expense of their citizens, and in the process destroy what wealth is left.

He never gets to the usual advocacy for a gold standard, but he comes pretty darn close. However, as a brief look at Galbraith’s book will show, we have had crises even during the heydays of the gold standard.

The problem is not big money. The problem is big entitlement. It would be nice if Austrians could put down their Scriptures and help us get rid of the welfare state in a sound, stable way that encourages people to be optimistic about the future. If they are not interested in that, may I suggest they withdraw to their academic chat rooms and stop pretending to be concerned.

Another Failed Austerity Defense

Discussing austerity policies with an Austrian economist is a little bit like discussing free-market capitalism vs. socialism with a leftist. Both compare an abstract ideal of their favorite theory to a poorly managed, diluted and distorted example of their opponent’s theory. There is a reason for this common character trait: both Austrian economics and socialism are exclusively theories with only inferential contact with the real world.

Unfortunately, a Keynesian economist cannot afford himself that privilege. He has to stand with both feet on the ground and begin his reasoning right there. The same goes for the free-market capitalist who is trying to propose policies that will let private citizens – be they consumers, investors or entrepreneurs – go about their business unfettered by government.

Some would object right there and say that there are no more fervent advocates for free-market capitalism than Austrian economists. Rhetorically, that may be true, but as soon as we get down to the policies that Austrians suggest, a divide opens up between them and the free-market capitalist whose cause they claim to be advancing.

This gap between Austrian theory and the real life is particularly obvious in today’s Europe, where Austrian economists have had lauded the current destruction of GDP and have had only one complaint: it’s not enough. The former point is made by economics professor Phillip Bagus and the latter comes from think-tank economist Veronique de Rugy.

As I have explained at length, both Bagus and de Rugy are wrong, morally as well as analytically. And perhaps the Austrian community is beginning to realize that they have ended up on the wrong side of the European crisis. Today a good friend sent a link to the latest issue of The Free Market, a monthly publication of the Mises Institute. There, Mark Thornton makes a case for what he calls “real” austerity, joining his fellow Austrians Bagus and de Rugy in a passionate plea for tough budget cuts all across Europe.

However, unlike his two comrades Bagus and de Rugy, Thornton actually takes time to try to elaborate his case. Therefore, it is my pleasure to counter his analysis with free-market Keynesianism.

First, a quick reminder of where I stand with reference to big government: the welfare state must go, permanently and forever – but it must do so in a way that does not cause undue harm to the most vulnerable of our fellow citizens.

With that in mind, let’s give microphone and spotlight to Mark Thornton:

Austerity has been hotly debated as either an elixir or a poison for tough economic times. But what is austerity? Real austerity means that the government and its employees have less money at their disposal. For the economists at the International Monetary Fund, “austerity” may mean spending cuts, but it also means increasing taxes on the beleaguered public in order to, at all costs, repay the government’s corrupt creditors. Keynesian economists reject all forms of austerity. They promote the “borrow and spend” approach that is supposedly scientific and is gentle on the people: paycheck insurance for the unemployed, bailouts for failing businesses, and stimulus packages for everyone else.

Three points.

1. “Real austerity means that the government and its employees have less money at their disposal.” Well, that is exactly what has happened in Greece, and is currently happening in Spain and, to a lesser degree, in Italy. Thornton better provide a more concise definition of Austrian-based austerity, or else we will have to assume that Phillip “Less GDP is good” Bagus has the final say on that matter.

2. The austerity policies that are currently being forced upon crisis-ridden countries in Europe has nothing to do with repaying “the government’s corrupt creditors”. I would not consider the regular middle-class family corrupt because it buys treasury bonds. Nor would I consider retirement funds, investing the same middle-class family’s long-term savings, to be corrupt because it buys treasury bonds.

The real reason why Greece, Spain, Portugal and Italy are raising taxes and cutting spending is that they are trying to close a budget gap. This budget gap, in turn, is the work of an overloaded, over-bloated welfare state.

3. Bailouts for failing businesses has nothing to do with Keynesianism. I challenge Thornton to provide one logically consistent example from the vast academic Keynesian literature that prescribes corporate welfare. This is a good example of how Austrian theorists bastardize Keynesianism to lower the analytical bar for themselves.

Austrian School economists reject both the Keynesian stimulus approach and the IMF-style high-tax, pro-bankster “Austerian” approach. Although “Austrians” are often lumped in with “Austerians,” Austrian School economists support real austerity. This involves cutting government budgets, salaries, employee benefits, retirement benefits, and taxes. It also involves selling government assets and even repudiating government debt. Despite all the hoopla in countries like Greece, there is no real austerity except in the countries of eastern Europe.

