The Austrian Economic School of Thought

Perspective on Economic Cycles and the Great Recession

The Austrian School of Economics, founded in the late 19th century by Carl Menger and developed by luminaries such as Ludwig von Mises and Friedrich Hayek, offers a distinct approach to understanding economic cycles, government intervention, and monetary policy. Unlike mainstream Keynesian or Monetarist approaches, the Austrian perspective emphasizes free markets, individual choice, and skepticism toward central economic planning. This financial framework gained renewed attention and relevance during the 2007-2008 Great Recession, as its proponents claimed the crisis validated their theories about artificial credit expansion.

Key principles of Austrian economics include:

1. Methodological individualism: Economic analysis should focus on individual decision-making, not aggregates.

2. Subjective theory of value: Value is determined by individual preferences and utility, not objective properties.

3. Time preference: People naturally prefer present goods over future goods, affecting interest rates and capital formation.

4. Spontaneous order: Complex economic systems emerge from individual actions, not central planning.

5. Economic calculation: Market prices provide crucial information that central planners cannot replicate.

The Austrian School Theory of Business Cycles

At the heart of Austrian analysis is its unique business cycle theory, developed primarily by Ludwig von Mises and Friedrich Hayek. According to this theory, market economies naturally tend toward equilibrium and sustainable growth when left undisturbed. Economic cycles of boom and bust are not inherent to free markets but result from artificial manipulation of money and credit.

The Austrian business cycle theory posits that when central banks artificially lower interest rates below their natural market level, they distort the production structure. These artificially low rates create an illusion of abundant savings, encouraging businesses to invest in longer-term projects that the actual supply of real savings cannot sustain. This misallocation of resources—termed “malinvestment”—creates an unsustainable boom destined for correction.

As economist Roger Garrison explains, “The Austrian theory is not a theory of depression per se but rather a theory of the unsustainable boom.” The inevitable bust or recession is viewed not as a market failure but as a necessary correction process where malinvestments are liquidated and resources reallocated to more sustainable uses.

The Great Recession Through Austrian Eyes – Prelude to Crisis

Austrian economists view the Great Recession as a textbook illustration of their business cycle theory. Following the dot-com crash and the economic uncertainty after 9/11, the Federal Reserve under Alan Greenspan kept interest rates exceptionally low. The federal funds rate was reduced to 1% in 2003 and remained below historical averages for an extended period.

From the Austrian perspective, these artificially low interest rates sent false signals to market participants about the availability of real savings. The result was a massive housing boom fueled by cheap credit. As interest rates remained depressed, consumers and investors increasingly directed resources toward housing, leading to unprecedented price increases in real estate markets across the United States.

The explosion of novel financial instruments like collateralized debt obligations (CDOs) and mortgage-backed securities further amplified the distortions. Rather than reflecting true market risks, these instruments thrived in an environment where artificially cheap credit obscured underlying economic realities.

The Inevitable Correction

By 2006-2007, as the Federal Reserve began raising interest rates to combat inflation concerns, the unsustainable nature of the housing boom became apparent. The Austrian view holds that this wasn’t a random market failure but the inevitable consequence of previous monetary manipulation.

As housing prices began to fall and mortgage defaults increased, the financial system faced a reckoning. Institutions heavily invested in mortgage-backed securities and related derivatives experienced mounting losses. The crisis spread throughout the financial system, culminating in the collapse of Lehman Brothers in September 2008 and the subsequent global financial crisis.

For Austrian economists, this sequence represented not a failure of capitalism but the predictable outcome of government intervention in money and credit markets. As economist Robert Murphy noted, “The housing bubble and its aftermath followed the script of Austrian business cycle theory almost perfectly.”

The Austrian Prescription vs. Actual Response

The Austrian prescription for handling economic crises differs markedly from mainstream approaches. When faced with the collapsing housing market and financial system in 2008, Austrian economists recommended:

1. Allowing insolvent institutions to fail: Market discipline requires that businesses making poor decisions face the consequences.

2. Avoiding bailouts and stimulus packages: Government attempts to prop up failing sectors only delay necessary adjustments.

3. Permitting prices to fall: Price adjustments provide information necessary for economic recalculation and resource reallocation.

