Ignorance of Money and the Rejection of Austrian Economics

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As the traditional Thanksgiving Day shopping weekend is upon us, we hear the usual canards of hope — hope that consumers will "stimulate" the economy, or we read from people like Karl Rove that President-elect Barack Obama’s "economic team" is "first-rate," and will have the "answers" for the economy. Paul Krugman, who already had advocated trillion-dollar deficits as a way to bring the economy into recovery, says that this new government can "fix the financial system" by even more regulation, thus avoiding the next recession (if we ever recover from this one).

The spate of bad advice and outright ignorance of what actually is happening will continue into the Obama presidency, which has promised "green jobs" as a means of bringing the economy back into balance. (What Obama means is that his administration plans to destroy the relatively-healthy energy industries and replace them with unreliable substitutes like wind power and corn-based ethanol, thus destroying millions of jobs in order to create a few thousand "new" ones.) Moreover, the vaunted "economic team" so lavishly praised by the former Bush political officer Rove so far has offered nothing but more Keynesian "solutions" of massive debt and inflation.

Instead of simply attacking the newest Keynesian nonsense, however, I will note that the eternal default position on economic crises — the Keynesian one — arises because academic economists foolishly have rejected Austrian Economics and the wise counsel it provides. This hardly is an accident or a problem that can be "solved" by being more aggressive in promoting the Austrian position. Instead, the failure of economists to embrace Austrianism comes both from ignorance about the economy in general and the fact that Austrian "solutions" do not provide a central role for economists to be seen as heroes or "fixers" of the economy.

Robert Murphy, in a recent "open letter" to the famed Nobel-winning economist Gary Becker, writes the following:

Mainstream economists often have a hard time grasping the Austrian theory of the business cycle because it relies on a theory of the complex capital structure in a modern economy. Most mainstream economists, in contrast, usually think of the “capital stock” encapsulated by a single value, K. Relying on the framework of the Solow growth model, mainstream economists usually interpret the Austrian theory as one of “overinvestment” during the boom.

As Murphy continues, it is clear that modern neoclassical economists are clueless in general about capital:

In order to even comprehend the Austrian claim, the mainstream economist needs to discard the simplistic homogeneous notion of the capital stock, and seek a richer framework that reflects the time structure of production. In a modern economy, if we picked a random consumer good off the store shelf, it would probably have a “life history” going back many years, and involving thousands of workers handling resources originating in dozens of countries. (Leonard Read’s wonderful essay “I, Pencil” is apposite.)

Indeed, if one were to ask a typical economist how an economy grows, he or she might reply: "Aggregate demand has been increased." (The so-called Supply-Siders might say that "aggregate supply has increased," but neither statement really makes any sense. There really is no such thing as "aggregate demand" or "aggregate supply"; they are figments of economists’ imaginations.) For now, it seems that economists, no matter if they are of the "free market" variety or if they are disciples of Keynes and Krugman, all are calling for the government to become involved in schemes to "jump start" the economy. The blind are leading the blind.

Furthermore, as Murphy points out in his "open letter," even accomplished economic thinkers like Becker seem incapable of understanding the basic Austrian notion of "malinvestment," instead mistakenly calling it "overinvestment." (Krugman refers to it as the "Hangover Theory," but presents a caricature not only of the theory itself, but also in his portrayal of Austrian economists as people who revel in the economic misery of others.)

Murphy and others of the Austrian School are correct in pointing out that typical academic economists really don’t understand capital very well, and their few attempts at formulating a theory of capital have been failures. Yet, I believe that the mainstream failure of capital theory is due to the greater failure of economists to understand that simple good: money.

About 30 years ago, I read The Biggest Con by Irwin Schiff, and I have not forgotten his opening statement that money in the United States had "disappeared." I was taken aback when first reading those words, but as I read his book and then read the Austrian economists, I realized that Schiff was right: money has disappeared in this country, and has been gone for a long time. In fact, almost all modern economists have grown up in a time when fiat "money" has been the norm. Few economists (and I include myself) ever have seen real money in circulation. The closest thing that most of us have seen was the silver (or part-silver) coinage that existed in the United States until 1965, but was replaced by government tokens.