Mark  Thornton might want to talk to his fellow Austrian economist Phillip Bagus about this. In December, Bagus said:

One would think that a person is austere when she saves, i.e., if she spends less than she earns. Well, there exists not one country in the eurozone that is austere. They all spend more than they receive in revenues. In fact, government deficits are extremely high

Bagus then goes on to argue that so long as there is a deficit, governments are by definition not austere. When governments close their deficits, they are austere, he concludes. This definition is quite different from the one Thornton is putting forward, which couples tax cuts with spending cuts. The question, then, is: what role does the deficit play in Thornton’s definition of austerity?

I realize that any theory, be it Austrian, Keynesian, Rational Expectations or Marxism, is full of internal disagreements. Being only one of two libertarian Keynesians in the world (there is another one in Australia…) I know very well what it is like to clash with people who share your overall theoretical viewpoint. That said, the disagreement between Bagus and Thornton has nothing to do with fundamental theory or methodological principles. It is entirely on the application side, where things are conditioned by solid theory and methodology. Therefore, the question is: how deeply does this disagreement cut into Austrian theory?

Back to Thornton:

For example, Latvia is Europe’s most austere country and also has its fastest growing economy. Estonia implemented an austerity policy that depended largely on cuts in government salaries. There simply is no austerity in most of western Europe or the U.S. … The Keynesians’ magical multipliers have once again failed to materialize. Given that most of these economies have not achieved growth from stimulus, they should give the idea of true austerity a fresh look.

Let’s start with Thornton’s claim about Latvia. Here are the latest numbers from Eurostat on real GDP growth in Latvia:

2006 2007 2008 2009 2010 2011 2012 2013 2014
Latvia 11.2% 9.6% -3.3% -17.7% -0.9% 5.5% 4.3% 3.6% 3.9%

Needless to say, the numbers for 2013 and 2014 are forecasts, and as we know from the past few years any GDP growth forecast in Europe should be taken with a big grain of salt. Therefore, the only numbers worth looking at are the ones from 2006 to 2011; the 2012 figure is still an estimate, as it takes about one quarter of a year to process all data for last year’s GDP. But let’s be generous to Thornton and assume that the 4.3-percent growth number is accurate.

If you started out with $100 in 2006, and that money grew on par with GDP, you’d have $105.70 in 2012. That is less than one percent growth per year.

The same experiment on the U.S. economy, using the same database from Eurostat, allows the $100 to grow to $107.52. By Thornton’s own reasoning, this means that the U.S. policies of out-of-control debt spending, bank bailouts and completely irresponsible and wasteful stimulus packages is in fact a better strategy than what he defines as “real austerity”.

As for Estonia, here is my exchange with Michael Tanner where I refute the idea that Estonia has implemented some sort of “real” austerity.

There is one point, though, where I will give Thornton a thumbs up. He is absolutely correct about the multiplier and its failure to work in Europe. There are two reasons why it has failed (and neither is that the multiplier does not exist, which it does). First, there is a confidence component embedded in the multiplier, which econometricians – who do forecasting on suggested fiscal policy measures – consistently fail to recognize. A consumer will respond to an income increase with more spending if, and only if, he is confident that: a) the income increase is of a lasting nature, or: b) he won’t need the money in the bank for contingency purposes.

If a consumer is uncertain about the future, he will refrain from spending a dollar extra he has earned so that he can have money in the bank in case tomorrow turns out to be worse than today. The same goes for entrepreneurs, whose responses to certainty exhibit themselves in their investment and hiring decisions. A temporary increase in orders will not make a construction contractor hire more people on permanent payroll. A temporary rise in the demand for a certain car model will not be enough to motivate the manufacturer to invest in a new assembly plant.

Confidence, or its flip side which we know as uncertainty, is hard to quantify. The consumption functions that form the base for traditional multipliers do not come with specific confidence components. Mainstream economics still resists the very notion of distinguishing between risk and uncertainty, but in some heterodox circles, primarily Post Keynesian economics, there is a reasonably good body of literature on this. My own doctoral thesis is one of them.

There are ways to quantify the confidence component and embed it in the multiplier. However, those applications have not been absorbed by the mainstream economics literature, and are therefore – understandably yet regrettably – still not used in econometrics.

The second reason why the multiplier has failed in Europe has to do with a recently recognized asymmetry in the multiplier. The traditional view is that the multiplier mechanically works the same way for expansions and contractions in economic activity. This is still true under regular business-cycle circumstances, and when it comes to private-sector economic activity. When these two conditions do not apply, however, the multiplier starts acting up, throwing economists out of their comfort zone.

