March 14, 2016

Austrian Economics and the Real World

I have really tried to give Austrian economics a fair chance. My libertarian friends are without exception dedicated followers of Austrian theory, and since I highly respect them and their scholarship and research I have really tried to take Austrian economics seriously. 

In fact, I wrote favorably about it in my book Industrial Poverty, one reason being that I do indeed find some promising elements in Austrian economic theory, and I wanted to give those elements a fair chance. However, the more I look into the works of Carl Menger, Ludwig von Mises, Murray Rothbard and other Austrians, the less useful the theory seems to get. 

It seems as though the pieces, which are well defined in and by themselves, do not form a coherent, workable system. Maybe it can be used at the microeconomic level, but since we already have a well-working mainstream theory for the analysis of individuals, markets and industries, I do not see much room for Austrian theory to distinguish itself there. 

Macroeconomics, on the other hand, requires a coherent system of economic analysis. I have never been able to find that system in Austrian theory.

Perhaps my biggest beef with the Austrians has to do with their theory of the interest rate. They claim that the economy moves forward at a pace defined by a "natural" rate of interest. It is not entirely clear how this rate is determined, other than that it is an equilibrium price for the allocation of capital. But what capital are we talking about? 

This question is important: in Keynesian theory the interest rate is the price of liquidity, which means it is a price on money. This makes sense: the more illiquid an asset is, the bigger a risk do you as an investor take. However, in order for the interest rate to be a monetary price in this way, the goal of the agents on the market cleared by that interest rate has to be to shield themselves against uncertainty. When you hold your assets as cash, you never have to worry about liquidity in order to be able to pay for your regular expenditures.

By contrast, if you buy an office building in downtown Rawlins, WY, you will earn a return. That return is a premium for the risk you take by locking up your assets in a slow-moving real-estate market. To obtain cash you have to sell the building, which can take months. (You can borrow with the building as collateral, but that procedure only follows the same reasoning - only now the lender is giving up cash and wants interest from you.) 

Besides, a loan comes with spending commitments for the future. The more uncertain we are about the future, the less inclined we are to make big spending commitments. We prefer to keep our future incomes as "liquid" as possible.

In short: the Keynesian interest rate is a monetary price, compensating individual investors for giving up liquidity in the face of uncertainty. 

The Austrian interest rate, on the other hand, is compensation for a service, namely the service that is provided by a capital owner to an entrepreneur. For example, the owner of a car manufacturing company rents a production facility, paying his landlord a monthly rate of interest for the machinery and the facility. 

Some would, correctly, define that transaction as a lease on a property. That comparison is correct, showing the essence of the interest rate under Austrian theory. While there is nothing wrong with it per se, this interest rate definition runs into problems when injected into a macroeconomic system. The key difference, namely, between macroeconomics and microeconomics is that the former includes uncertainty while the latter does not. 

In an uncertain world, economic agents, be they consumers, investors or entrepreneurs, need instruments to manage and, as far as possible, reduce uncertainty. In the Keynesian system that is done by allocating investments on a scale from 100 percent liquidity to zero percent. The Austrian system lacks such a mechanism.

To further make the point that their interest rate has nothing to do with uncertainty, Austrians use their "natural" interest rate to create an intertemporal link between today and a specified time in the future. The practical meaning of this link is a decision on how to allocate capital:

  • If the natural interest rate of "today" is higher than the natural interest rate of "tomorrow", then the entrepreneur will postpone his investment until tomorrow;
  • If the natural interest rate of "today" is lower than the natural interest rate of "tomorrow", then the entrepreneur will make his investments today instead of tomorrow.

Intertemporal allocation of capital is a key to the Austrian attempt at explaining business cycles. If we have a recession it is because the natural interest rate has risen and entrepreneurs postpone investments. In the parlance of Keynes, General Theory, Chapter 16, the entrepreneurs decide not to "have dinner" today. However, there is a fundamental difference here. Keynes made it clear that the decision to not spend money today is not followed by a decision to "have dinner" tomorrow or at any other specific point in time in the future. The reduction in economic activity today is a "net diminution" of spending. 

Austrians, on the other hand, claim that the decision maker who chooses to not spend money today will also make a decision when to spend that money in the future. This is the entire point about the rate of interest being a price on the intertemporal allocation of the services of capital. In order to make the intertemporal allocation decision the entrepreneur has to have as much knowledge about the future date when he intends to make his postponed investment, as he has about today.

This eradicates the differences between the present and the future. It necessitates perfect foresight and eliminates the introduction of uncertainty into the model. 

I have several problems with perfect foresight. For example: if everybody knows perfectly well what will happen in the future, then where do business cycles come from?

No comments:

Post a Comment