Best of the Week
Most Popular
1. Stock Markets and the History Chart of the End of the World (With Presidential Cycles) - 28th Aug 20
2.Google, Apple, Amazon, Facebook... AI Tech Stocks Buying Levels and Valuations Q3 2020 - 31st Aug 20
3.The Inflation Mega-trend is Going Hyper! - 11th Sep 20
4.Is this the End of Capitalism? - 13th Sep 20
5.What's Driving Gold, Silver and What's Next? - 3rd Sep 20
6.QE4EVER! - 9th Sep 20
7.Gold Price Trend Forecast Analysis - Part1 - 7th Sep 20
8.The Fed May “Cause” The Next Stock Market Crash - 3rd Sep 20
9.Bitcoin Price Crash - You Will be Suprised What Happens Next - 7th Sep 20
10.NVIDIA Stock Price Soars on RTX 3000 Cornering the GPU Market for next 2 years! - 3rd Sep 20
Last 7 days
Online Elliott Wave Markets Trading Course Worth $129 for FREE! - 22nd Sep 20
Gold Price Overboughtness Risk - 22nd Sep 20
Central Banking Cartel Promises ZIRP Until at Least 2023 - 22nd Sep 20
Stock Market Correction Approaching Initial Objective - 22nd Sep 20
Silver Bulls Will Be Handsomely Rewarded - 21st Sep 20
Fed Will Not Hike Rates For Years. Gold Should Like It - 21st Sep 20
US Financial Market Forecasts and Elliott Wave Analysis Resources - 21st Sep 20
How to Avoid Currency Exchange Risk during COVID - 21st Sep 20
Crude Oil – A Slight Move Higher Has Not Reversed The Bearish Trend - 20th Sep 20
Do This Instead Of Trying To Find The “Next Amazon” - 20th Sep 20
5 Significant Benefits of the MT4 Trading Platform for Forex Traders - 20th Sep 20
A Warning of Economic Collapse - 20th Sep 20
The Connection Between Stocks and the Economy is not What Most Investors Think - 19th Sep 20
A Virus So Deadly, The Government Has to Test You to See If You Have It - 19th Sep 20
Will Lagarde and Mnuchin Push Gold Higher? - 19th Sep 20
RTX 3080 Mania, Ebay Scalpers Crazy Prices £62,000 Trollers Insane Bids for a £649 GPU! - 19th Sep 20
A Greater Economic Depression For The 21st Century - 19th Sep 20
The United Floor in Stocks - 19th Sep 20
Mobile Gaming Market Trends And The Expected Future Developments - 19th Sep 20
The S&P 500 appears ready to correct, and that is a good thing - 18th Sep 20
It’s Go Time for Gold Price! Next Stop $2,250 - 18th Sep 20
Forget AMD RDNA2 and Buy Nvidia RTX 3080 FE GPU's NOW Before Price - 18th Sep 20
Best Back to School / University Black Face Masks Quick and Easy from Amazon - 18th Sep 20
3 Types of Loans to Buy an Existing Business - 18th Sep 20
How to tell Budgie Gender, Male or Female Sex for Young and Mature Parakeets - 18th Sep 20
Fasten Your Seatbelts Stock Market Make Or Break – Big Trends Ahead - 17th Sep 20
Peak Financialism And Post-Capitalist Economics - 17th Sep 20
Challenges of Working from Home - 17th Sep 20
Sheffield Heading for Coronavirus Lockdown as Covid Deaths Pass 432 - 17th Sep 20
What Does this Valuable Gold Miners Indicator Say Now? - 16th Sep 20
President Trump and Crimes Against Humanity - 16th Sep 20
Slow Economic Recovery from CoronaVirus Unlikely to Impede Strong Demand for Metals - 16th Sep 20
Why the Knives Are Out for Trump’s Fed Critic Judy Shelton - 16th Sep 20
Operation Moonshot: Get Ready for Millions of New COVAIDS Positives in the UK! - 16th Sep 20
Stock Market Approaching Correction Objective - 15th Sep 20
Look at This Big Reminder of Dot.com Stock Market Mania - 15th Sep 20
Three Key Principles for Successful Disruption Investors - 15th Sep 20
Billionaire Hedge Fund Manager Warns of 10% Inflation - 15th Sep 20
Gold Price Reaches $2,000 Amid Dollar Depreciation - 15th Sep 20
GLD, IAU Big Gold ETF Buying MIA - 14th Sep 20
Why Bill Gates Is Betting Millions on Synthetic Biology - 14th Sep 20
Stock Market SPY Expectations For The Rest Of September - 14th Sep 20
Gold Price Gann Angle Update - 14th Sep 20
Stock Market Recovery from the Sharp Correction Goes On - 14th Sep 20
Is this the End of Capitalism? - 13th Sep 20
The Silver Big Prize - 13th Sep 20
U.S. Shares Plunged. Is Gold Next? - 13th Sep 20
Why Are 7,500 Oil Barrels Floating on this London Lake? - 13th Sep 20
Sheffield 432 Covid-19 Deaths, Last City Centre Shop Before Next Lockdown - 13th Sep 20
Biden or Trump Will Keep The Money Spigots Open - 13th Sep 20
Gold And Silver Up, Down, Sideways, Up - 13th Sep 20

