The Austrian School of Economics - Pluses and Minuses

[ecoli]

That he certainly did, and it played a role in the financial crisis. But it was not the direct cause. Unregulated markets, an assumption of too much toxic debt by individual organizations, and complex financial instruments no one understood were the direct causes.

 

It depends on who you ask. This is far from a definitive truth, though it certainly has become part of the global narrative.

 

 

Greenspan stringently opposed attempts to regulate derivatives and securities. It was the collateralized debt obligations backed by mortgages which became incredibly toxic after the housing bubble burst which lead to the financial crisis.

But the money to buy these mortgages didn't come out of thin air... wait, actually it did... it came from the Fed.

 

Have you seen this video:

 

http://www.scienceforums.net/forum/showthread.php?t=45258

 

What role do you think derivatives and securities had in the financial crisis?

Sorry I'm at work now and can't watch video (forgot my headphones). I'll take a look later though.

 

Obviously I'm not saying derivatives and securities were inconsequential to the crisis. Obviously, this WAS the crisis.

 

However, in my mind, the reason why financial models failed and the reason why our economic models failed are the same - people don't understand how to account for risk.

 

I can't prove this, but I don't think it matters what kind of regulation (or deregulation) is going on. If you fund risk-taking behavior, and let people know that they won't be held accountable, then we going to keep getting in trouble (again and again and again).

 

Business cycles won't stop if you don't regulate the economy (I disagree with some austrians on this point) but the regulators allow us to become much more arrogant about our ability to deal with them.

 

 

No, the let it fail option doesn't look any worse, because it continues to be, in my mind, the worst possible outcome: a total collapse of the worldwide financial system. It would represent total credit gridlock and have some of the most dire economic consequences imaginable. Our daily lives would've been dramatically altered. I certainly wouldn't be looking to buy a new house now, because there's no way I could ever get a mortgage.

My gut tells me that you're right, but without a many worlds looking glass, we can't, say, look into a free marketverse and see what happens.

 

What do you think would've happened to the US and the world if multiple financial institutions collapsed leaving $3.6 trillion in debt?

That's a nice narrative, but you seem to have forgotten debt still exists, its just that the taxpayers now own it. All we've done is socialize that debt, so we can let these companies take the dollar with them when they go.

 

We're operating under the assumption that we can pay it back when things get better, but if the austrians are correct and that easy money (which we are using now more than ever) will lead to malinvestment than possibly not only are we delaying the inevitable crash, but we're also making that crash worse.

 

In this view (which may or may not be correct, of course) the recession is the cure for previous excess. Ramping up the national debt, trying to maintain that excess, is not going to help the recession.

[iNow]

Fairly critiquing and supporting Austrian economics has become my speciality of late. Which part is bothering you?

First, let me state that I appreciate the clarity with which you described it, and how you did so in laymens terms. It's obvious this is not the first time you've shared this.

 

However, what I am missing (and don't see in your post) is why this approach is supposed to better... What are it's pluses? We did a fine job of exploring the negatives on the previous page, but (frankly) all I see in the "pluses" category is "I prefer it this way." It's all based on fuzzy personal preferences, and not a lot of objective comparisons (AFAICT).

 

So... What are the pluses? Why is this approach (which has so many obvious limitations and lack of practicality) somehow better?

 

 

 

 

I'm not thoroughly convinced that the quick bailouts and subsequent stimulus has saved us.

 

<...>

 

Certainly it would have been worse for bank employees. Certainly it would have been worse for people with investments and deposits with these banks. But how much worse and for how long? Who knows.

 

<...>

 

I'm getting into heavy speculation now, but isn't that what everyone is doing? Certainly my form of speculation is no worse (and better) about the many spurious claims about how stimulus is helping us... whether its through "job creation" or providing "stability."

I think you are dangerously close to argument from incredulity here, and find your dismissal of the impact of the government interventions somewhat misinformed. For example, see the below... which is taken from three different independent sources... and shows how different things would have been had we "let them fail."

 

 

[ecoli]

First, let me state that I appreciate the clarity with which you described it, and how you did so in laymens terms. It's obvious this is not the first time you've shared this.

Thanks buddy! I think we're having a good discussion here, and yes I've had this discussion many times this year.

 

 

So... What are the pluses? Why is this approach (which has so many obvious limitations and lack of practicality) somehow better?

