April 16, 2016

Austrian Economics and Big Government

In my recent articles I explained that there are two theories on how the economic system operates:

One theory says that the system is inherently stable, prices are perfectly flexible and if left alone, the economy will always operate at full utilization of available resources;

Another theory says that economic agents prefer so called sticky prices to flexible prices - namely prices that only change a couple of times per year - and that even if left alone, the economy is not at all guaranteed to operate at full capacity utilization.

The first theory serves as the foundation for mainstream neoclassical economics as well as Austrian theory. The second theory is the microeconomic foundation for Keynesian economics.

A couple of readers have asked me how it is possible that the former microeconomic theory permits big government but the latter does not. Here goes.

Mainstream theory suggests, again, that the economic system has a built-in stability mechanism. When something disturbs the economy, so that it goes into a recession, then mainstream theory prescribes an automatic, and immediate, return to full employment if only the economy is left alone. Thanks to flexible prices, households, workers, investors and entrepreneurs quickly get the right signals as to how to re-allocate their resources and put them to optimal use again.

The underlying premise is that in every given situation, economic agents know perfectly well what decisions they need to make, and what the return will be, on any economic transaction they commit to. As a result, the theory concludes that there is no need for corrective government policies; strictly speaking, there are no business cycles either, since the first glimpse of a recession would cause relative-price adjustments and revert the economy back to full employment.

Because of these properties of mainstream microeconomics, the economic theories that are built on it - neoclassical macroeconomics, New Keynesian economics and Austrian theory - imply that there is no need for government. However, economists with a preference for social-liberal, social-democrat and even socialist political philosophy have found a way to use this very microeconomic theory to advocate a large welfare state.

At the core of the pro-welfare state argument is the long-term full-capacity utilization growth path that, according to mainstream microeconomics, the economy follows when left alone. When government - or some unforeseen event that agents with perfect foresight oversaw - disturbs that path, it happens in the form of a reduction in money spent. However, left-leaning economists learned to use this system to their advantage by suggesting that if the same amount of money that goes out of the system in the form of taxes also goes back in, then there will be no deviation from the long-term growth path.

In fact, it is even suggested that redistribution of income can increase economic output and carry the level of capacity utilization even higher if high-income earners are taxed while low-income earners are given the same amount of money in the form of a cash entitlement. The argument is that lower-income earners spend a higher share of every dollar than those with high incomes, which means that income redistribution increases the multiplier and thereby economic growth.

There is no systemic way to refute this argument within mainstream microeconomics. Provided that the redistribution mechanism literally feeds $1 back into the economy for every $1 it taxes out of it, there will be no aberration from full employment.

To economists loyal to Austrian theory,  this is a bit of a conundrum. They readily present their theory as the bulwark of the free-market economy, being just as quick to pin big government on Keynesianism. However, the microeconomic underpinnings of their theory give them no logical fuel for any such maneuvers. Instead, economists with a leaning in favor of free markets have developed ad-hoc supplements to Austrian theory. One of them is public choice, which does a reasonably good job at exposing the inherent inefficiency in government.

An ad-hoc explanation of why government should be kept limited is still useful and can be convincing. However, the case against big government in Austrian theory is not nearly as strong as its followers suggest.

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