Market Oracle FREE Newsletter

How to Get Rich Investing in Stocks by Riding the Electron Wave

Rethinking Depression Economics

Economics / Economic Theory Aug 13, 2011 - 05:01 PM GMT

By: J_M_Finegold_Catalan

Economics

Best Financial Markets Analysis ArticleOne criticism of Austrian business-cycle theory is that it gives little insight as to what should be done to push an economy out of recession. Even accepting the premise that monetary overexpansion leads to a misallocation of capital goods, detractors claim that this says little in regards to the nature of the depression period. Leland Yeager, for example, argues that "Austrian economists can explain the continuing depression only lamely."[1] Lord Robert Skidelsky once made a similar comment in a live debate with George Selgin and Jamie Whyte.


It is somewhat true that most Austrian literature on intertemporal coordination deals with the allocation of capital goods either during periods of healthy growth or during extensive fiduciary expansion. This does not mean, though, that none of this research provides anything of use when describing the consequent depression. The laws of economic coordination, after all, do not cease to apply during eras of economic difficulty.

It is the understanding of economic calculation and coordination that leads most Austrians to argue in favor of what critics call "do-nothing" policies. Opposition to fiscal and monetary policy is based, not on a blind faith in markets, but rather on the idea that the recovery must rely on the same principle that governs the allocation of resources during times of prosperity: economization. It is because of this understanding that Austrians argue that government spending and monetary expansion are counterproductive and handicap economic calculation.

Coordination Theory Briefly Reviewed

I have discussed macroeconomic coordination at some length in a prior article, "The Foremost Austrian Contribution to Economic Science." The basic premise of calculation theory is that money prices, formed on the basis of consumer preferences, convey certain pieces of knowledge to market agents. These prices allow individuals to economize the use of resources by providing a tool by which to calculate the merit of a certain action. That is, if an action is defined by using means to achieve an end, prices allow the economization of both means and ends based on the subjective valuation of the individual.

For instance, a person may want to buy an ebook reader, but the price may make it prohibitively expensive. That person may consider a different end a better use of that money. To put it concisely, money provides a standard to compare the values of different economic goods in a society characterized by advanced indirect exchange.

Money prices play an important role in intertemporal calculation. Without money prices, it is questionable whether advanced intertemporal calculation would even be possible.

Entrepreneurs also use these prices as a basis of economization, by exploiting differences between the present prices of relevant capital goods and the expected future prices of the goods they plan to produce. It is this constellation of prices in conjunction with entrepreneurial action, all of which finds its genesis in consumer preferences, that dictates the allocation of economic goods throughout the structure of production.

Austrian intertemporal-discoordination theory is an extension of coordination economics. It explains why there occurs a miscoordination of goods and why such a phenomenon must necessarily lead to a period of industrial depression. In its simplest form, the theory suggests that changes in the supply of fiduciary media in the loanable-funds market will impact the distribution of money throughout the structure of production.

Specifically, it will lead to a higher amount of nominal investment in the capital-goods sector. This is because low interest rates make it cheaper for entrepreneurs to invest in capital-good stages directly before the final consumer-good stage, which in turn increases the profitability of investment in preceding stages. Such investments, however, require real capital goods. Because these goods have not been set aside by a rise in savings, there is an insufficient amount of capital goods to complete ongoing productive processes. There follows a necessary liquidation and an industrial fluctuation.

Depression Economics

What we know about the boom can tell us a lot about the bust. We know that the boom is characterized by a misallocation of economic goods, and that the bust is a product of the necessary liquidation of this malinvestment. Liquidation is necessary as a means of cutting one's losses. If the investment is unprofitable, and you will lose less if you end the investment rather than complete it, then it makes sense to do just that. It is this process that underlies the unfolding secondary events of the depression period.

The liquidation of investment causes the credit contractions typical of these sorts of fluctuations through three processes: a broad default on loans, a contraction of fiduciary media on the part of banks suffering from insufficient capital balances to deal with widespread financial losses, and an increase in the demand for money to deal with a rise in uncertainty. The causal relationship between malinvestment and credit contraction is an important one, because it sheds light on the (lack of) value of attacking what is not the root of the problem.

Within the context of the pricing process, this is a period of substantial chaos. Prices have to recalibrate based on consumer preferences amid credit contraction. How much time this will take is impossible to answer with any accuracy, but generally it will be roughly equal to the amount of time necessary to liquidate the malinvestment that pervades the market at the point of collapse — that is, the amount of time for total unaffordable debt to be defaulted on and for banks to stabilize.

Whether this process is "painful" is not relevant to its necessity; if resources have been misallocated, what purpose can maintaining this misallocation possibly serve? Liquidation of real investments and of unaffordable financial assets, therefore, is one aspect of the Austrian "policy" to restore health to the market.

While prices are adjusting, entrepreneurs must allocate capital goods toward production processes that are coordinated with consumer preferences. This may require a dramatic change in the structure of production. Capital goods are heterogeneous: nails cannot be turned to glass, nor hammers to automobile carburetors. How flexible an economic good is in its ability to move from one process of production to another varies, and this flexibility plays an important role in determining how the postboom stock of capital goods can be rearranged toward new lines of investment.

