A beginner's guide to Austrian economics

By Tim Price Jun 06, 2011

Tim Price

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One of the most striking lessons I have learned during the financial crisis is that while many branches of economics are fundamentally flawed, the so-called Austrian School has much to teach the modern investor.

For me, the Austrian approach amounts to a belief in three specific things: sound money; small government; and the primacy of the individual. It values the genuine wealth creation of the entrepreneur over the dead and largely value-destructive hand of the leviathan state.

Why is it so relevant to today's ongoing financial crisis? Because the view of (Austrian) scholar Murray Rothbard, expressed in his classic study, America's Great Depression, is that rather than 'solving' the depression, government intervention made it dramatically worse.

Rothbard describes Austrian business cycle theory as follows: bank credit expansion (easy lending) causes an inflationary boom, marked by an expansion in the money supply; that boom triggers mal-investments, both by bankers and businesspeople more generally.

In other words, when money is free and easy, people don't discriminate between projects as much as they do when money is tight. Cheap credit also pushes up asset prices in certain areas, leading to more money chasing easy capital growth rather than long-term returns.

When credit expansion halts abruptly and those mal-investments become visible, the "depression recovery" starts the process of adjustment and economic healing.

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"Inefficient firms, buoyed up by the artificial boom, must be liquidated or have their debts scaled down or be turned over to their creditors. Prices of producers' goods must fall, particularly in the higher orders of production – this includes capital goods, lands and wage rates," says Rothbard.

What the Great Depression has in common with today's crisis

But that is not what happened in the US in the 1930s. The government did everything it could to 'support' various industries (and interfere in the market's clearing process).

And it has not happened this time round either, with extraordinary levels of government support granted to the financial crisis' largest culprits – the banks themselves.

Rothbard identified a number of ways in which government exacerbated rather than resolved recessions, among them:

• Preventing or delaying liquidation by the ongoing lending of money to insolvent businesses;
• Further inflation, which blocks the necessary market clearing process of lower prices;
• Keeping prices up above their free market levels;
• Stimulating consumption and discouraging saving.

All of which are occurring today. Rothbard concluded that any depression will be prolonged and worsened by inflationist intervention on the part of politicians. Sound familiar?

Comments (8)

Published in Global economy | More articles by Tim Price

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  • 1. John M

    (06 June 2011, 11:24AM)  Complain about this comment

    Yes, but now the situation is much worse. Governments have taken over the huge malinvestments made by the banking sector so that most Western Countries (PIIGS, UK US etc.) are themselves malinvestments.
    The three normal escape routes are growth, default or inflation.
    Growth just will not happen (lack of investment, bad working practices, incompetent welfare system).
    Default is the best solution; a short sharp shock and a sound recovery within 3 years.
    Inflation is the unspoken Government policy. Just 4% a year will halve the National Debt in 10 years.
    This amounts to shafting savers with inadequate interest rates and nationalising the debts of imprudent borrowers.
    What happened to morality?

  • 2. shipitin

    (06 June 2011, 11:52AM)  Complain about this comment

    John M - I agree with your basic premiss but feel that given the size of the leverage/debt vs GDP, recovery after default will take longer than 3 years. Equally for inflating to recovery sticking to 4% for 10 years will be a tough call and risk hyper inflation. Also it will require constant injections of liquidity (QE10?), which in itself will keep the debt rising and unobtainable.
    I say default or hyper-inflation and 10 years of pain with either.

  • 3. Peter Kellow

    (06 June 2011, 12:44PM)  Complain about this comment

    The Austrian school analysis is useless for understanding today’s crisis.

    Tim Prices says the cycle starts with “bank credit expansion (easy lending)” when “money is free and easy”. But we should not have that situation in the first place to kick the cycle off.

    In the noughties inflation was low mainly because of cheap Chinese goods. We should have profited from this by using the surpluses generated to invest in productivity. The money supply should have been regulated to ensure there was no asset price boom to suck all the benefit out of the productive economy.

    The opposite happened whereby the money supply was allowed to let rip creating an unsustainable bubble.

    Austrian economics has nothing to say about banking regulation and the money supply. Because of this it does not what Price says when he writes:

    “It values the genuine wealth creation of the entrepreneur over the dead and largely value-destructive hand of the leviathan state.”

  • 4. Peter Kellow

    (06 June 2011, 12:46PM)  Complain about this comment

    Rather it values the dead and largely value-destructive hand of the financial sector over the genuine wealth creation of the entrepreneur.

    The free market is what we so desperately need but it is not the state that kills this but the dominance of the global plutocracy.

    It is one of the most depressing aspects of the present situation that economists are still trying to use failed theories to find solutions.

    Shame on you. Go line up for your Nobel Prize with the other dinosaur economists.

  • 5. Will

    (06 June 2011, 03:16PM)  Complain about this comment

    Austrian Economics has an admirable focus on the problems when the private sector has too much debt but seems to miss the point by erroneously projecting these onto public debt, as this is held as net financial assets/wealth in the private sector.

    There seems to be a lack of appreciation that if a country is net saving and foreigners are net saving in the currency, the government has to run deficits equal to the total private domestic and foreign savings desires, to try to meddle with and negate private saving is practically communist, it's one way they killed off the kulaks.

    Here is a good analysis of the problems with the Austrian approach and how Modern Monetary Theory addresses and solves these public policy and public purpose issues.

    http://bilbo.economicoutlook.net/blog/?p=4870

  • 6. Alex D

    (06 June 2011, 03:29PM)  Complain about this comment

    This is the closest I’ve seen any anybody get to the root cause of the problem, even mentioning someone like Rothbard, but stopping short of uttering the words, “fiat currency” & “fractional reserve banking”. Is it that this outrageous scam is too obvious for you to mention or that no one believes it. The fact that private banks are allowed by law to create our currency virtually at will, I find utterly fantastic, surely it is up to the government of the people to create our sovereign currency. I hold our governments in no higher regard than anyone else, but at least they have some accountability to us, more than a bunch of faceless financiers at any rate. When you see private banks printing our money to lend to our government so that we can pay billions in interest on that money, you can’t help but think that something isn’t quite right.

  • 7. Tim Price

    (06 June 2011, 04:54PM)  Complain about this comment

    @Alex D: I've written at some length, both in my newsletter and elsewhere, about the fiat currency and fractional reserve banking scams. The best work I know of in this regard is Jorg-Guido Hulsmann's "The ethics of money production". The title sounds daunting but it's a fantastic history of money (and morality, or lack thereof): http://mises.org/books/moneyproduction.pdf.

  • 8. NG2 Will

    (19 June 2011, 02:54PM)  Complain about this comment

    There's more on comparing what Austrian's get right and wrong with Modern Monetary Theory MMT Understanding Modern Sovereign Money here;

    http://pragcap.com/the-austrians-are-intrigued

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