The IMF recognized this in a good, highly recommendable paper by Olivier Blanchard and Daniel Leigh. Concerned over the consistent errors that the IMF made in forecasting the effects of austerity policies in Europe, they set out to find the bug in their models. It turned out that the multiplier is stronger for contractions in economic activity than for expansions. While not explicitly spelled out by Blanchard and Leigh, their results indicate that the stronger reaction to a contraction has to do with the fact that the contraction is caused by government spending. The explanation could be that the reductions in spending hit low-income families more than others, whose economic margins are small or non-existent. As a result, they contract their spending more than higher-income families would.

Uncertainty and asymmetric response together explain why the multiplier has not kicked the European economy into higher gear. There is, however, a third one. Thornton seems to believe that just because there are persistent deficits in Europe, no spending cuts have taken place. This is a regrettable exercise of armchair theorizing; there is plenty of evidence to the contrary. Thornton might want to start with this piece.

Then, finally, we get to some specifics as to what Thornton himself wants to do about a nation in economic crisis:

Austerity applied … simply means that the government has to live within its means. If government were to adopt a thoroughgoing “Libertarian Monk” lifestyle, then government would be cut back to only national defense (withoutstanding armies and nuclear weapons), with Mayberry’s Andy and Barney protecting the peace.

A philosophical view I definitely share – I am strong supporter of Robert Nozick’s minimal state. But pointing to a star in the sky is one thing. Building the space ship that will get us there is an entirely different matter, one that Austrian theorists do their best to avoid discussing. They touch upon it in the passing, like Thornton:

The national debt would be wholly repudiated. This would involve certain short-run hardships, although much greater long-run prosperity.

Thornton is more than welcome to explain exactly what he means by “repudiating” the national debt. I was under the impression that Austrians considered contractual enforcement a cornerstone of a functioning, civilized economy.

As for the reference to “long-run prosperity”, I am curious: how long is that run? The only concerted effort at estimating that long run, based on Say’s law, that I can remember ever seeing actually places the end of the long run at 100 years. The proof offered (by Swedish economist Assar Lindbeck) is that there is no trend in unemployment  over that period of time. This would echo Keynes’s famous comeback that “in the long run we’re all dead”.

Another question is what the “short-term hardships” actually involve. Does Thornton recommend immediate turn-off of the welfare faucet? An immediate shut-down of tax-funded, government-run hospitals?

I like the challenge that Austrian theory presents, partly because it is often of high analytical quality. But so long as its advocates won’t even waste a single breath on specific policy recommendations, their theory amounts to little more than fiscal sophistry. Unfortunately, Mark Thornton confirms this impression.

But more than that, the steady stream of calls for even more spending cuts, even harder reductions in entitlement spending, and a faster execution of them, puts Austrians in rather ugly moral company. They come across as little more than sophisticated Ayn Randians, their policy ambitions darkened by the shadow of overt egoism and disrespect of the poor and weak.

Mark Thornton and his Austrian fellows should also keep in mind that their dismissive attitude toward the suffering that tens of millions of European families are now enduring does – in some people’s eyes (not mine) – qualify him for even more ominous friendships.

In contrast to Austrian armchair theorizing, I offer a facts-based, empirically workable, Keynesian route to limited government. It is built on reality, solid analysis, recognition of human nature and a steadfast moral commitment to not let the poorest and weakest among us pay the price for the damage that big government has done to our economy.

Obama’s Keynesian Failure

As I reported on Friday, the latest macroeconomic data on the U.S. economy show that Obama’s big-government spending policies have been as big a failure as the debt his policies have caused. Numbers don’t lie, but while it is important to understand the nature of Obama’s macroeconomic failure, it is at least as important to understand why he has failed.

Some commentators are satisfied with stating that “government is too big” and then leave it at that. But this explanation is too shallow and, frankly, simplistic. I heard the same explanation for why Chile did not take off economically under Pinochet, despite all the privatization and deregulation efforts during the ’80s.

A deeper analysis starts with a look at: a) what Obama was trying to accomplish; b) how he wanted to go about it, and why; and c)  why he has failed. These three steps obviously involve making a few implicit assumptions about the motives for his policies, but that is true about any analytical endeavor (and even more so about non-analytical commentaries). I want to make this clear because some readers will probably disagree with my overall assessment that Obama actually is trying to get the American economy restarted. In other words: if you believe that Obama has chosen his policies because he is purposely trying to destroy or severely weaken America, then we disagree from the get-go.

With that said, let’s get to our first question.