 

Are you talking about the Austrian approach in general? I'm not a practioner, so its sort of hard for me to talk about specifics in application of the science. Also note that Austrain economics has become a lot more empirical than it used to be (not all a priori reasoning based on deduction). There are a few econ journals with "Austrian" in the title that are always worth taking a look through. Many of the modeling is still done without much math, but then try to use comparative economics to support these models (for example).

 

It sounds like you wanted to avoid specifics for this thread, but barring that, I can only recommend reading a bit about Austrian ideas. Here's a good general encyclopedia-like essay. http://www.econlib.org/library/Enc/AustrianSchoolofEconomics.html

 

 

 

 

I think you are dangerously close to argument from incredulity here, and find your dismissal of the impact of the government interventions somewhat misinformed. For example, see the below... which is taken from three different independent sources... and shows how different things would have been had we "let them fail."

 

I think I'm arguing from incredulity. At least its not my intent. I'm not saying "I can't imagine how P could be false, therefore P." I'm saying "It's easy to say P is false, therefore we should be careful before dismissing it."

 

I'm not sure what data these models are based on, but my gut tells me they're too presumptuous. After all, the same basic economic models allowed us to miss the recession in the first place. The same economic models helped Obama's economic team come up with this graph (superimposed with actual data):

 

 

From this chart I could conclude:

 

1) we should trust mainstream gov't economist's ability to forecast, so we shouldn't trust their policies

 

OR

 

2) we shouldn't trust their ability to forecast so who knows the effect policy is really having.

 

I'm going to give them the benefit of the doubt and go with option 2.

[npts2020]

ecoli; The biggest problem with a so-called free market is that in the past it has simply meant freedom for "capitalists" to exploit everything from resources and environments to societies and individuals with little or no regard for the consequences of anything other than if it makes them money at a high enough rate.

 

bascule; While I agree with the proposition that we are better off right now having done economic stimulus and bailouts, there is still a very real possibility that it will ultimately make things worse. If those financial companies had been allowed to fail (like the rules of the game said they should have) it would have caused a bigger mess for some time but IMO very real reform and change would have already taken place in the American financial sector. The main reason any of those companies were in trouble to begin with was the Ponzi scam known as derivatives. The derivative market is (still) so unregulated that nobody can even put a good number on what the total "worth" of the market is. The estimates I have seen range from $200 trillion to well over a quadrillion dollars, with most closer to the upper figure. Now what possible problems could that present? (hint; the total world's annual GDP is around $60 trillion). If the derivative market goes bust, what happened to likely 10+ years of world GDP?

[ecoli]

ecoli; The biggest problem with a so-called free market is that in the past it has simply meant freedom for "capitalists" to exploit everything from resources and environments to societies and individuals with little or no regard for the consequences of anything other than if it makes them money at a high enough rate.

 

I agree. But of course, what you've described is not free market capitalism, from mercantilism or corporatism, and not what Austrians propose. I suppose you could make the argument that capitalism leads to corporatism, but I've seen no compelling argument for this (especially not that any other economic system won't come to a similar end).

[bascule]

Let me start with this as it's the main line I keep hearing out of Austrian school people who apparently don't understand how the financial crisis came about:

 

If you fund risk-taking behavior, and let people know that they won't be held accountable, then we going to keep getting in trouble (again and again and again).

 

Nobody ever "let people know they won't be held accountable". The Fed let Lehman Brothers fail.

 

Please read that again:

 

The Fed let Lehman Brothers fail. They held them accountable. They did not bail them out. They let them collapse.

 

They were trying to do exactly what the Austrian School people would've suggested in that situation. Lehman Brothers put themselves at risk. The Fed let the market take its course.

 

Then what happened? The worldwide financial system almost collapsed as an institution with $613 billion in debt declared bankruptcy.

 

You are aware of this, right? The Fed doesn't automatically give these institutions a "get out of debt free" card. The bailout plan came in full 20/20 hindsight of the effect the collapse of Lehman Brothers had on the worldwide financial system.

 

They were trying to let it fail. They did an experiment. The experiment was a failure.

 

Would you prefer the Fed let the other institutions with more debt fail as well, expecting different results?

 

However, in my mind, the reason why financial models failed and the reason why our economic models failed are the same - people don't understand how to account for risk.

