Best of the Week
Most Popular
1. Market Decline Will Lead To Pension Collapse, USD Devaluation, And NWO - Raymond_Matison
2.Uber’s Nightmare Has Just Started - Stephen_McBride
3.Stock Market Crash Black Swan Event Set Up Sept 12th? - Brad_Gudgeon
4.GDow Stock Market Trend Forecast Update - Nadeem_Walayat
5.Gold Significant Correction Has Started - Clive_Maund
6.British Pound GBP vs Brexit Chaos Timeline - Nadeem_Walayat
7.Cameco Crash, Uranium Sector Won’t Catch a break - Richard_Mills
8.Recession 2020 Forecast : The New Risks & New Profits Of A Grand Experiment - Dan_Amerman
9.Gold When Global Insanity Prevails - Michael Ballanger
10.UK General Election Forecast 2019 - Betting Market Odds - Nadeem_Walayat
Last 7 days
Labour vs Tory Manifesto Voter Bribes Impact on UK General Election Forecast - 6th Dec 19
Gold Price Forecast – Has the Recovery Finished? - 6th Dec 19
Precious Metals Ratio Charts - 6th Dec 19
Climate Emergency vs Labour Tree Felling Councils Reality - Sheffield General Election 2019 - 6th Dec 19
What Fake UK Unemployment Statistics Predict for General Election Result 2019 - 6th Dec 19
What UK CPI, RPI and REAL INFLATION Predict for General Election Result 2019 - 5th Dec 19
Supply Crunch Coming as Silver Miners Scale Back - 5th Dec 19
Gold Will Not Surpass Its 1980 Peak - 5th Dec 19
UK House Prices Most Accurate Predictor of UK General Elections - 2019 - 5th Dec 19
7 Year Cycles Can Be Powerful And Gold Just Started One - 5th Dec 19
Lib Dems Winning Election Leaflets War Against Labour - Sheffield Hallam 2019 - 5th Dec 19
Do you like to venture out? Test yourself and see what we propose for you - 5th Dec 19
Great Ways To Make Money Over Time - 5th Dec 19
Calculating Your Personal Cost If Stock, Bond and House Prices Return To Average - 4th Dec 19
Will Labour Government Plant More Tree's than Council's Like Sheffield Fell? - 4th Dec 19
What the UK Economy GDP Growth Rate Predicts for General Election 2019 - 4th Dec 19
Gold, Silver and Stock Market Big Picture: Seat Belts Tightened - 4th Dec 19
Online Presence: What You Need to Know About What Others Know About You - 4th Dec 19
New Company Tip: How To Turn Prospects into Customers with CRM Tech - 4th Dec 19
About To Relive The 2007 US Housing Market Real Estate Crash Again? - 3rd Dec 19
How Far Will Gold Reach Before the Upcoming Reversal? - 3rd Dec 19
Is The Current Stock Market Rally A True Valuation Rally or Euphoria? - 3rd Dec 19
Why Shale Oil Not Viable at $45WTI Anymore, OPEC Can Dictate Price Again - 3rd Dec 19
Lib Dem Election Dodgy Leaflets - Sheffield Hallam Battle General Election 2019 - 3rd Dec 19
Land Rover Discovery Sport Brake Pads Uneven Wear Dash Warning Message at 2mm Mark - 3rd Dec 19
The Rise and Evolution of Bitcoin - 3rd Dec 19
Virtual games and sport, which has one related to the other - 3rd Dec 19
The Narrative About Gold is Changing Again - 2nd Dec 19
Stock Market Liquidity & Volume Diminish – What Next? - 2nd Dec 19
A Complete Guide To Finding The Best CFD Broker - 2nd Dec 19
See You On The Dark Side Of The Moon - 2nd Dec 19
Will Lib Dems Win Sheffield Hallam From Labour? General Election 2019 - 2nd Dec 19
Stock Market Where Are We?  - 1st Dec 19
Will Labour's Insane Manifesto Spending Plans Bankrupt Britain? - 1st Dec 19
Labour vs Tory Manifesto Debt Fuelled Voter Bribes Impact on UK General Election - 30th Nov 19
Growing Inequality Unrest Threatens Mining Industry - 30th Nov 19
Conspiracy Theories Are Killing This Nation - 30th Nov 19
How to Clip a Budgies / Parakeets Wings, Cut / Trim Bird's Flight Feathers - 30th Nov 19
Hidden Failure of SIFI Banks - 29th Nov 19
Use the “Ferrari Pattern” to Predictably Make 431% with IPOs - 29th Nov 19
Tax-Loss Selling Drives Down Gold and Silver Junior Stock Prices - 29th Nov 19
We Are on the Brink of the Second Great Depression - 29th Nov 19
How to Spot REAL Amazon Black Friday Bargains and Avoid FAKE Sales - 29th Nov 19
Central Banks’ Gold Buying and Repatriation Spree - 28th Nov 19
Another Precious Metals’ Reversal Coming Right Up! - 28th Nov 19
Stock Market 100% Measured Moves May Signal A Top - 28th Nov 19
Don’t Look for Investing Advice in the Media - 28th Nov 19
Why You Should Buy Trailer Park Stocks - 28th Nov 19
Will YouGov General Election Forecast 2019 be as Wrong as their REAL Forecast was for 2017? - 28th Nov 19

Market Oracle FREE Newsletter

UK House prices predicting general election result

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