What was Obama trying to accomplish with his big-government spending?

In 2009 the Obama administration saw the U.S. economy fall quickly into a recession. It was a deeper downhill slope than we had seen in a recession in decades. (Some economic pundits, holed up in colleges and disguised as “economics professors”, tried to tell their students, blatantly ignoring all available data, that the Millennium recession was the worst thing since the Great Depression. It was in fact the shallowest recession on record.) They saw a combination of a financial market collapse and a severe risk for negative GDP numbers for a couple of years to come.

This depression-level analysis was false for two reasons. First, a major part of the driving force of the crisis was financial, as it was back in the Great Depression, but the institutional structure of the economy is entirely different today from what it was back then. In the 1930s we did not have a central bank that could flood the financial system with liquidity to keep it afloat. Today we do. This avoided a run on banks and widespread panic. We also have a regulatory framework today that did not exist back then. Taken together, the supply of liquidity and the regulatory framework provided a strong guarantee that there was not going to be a collapse of the U.S. financial system.

Secondly, for a depression to open up you need a virtual collapse of private consumption, the biggest variable in GDP. But while there was a downturn in private consumption of 0.6 percent, adjusted for inflation, in 2008, this is very far from signs of a pending collapse. In fact, when private consumption reached its recession trough in 2009 it was back to 2006 levels, in constant prices. This is a downward adjustment that is even smaller than in a normal recession (see GDP data from the 1960 and ’70s) and absolutely nothing to be all worked up about.

Still, despite their erroneous analysis the Obama administration was actually trying to turn the economy around. Now that we have established this, let us move on to the question as to how they were trying to achieve their goals.

How did the Obama administration try to save the American economy?

The theory behind, primarily, the stimulus bill was a crude version of the standard Keynesian macroeconomic model known as IS-LM (or Hicks-Hansen for all you macroeconomics nerds out there). This model, which is as established in economics as internal combustion is in automotive engineering, has two properties that appeals to big-government spenders like Obama:

1. The consumption multiplier. Ever since Keynes’s General Theory of Employment, Interest and Money economists have been in virtual agreement of the so called multiplier: whenever a consumer spends $1, there is a proliferation effect through the economy that augments that economic activity by a factor of four or even five depending on model and data. Advocates of government spending as a recession remedy use this multiplier to explain why increased government spending is good for the economy: when government spends money, the reasoning goes, it creates jobs and people’s incomes go up; as a result they spend more money and the consumption multiplier kicks in.

2. The investment accelerator. A less-known but relatively powerful feature of the economy is the response from businesses to increased sales. When GDP increases – to use the most basic measure of business sales – business investments increase by a factor smaller than the consumption multiplier but with longer-range effects on the economy. In theory, the accelerator kicks in when the consumption multiplier’s effects end.

These two mechanisms of standard macroeconomics do exist. It is relatively easy to correlate swings in investment with GDP fluctuations, and even to find correlations with consumer spending. The same holds true for the multiplier, which exists even under non-Keynesian theories of consumption. (Not even Milton Friedman would deny that people’s consumption has something to do with their income.) The problem with the Obama administration’s reliance on these two mechanisms lies not in whether or not they exist, but in their understanding of how these mechanisms work.

Why did Obama’s fiscal policy fail?

The most important reason why the stimulus bill failed to re-ignite the U.S. economy lies in its design. It  is indisputable that if you inject hundreds of billions of dollars into the U.S. economy, you are going to see an uptick in economic activity. We saw precisely that in 2010, when GDP grew by an inflation-adjusted three percent. But that increase was primarily the result of the initial spending injection, i.e., the stimulus package itself. In order to spark sustained and recession-ending growth in the economy, the stimulus package would have had to stimulate lasting private economic activity.

This is where the bill failed. It was the belief of Obama’s economists (or whoever designed the stimulus bill) that a dollar spent anywhere in the economy will automatically cause a factor-of-four increase in GDP. That is, after all, what standard economic models will tell us. But these models fail to include a very critical part of economics, namely confidence. A consumer will increase his spending with increased earnings, as the multiplier prescribes, but only if he feels confident that his increased income will last for some period of time. When someone is hired out of unemployment and on to a temporary contract working for a stimulus-bill-funded government project, he is unlikely to make other than marginal upward adjustments in his spending. He knows, after all, that the contract will end when the project is complete. If the overall economy is not better at that time, he will need a financial cushion.