 

Incorrect. The risks associated with CDOs allow the person who constructed them to hide toxic debt inside of them in a way that the buyer cannot discover:

 

http://www.freedom-to-tinker.com/blog/appel/intractability-financial-derivatives

 

Trading in derivatives brought down Lehman Brothers, AIG, and many other buyers, based on mistaken assumptions about the independence of the underlying asset prices; they underestimated the danger that many mortgages would all default at the same time. But the new paper shows that in addition to that kind of danger, risks can arise because a seller can deliberately construct a derivative with a booby trap hiding in plain sight.

 

It's like encryption: it's easy to construct an encrypted message (your browser does this all the time), but it's hard to decrypt without knowing the key (we believe even the NSA doesn't have the computational power to do it). Similarly, the new result shows that the seller can construct the CDO with a booby trap, but even Goldman Sachs won't have enough computational power to analyze whether a trap is present.

 

This is a very different type of risk and one which wasn't known at the time. Buyers of derivatives place themselves at risk of purchasing something which was maliciously constructed to pass along toxic debt in a way they can't discover or realize.

 

A simple solution would be to regulate the derivatives market, but Greenspan was adamantly opposed.

 

That's a nice narrative, but you seem to have forgotten debt still exists, its just that the taxpayers now own it. All we've done is socialize that debt, so we can let these companies take the dollar with them when they go.

 

Incorrect. At least in the case of Goldman Sachs and CitiGroup, they were loaned money by the government, and they repaid it. The government isn't holding $3.6 trillion in debt from them.

 

In this view (which may or may not be correct, of course) the recession is the cure for previous excess. Ramping up the national debt, trying to maintain that excess, is not going to help the recession.

 

You keep downplaying the alternative, which is a collapse of the worldwide financial system and a deep global depression.

 

I will take "maintaining the excesses" as at least something to try in order to prevent a deep global depression. I do not see a deep global depression as a superior alternative, even if to the Austrian School that, in some way, looks better on paper.

[iNow]

Incorrect. At least in the case of Goldman Sachs and CitiGroup, they were loaned money by the government, and they repaid it. The government isn't holding $3.6 trillion in debt from them.

In fact... we actually made quite a bit of money back on some of those investments.

 

 

http://www.mcclatchydc.com/329/story/69754.html

When Congress passed the $700 billion Wall Street bailout package last fall, critics said it'd be a money loser. But when 10 banks returned $68 billion of the money on Tuesday, President Barack Obama said the government had realized a small profit.

 

Did it really?

 

In addition to returning the $68 billion, the 10 banks paid the government $1.8 billion in dividends on the preferred shares of stock the government owned. That translates to an annualized rate of return of about 4.64 percent on the $68 billion.

 

In all, the government has received $4.5 billion from all bailout recipients, who've received $200 billion, for an annualized rate of return since Nov. 12, 2008, when the money was lent out, of 3.94 percent.

 

<...>

 

The government stands to earn even more when it sells the stock warrants it holds in conjunction with its preferred shares in the 10 bank-holding companies that are paying their bailout. Treasury and the banks are negotiating a fair-market value for these warrants.

 

Mark Zandi, chief economist of Moody's Economy.com, thinks that the warrants issued against preferred shares of stock from all bailout recipients — not just the 10 authorized Tuesday to repay the government — are worth at least $5 billion.

So for a snapshot in this point in time, the Wall Street bailout has been profitable

.

[Mr Skeptic]

That [hold down interest rates] he certainly did, and it played a role in the financial crisis. But it was not the direct cause. Unregulated markets, an assumption of too much toxic debt by individual organizations, and complex financial instruments no one understood were the direct causes.

 

You get problems when the interest paid on debts is not high enough to account for inflation plus losses due to the risk of having made the loan. That is the only way to get problems making loans.

 

There has always been a risk to making loans, and it is well known that there is no way to determine the true risk, especially so when the risk is estimated to be really small. The interest is supposed to be high enough to cover these risks. What do you think an artificially low interest rate means?

 

What do you think would've happened to the US and the world if multiple financial institutions collapsed leaving $3.6 trillion in debt?

 

Probably roughly the same as the US government soaking up the debt, only far less bad and with lessons learned.

[ecoli]

I believe (but not completely sure) that the Austrian economists say that this is proof that the bailouts where not needed. Or at least that not as much bailout was needed. The banks that are posting the profits were never in much trouble to begin with.

 

The more conspiracy theory minded say banks were forced to take TARP money to obscure which banks were in trouble and which were not, or perhaps to obscure the fact the bailouts were to help out the politically well-connected Goldman-Sachs.

 

In any case, iNow, the part that has been "profitable" is only a fraction of the $700 bil.