Thus, few, if any, of us have experience in dealing with what historically has been termed "money," and that situation only adds to the overall ignorance that economists have of this subject. Furthermore, because of the artificial division of economics into "microeconomics" and "macroeconomics," economists who choose the more-popular "micro" fields have almost no contact at all with monetary theory, save a class or two from graduate school in which a near-pure quantity theory prevails.

Economists can speak of "money supply" or "price levels," but very few understand the very nature of the money economy and what happens when governments predictably abuse their monopolies of "money creation." Even the "free market" economists often stumble over the issue of money, even when they "specialize" in it, as did Milton Friedman.

This state of affairs was made clear to me in an exchange of articles by Joseph Salerno and Richard Timberlake in The Freeman nearly a decade ago. Salerno argued the Austrian position while Timberlake followed the Monetarist view. Timberlake, for example, could not understand Salerno’s contention that the 1920s was an era of Federal Reserve-induced inflation in this country because the consumer price index fell slightly during that decade. Timberlake’s reasoning was that if the government index was falling, then the 1920s had to be a time of deflation, not inflation.

Yet, Salerno and Timberlake were arguing past each other because each man was defining money in very different terms. Salerno was defining money as a good used for exchange that had all the properties of any individual good, and if the amount of money in circulation increases, the marginal utility of money falls, with inflation being the decrease of the value of money relative to the goods it is used to purchase.

Timberlake, on the other hand, defined money in the more typical neoclassical fashion of being a quantity variable monopolized by government and manipulated by the central bank as a means of influencing economic activity. The difference between the two points is crucial not only in understanding the current economic crisis, but also in understanding Austrian Capital Theory and the Austrian Theory of the Business Cycle. If one cannot understand money and capital, then one cannot understand the whole issue of malinvestments and what causes the boom and bust cycle.

The consequences of this ignorance are not esoteric. This is not a parlor discussion among economists on how many spirits of George Stigler can dance on the head of a pin. Instead, it is about understanding how this current crisis came to being, what to do about it, and, just as important, what not to do.

The upshot is that economists are creating crude models of imaginary "aggregate demand and aggregate supply," throwing in government spending and expansion of fiat currency, and calling it a "solution." However, one applies these "solutions" the same way that one pours gasoline on a house fire to extinguish the flames. The Keynesian "solution" is a disaster which is made worse because most academically-trained economists are ignorant of the causes of the problem and, thus, are not intellectually equipped to recommend the needed steps to put the economy back into balance.

Austrian economists and the intellectual tools they bring to the table are needed more than ever, yet the response of the economics profession has been to be even more aggressive in denouncing Austrians as "quacks" and "charlatans" and making sure that they are excluded from any academic and political discussions about this crisis. However, if one wishes to see just how superior the Austrian position has been, the best proof is to watch clips of Peter Schiff (Irwin’s son), who is a well-known investor and fund manager, debate mainstream economists and other “financial experts” by using the Austrian analysis against their viewpoints. Schiff clearly understands the nature of the crisis and how to stop the bleeding and cure the "patient"; the others blindly stumble about, citing the "expertise" of economic theories that lead to nowhere.

For years, economists from the University of Chicago and others influenced by them have claimed that Austrian Economics is rejected by the mainstream because it "fails the market test." Their logic goes like this: (a) Mainstream economists accept good theory and reject bad theory; (b) Austrian Economics is rejected by the mainstream; (c) Therefore, Austrian Economics is bad economics.

This is circular reasoning, not economic logic. The Chicago economists never deal with the actual Austrian arguments or if they attempt to do so, they usually get them wrong. In my view, the reason they get them wrong is because most economists do not have a clue as to understanding money. The consequences for this ignorance are serious. We have a financial and economic crisis that is going to turn into a major depression because the economic mainstream is intellectually incapable of understanding causes and solutions, and when the Austrians speak up, the other economists close their ears, start screaming, and continue to lead everyone else down the same path of destruction.

November 29, 2008

William L. Anderson, Ph.D. [send him mail], teaches economics at Frostburg State University in Maryland, and is an adjunct scholar of the Ludwig von Mises Institute. He also is a consultant with American Economic Services.

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