Other consumers are afraid to increase their spending very much, because they are uncertain as to whether or not they will lose their jobs. They do not take on long-term spending commitments that would be associated with purchases of new homes, new furniture on long-term payment plans, or new cars. Instead they spend on occasional items, such as electronics and appliances. The small increase in consumption (2.1 percent per year) that we can witness over the past two years is the result of precisely that: increased spending on durable goods. While often paid for with credit cards, it is not a matter of multi-year payment commitments.

An increase in consumption that relies on occasional spending on durable goods is not strong enough to last. That is part of the reason why we saw a much smaller increase in GDP in 2011 than in 2010. Consumer confidence is simply not strong enough to yield the multiplier that Obama’s economists thought they could rely on.

In terms of economic theory, the Obama economics team read the first few chapters of Keynesian macroeconomics but never got to the part where he talks about the role of confidence and expectations. And they definitely ignored several other of Keynes’s publications that elaborate on the role of expectations and confidence in determining the strength of economic growth.

The accelerator also eluded the Obama stimulus bill. Superficially, GDP data says that businesses have started investing again in America, but a closer look shows that their activities are limited almost exclusively to the category called “equipment and software.” These are easy-to-move items that businesses can relocate – overseas if they want to – if it turns out that their expectations of higher sales are disappointed. Corporate America is still very reluctant to spend more on “structures”, which includes office buildings, warehouses, factories and other facilities related to business operations.

What this means, in macroeconomics speak, is that the accelerator is weakened by an absence of strong business confidence. The reasons why businesses fail to respond to the uptick in GDP growth in 2010 is somewhat complex, but the main explanation lies in their lack of faith in two things: the regulatory environment in America (too much micromanagement form Washington, DC) and the expected cost of doing business in the next few years.

The latter is an enormously important variable. If the Obama administration has it its way, America will combine the highest corporate taxes in the industrialized world with a health reform that is already making health benefits a much more expensive cost item for businesses. This is more than enough to severely tarnish business confidence in the future, and dramatically weaken the investment accelerator.

There is yet another explanation why the stimulus bill failed. Large parts of its spending – exactly how much remains to be seen – has gone into government-run, tax-paid entitlement programs under the “Federal Aid to States” label. In many cases the stimulus bill only maintained current levels of spending, which means that there were no extra job-creating dollars going out in the other end. Furthermore, the stimulus funds that did add some spending, such as for schools, was in many cases used to increase compensation for teachers. There is a very small marginal-spending effect from increasing school district expenses for health benefits for teachers. Barely anything of that comes out as increased spending through the consumption multiplier (let alone the business investment accelerator).

All in all, even if the Obama administration had economics experts at their disposal for designing the stimulus bill, it is evident that those experts had little if any understanding of the “fine print” of the economy. They did not understand that the mechanisms that they relied on for their forecasts of a recovery (such as no unemployment above eight percent) are significantly weaker in a recession than when the economy is doing well. Had they understood that, they would have concentrated on letting the free market restore its confidence in the future before anyone did anything to nudge the economy forward.

That said, if they had done their homework on the microeconomic underpinnings of their Keynesian model, they would have come to the conclusion that even if government spending helps the economy move forward, it is a far less efficient way to create an economic recovery than to let the private sector do it through the free market.

The Obama administration used Keynesian analysis to try to kick the economy into recovery mode. Their basic mechanical understanding of the economy was correct, but their analysis only incorporated the macroeconomic half of Keynesian economics. Had they looked at the microeconomics that accompany Keynesian macroeconomics, they would have understood that what they were planning – and later executed as the “stimulus bill” – was contradicting virtually every aspect of Keynesian and Keynes-inspired research since at least the late 1970s.

Keynesian economics is a formidable way to understand how a modern, capitalist economy works. Unfortunately, it was hi-jacked for ideological purposes by radical leftists and statists back in the 1960s and ’70s. (A similar hi-jacking has taken place of, e.g., Hayek’s writings which nowadays are used mostly to deliver political punch lines to “Austrian economics” pundits.) For this reason, its powerful analytical tools are ignored by large parts of the policy makers in this country. This is too bad, but something that we Keynesians – and especially we Keynesian libertarians – will have to overcome…

Prosperity in Peril: Opportunities in the Face of Economic Uncertainty

 My latest research paper, Prosperity in Peril: Opportunities for Wyoming in the Face of Uncertainty, is available! It is of interest both to Wyomingites and to those of you who live in other states. Some of the policy solutions suggested could very well apply to your state as well. Click here and get your copy today!

But wait – there’s more! On Tuesday January 3, at 6PM MT (8PM ET; 5PM PT) you can log on to the Wyoming Liberty Group website and watch a live webcast of our seminar where we present and discuss this paper. Join us on Tuesday!