 

 

I'm skeptical about claims of profitability, in general. After all, billions of dollars in loses don't just disappear. Before declaring the bailouts a success I want to make sure that we're not dealing with new clever accounting tricks, schemes to secure government money through back channels, etc.

 

I'm not trying to claim the Austrians are right on this one. I'm just staying cautious and skeptical.

 

Maybe the bailouts were good and provided temporary stability, but I'm not convinced that the stability is more than temporary and isn't a result of parlor tricks.

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This is a very different type of risk and one which wasn't known at the time. Buyers of derivatives place themselves at risk of purchasing something which was maliciously constructed to pass along toxic debt in a way they can't discover or realize.

 

A simple solution would be to regulate the derivatives market, but Greenspan was adamantly opposed.

I don't understand what regulation you think could have stopped this one.

 

The finance people using these risk-models didn't consider the unknown unknowns (the risk that the housing market would collapse) The politicians certainly didn't know about this possibility.

[Mr Skeptic]

Nobody ever "let people know they won't be held accountable". The Fed let Lehman Brothers fail.

...

They were trying to let it fail. They did an experiment. The experiment was a failure.

 

Would you prefer the Fed let the other institutions with more debt fail as well, expecting different results?

 

Well yes, eventually there would be an end to the collapse. It's not all fake money after all. After all the fake money disappears, we are left with only real money. Then people learn to be careful of fake money.

 

If the government wanted to make things easy on all of us, they should have let these fail and bailed out people who have real money not fake money.

 

Incorrect. The risks associated with CDOs allow the person who constructed them to hide toxic debt inside of them in a way that the buyer cannot discover:

...

This is a very different type of risk and one which wasn't known at the time. Buyers of derivatives place themselves at risk of purchasing something which was maliciously constructed to pass along toxic debt in a way they can't discover or realize.

 

But, this has been known and documented for a very long time. Caveat emptor! The seller will try to convince a buyer that something is worth more than he himself believes it is worth, while the buyer will pretend it is worth less than he believes it really is worth. How can anyone be surprised that derivatives were less valuable than they appeared? If they took the time to understand what they were buying they would have realized that they could be made to hide toxic assets, even if they were unable to tell whether they did.

[bascule]

What do you think would've happened to the US and the world if multiple financial institutions collapsed leaving $3.6 trillion in debt?

 

Probably roughly the same as the US government soaking up the debt, only far less bad and with lessons learned.

 

I do not find this outlook to be remotely in line with reality.

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I don't understand what regulation you think could have stopped this one.

 

Brooksley Born, head of the CFTC, moved to regulate derivatives in the late '90s. Greenspan opposed her, because, well, REGULATION BAD!

 

I believe such legislation would've helped mitigate and possibly prevent the financial crisis.

 

(Watch the Frontline video plztks)

Edited December 1, 2009 by bascule
Consecutive posts merged.

[bascule]

Have the Austrians given up?

 

I saw some interesting articles lately:

 

http://www.time.com/time/nation/article/0,8599,1942834-4,00.html

 

In Time's retrospective of this decade, they roundly blamed deregulation for the financial crisis. They blame the repeal of parts of Glass-Steagall Act on the existence of such entities as Citigroup, the largest and most complex financial company in the world, with total assets of $1.93 trillion.

 

They also blame changes to the fractional reserve lending laws, that "allowed the likes of Bear Stearns and Lehman to pile $30 of debt onto each $1 of capital." So for all of you complaining about unsound fractional reserve lending, yeah, it's deregulation in action.

 

http://www.economist.com/businessfinance/displayStory.cfm?story_id=15016132

 

The Economist had an article on the complexity of IT systems at financial institutions, and what a nightmare it is to actually collect the data needed to soundly assess the risks a large, complex modern financial organization is taking at a given point in time.

 

Brooksley Born, head of the CFTC, moved to regulate derivatives in the late '90s. Greenspan opposed her, because, well, REGULATION BAD!

 

And really the regulation Brooksley Born was pushing for was merely having public corporations document their derivatives trading so that the central bank can look for systemic risks.

 

The way I see our financial system was hit by metaphorical thermonuclear explosion. The housing bubble was like an initial fission device. When it goes off, the damage is devastating. But it's easy to recover.

 

Collateralized debt obligations were like a second stage fusion reaction. None of the computer models were able to predict what would happen when the overall system started breaking down. The result was, well, very very bad.