There may be a substantial amount of specific capital goods produced during the expansionary period that are no longer useful — that is, their purposes are no longer relevant to satisfying consumer demand. An example would be a machine that produces a very specific capital good useless for anything other than the original project it was intended for.

Some capital goods may not be useful at all, and they will lose their status as economic goods. Others may have to remain "idle" until their owners find it worthwhile to use them. These entrepreneurs may find it more profitable to invest in other capital goods instead of opting for means and ends with higher opportunity costs.

The rearrangement of the structure of production is not a simple process. Specificity aside, some capital goods require other capital goods for production purposes. If complimentary goods are unavailable or unaffordable, it may jeopardize the usefulness of the good in question. Or the product that can be produced with what is affordable will be much different from that produced when prices were skewed by fiduciary expansion. Goods that are substitutable for each other may alleviate some of the transition pains, but these too will impact the various production processes they are related to.

Another important aspect of depressions is the high unemployment that usually comes with a mass liquidation of productive processes. Like capital goods, labor must be reallocated. However, it is a grave error to prescribe policy based on unemployment alone. Employment of workers toward processes that do not satisfy the highest-valued consumer preferences is either unsustainable or comes at the cost of subpar productivity.

"Improvement in the labor market, therefore, is unquestionably tied to the capital structure."

Sustainable employment can only be accomplished by mixing labor with capital goods toward production processes that are based on consumer valuations. Improvement in the labor market, therefore, is unquestionably tied to the capital structure. Without a structural readjustment, there can hardly be a sustainable or economical reduction of unemployment.

This structural readjustment is the Austrian "recommendation" of what needs to occur to restore healthy productivity to an economy. There are two main components: a correction in the pricing process and a readjustment in the capital structure. Whether these would be "unfair" or "painful," frankly, does not matter. Rather than blaming the readjustment, guilt should be associated with the interventions that made the liquidation and restructuring necessary in the first place — the inflationary policies that led to the depression. Any step taken to avoid the readjustment will at best prolong the recession, or at worst aggravate the problem.

Interventionism and Its Consequences

On the surface, fiscal stimulus seems like a sensible policy prescription for reinvigorating industrial productivity. The general idea is to put "idle" resources to work. But those who are trained within the Austrian framework know that this idea has no basis in reality. As explained above, the issue is not about merely putting resources to work; it is about putting resources to work in the right areas as to best service consumer desires. This requires economization. A more comprehensive theoretical argument as to why government cannot economize is provided in my article "Government Spending is Bad Economics."

The market rewards those who economize well with profits, and it punishes those who do not with losses. Therefore, there is a tendency for capital to be distributed to those who use it best. Once one entrepreneur ceases to use capital wisely, it flows toward a better one. Government taxation disrupts this process by expropriating capital from those who earned it through the market. It then invests it in projects that are based, not on calculation, but rather on political whim, such as building highways or whatever make-work program the government concocts. Government spending represents a waste. The waste is the production foregone in favor of opting for a subpar investment opportunity.

Part of the problem is theoretical. The Austrian School, so far, is the only one characterized by an accurate theory of intertemporal pricing and distribution (that is, capital theory). Other schools, including the mainstream neoclassical and Keynesian schools, do not enjoy this body of theory. Instead, for them capital is an aggregated concept. They believe capital goods to be homogeneous; they do not differentiate among nails, hammers, glass, and carburetors.

One can see, then, how economization fails to play an important role in these schools' alleged solutions to the depression period of an industrial fluctuation. All goods are homogeneous and therefore flexible and substitutable. If there is scarcity, there still needs to be some form of economization, but it becomes less important: there is no distinguishing what goods should be economized toward what ends. Furthermore, if there are idle resources then the issue becomes almost one of nonscarcity.

Capital goods are not homogeneous, and they cannot be aggregated. Buying resources through taxation and then investing them based on a government policy has underlying economic implications that impact the structure of production. Furthermore, as noted above, any investment undertaken by the government is necessarily inferior to the investment that would have occurred otherwise, because government investment is not part of the market process.

Fiscal policy is not a legitimate response to a fall in industrial productivity caused by a previous misallocation of resources. The consequence of such policy is an inferior structure of production or, worse yet, one that is completely unsustainable.

Instead, what an economy in depression needs is an adjustment period, characterized by deflation, price adjustment, and structural change. This is not a "do-nothing" policy; the dichotomy between government response and "do nothing" is a false one. The alternative is this: let the relevant market agents and the market process readjust to cope with the problems caused by government intervention.

Jonathan Finegold Catalán is an economics and political science major at San Diego State University. He blogs at economicthought.net. Send him mail. See Jonathan M. Finegold Catalan's article archives.

© 2011 Copyright Ludwig von Mises - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisors.


© 2005-2019 http://www.MarketOracle.co.uk - The Market Oracle is a FREE Daily Financial Markets Analysis & Forecasting online publication.


Post Comment

Only logged in users are allowed to post comments. Register/ Log in

6 Critical Money Making Rules