 

It would've been really great if the data were actually available to assess risks, and be able to build this sort of graph in something other than 20/20 hindsight:

 

 

Requiring these organizations to, by law, collect the information needed to analyze systemic risks and give it to the federal government sure seems like a good idea to me. From the Economist article I gather these organizations, through bureaucratic inertia and IT hell, seem rather reluctant to self-police even their own risk, much less the systemic risks.

[npts2020]

IMO the long and short of it is that, federally insured financial institutions ought not to be allowed to trade in unregulated financial instruments.

[iNow]

I found this succinct and rather poignant:

 

 

Martin And The Austrians

My view is that the fatal flaw in Austrian economics is that it can’t explain unemployment — or, worse, that it thinks that it can explain unemployment, but is deluding itself. The Austrian view is that unemployment in a slump results from the difficulty of “adaptation of the structure of production” — workers are unemployed as resources are painfully transferred out of an overblown investment-goods sector back into production of consumption goods.

 

But this immediately raises the question, why isn’t there similar unemployment during the boom, as workers are transferred

into

investment goods production?

 

I’ve asked this question repeatedly over the years, and all I get is one of two things: gobbledygook, or “but during the phase of rising investment, the economy is booming!”, which is of course circular. In practice, Austrians seem to be Keynesians during booms without knowing it; they realize that high demand produces a boom, but don’t realize that this contradicts their own theory of slumps.

[ParanoiA]

I wish I was more knowledgeable on the Austrian view. The one knowledgeable one that I know of here at SFN (maybe ecoli too?) was considered a bore and was dismissed based on his lecture technique as opposed to actually being wrong, much less proven wrong. I actually really like the fella, and he seems to understand economics on a much deeper level than anyone here.

 

So, the sole expert has vacated, as far as I can tell. There is no "discussion" of any academic credibility here as long as the academics are not present.

 

In hopes that he may return, or some other expert could step up, I'd be very curious about full reserve banking and how it relates with the Austrian model. Also, do we save money and capital with a non-centralized, unplanned economy? It would seem a planned, regulated economy would cost more, if nothing else to pay the regulators. How much is this cost? Is it higher than the costs we would incurr from the disadvantages of an unplanned, non-centralized economy?

 

There are realities that I find disturbing. Ecoli pointed this out, way above and it certainly is curious. The regulator never gets blamed - failures are still the fault of the regulated. How does that happen? I claim to be able to regulate your economy to prevent disaster - but then I fail to anticipate the actions of millions of points of business interest and that's *not* my fault? Crazy.

[Sisyphus]

I've actually been asking a lot of questions on Austrian economics-centered forums. Some answers I've found enlightening, some ridiculous. I think they're right (or at least "not wrong") about a lot of things, but there's also a strong current of choosing theoretical internal consistency over consistency with reality, making it inherently kind of an anti-science.

[ecoli]

I've actually been asking a lot of questions on Austrian economics-centered forums. Some answers I've found enlightening, some ridiculous. I think they're right (or at least "not wrong") about a lot of things, but there's also a strong current of choosing theoretical internal consistency over consistency with reality, making it inherently kind of an anti-science.

 

The worst Austrians tend to be dogmatically anti-empirical (which is sort of a perversion of von Mises's praxeology).

 

Behavioral economics research shows that attempting to logically deduce human action a priori through logic isn't always going to work out. (though admittedly mainstream economic models aren't much better, and in certain ways much worse).

[iNow]

An interesting follow-up:

 

As predicted, many of the comments to my Austrian economics post are of the form “Well, of course employment rises when investment is expanding, and falls when the investment is falling — in the first case the economy is booming while in the second it’s slumping.”

 

As I tried to explain, however, that’s assuming the conclusion; there’s no “of course” about it.

Why

do periods when the economy is investing more correspond to booms, while periods when it’s investing less correspond to slumps? That’s easy to understand in Keynesian terms — but the whole Austrian claim is that they’re an alternative to Keynesianism. Yet I have never seen a clear explanation of this central point.

 

What happens, instead — or at least that’s how I read it — is that Austrians slip Keynesianism in through the back door. Implicitly, they associate booms and slumps with rising or falling aggregate demand — utterly unaware that their own theory doesn’t actually make room for such a thing as aggregate demand to exist, or at least to affect overall employment. So Austrians are basically Keynesians in denial — self-hating Keynesians? — pretending to themselves that they’re not using ideas that are in fact essential to their story.