4. Removing regulatory barriers: Government regulations often impede the market’s ability to correct itself.

5. Returning to sound money principles: Ending the cycle of artificial credit expansion that creates booms and busts.

As Ludwig von Mises once stated, “There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”

The Actual Response: Intervention and Stimulus

The actual policy response to the Great Recession followed a decidedly non-Austrian path. The U.S. government and Federal Reserve implemented:

1. Massive bailouts: The government committed hundreds of billions through programs like the Troubled Asset Relief Program (TARP) to rescue failing financial institutions.

2. Fiscal stimulus: The American Recovery and Reinvestment Act of 2009 directed \$787 billion toward government spending and tax cuts.

3. Quantitative easing: The Federal Reserve purchased trillions in government bonds and mortgage-backed securities, expanding its balance sheet unprecedentedly.

4. Zero interest rate policy: Interest rates were slashed to near-zero and kept there for years.

5. New regulations: Legislation like the Dodd-Frank Act imposed new rules on financial institutions.

From the Austrian perspective, these interventions prevented necessary economic adjustments and created new distortions. As the quoted Treasury Secretary Andrew Mellon advised during an earlier crisis, the Austrian view suggests that allowing liquidation would “purge the rottenness out of the system” and permit a more sustainable recovery.

Critical Evaluation of the Austrian Perspective

Strengths of the Austrian Analysis

The Austrian School correctly identified several key elements of the crisis:

1. Credit expansion’s role: The housing bubble was indeed fueled by easy money policies and artificially low interest rates.

2. Malinvestment: Resources were clearly misdirected toward housing and financial instruments that proved unsustainable.

3. Warning signals: Several Austrian economists warned about the housing bubble years before mainstream economists acknowledged the problem.

As early as 2003, Austrian-influenced economists were raising alarms about unsustainable housing prices and debt levels when many mainstream economists saw no cause for concern.

Limitations and Criticisms

Despite these insights, the Austrian perspective faces several critiques:

1. Depression risk: As noted in the provided information, without intervention, the Great Recession might have deepened into another Great Depression. The quote referencing “Hoovervilles” highlights how the Austrian prescription of allowing liquidation proved politically untenable during the 1930s.

2. Empirical validation: Austrian business cycle theory relies heavily on logical deduction rather than empirical testing, making its claims difficult to verify through conventional economic methods.

3. Political feasibility: The Austrian recommendation to allow widespread bankruptcies and economic pain in the short term is politically challenging to implement in democratic societies.

4. Historical precedent: The reference to Ludwig von Mises’s association with Austrofascist Chancellor Engelbert Dollfuss raises questions about the political implications of certain Austrian economic policies when implemented historically.

5. International trade effects: As noted in the discussion of the Smoot-Hawley Tariff Act, which Hoover supported despite its disastrous consequences, simplistic economic prescriptions can have complex and unintended consequences when implemented.

The Legacy of the Great Recession and Austrian Insights

Lingering Consequences

More than a decade after the Great Recession, the debate about the appropriate response continues. Austrian economists point to several consequences of the interventionist approach:

1. Expanded government debt: The national debt has grown dramatically, potentially creating vulnerability to future crises.

2. Asset inflation: Quantitative easing and low interest rates have contributed to rising asset prices, potentially creating new bubbles in stocks and bonds.

3. Moral hazard: Bailouts may have reinforced the perception that risky behavior will be rewarded with government assistance, encouraging future reckless behavior.

4. Zombie companies: Ultra-low interest rates have allowed inefficient firms to survive rather than reallocating resources to more productive enterprises.

Incorporating Austrian Insights

While few policymakers embrace pure Austrian prescriptions, certain Austrian insights have gained wider acceptance:

1. Monetary policy limits: There’s growing recognition that central bank policies can contribute to asset bubbles and financial instability.

2. Moral hazard concerns: Reforms have attempted to address the “too big to fail” problem that creates perverse incentives.

3. Structural analysis: More attention is paid to how monetary policy affects different sectors rather than aggregate measures.

Conclusion

As Western economies face new challenges in the 2020s, including unprecedented levels of government debt and ongoing monetary interventions, the Austrian warning about unsustainable credit should be considered to build a useful technology cycle model. However, the Austrian school offers an incomplete framework for modeling technology cycles. Allowing markets to correct themselves is not acceptable politically. Further, allowing sustained depressions exposes the practical limitation of a single-threaded approach. The experience of the Great Depression is not a practical prescription anymore. It led to prohibitive carnage to the economy and worldwide democracy. We see this even today.

Some Quotes

We got the infamous quote from President Herbert Hoover’s Treasury Secretary, Andrew Mellon. “Liquidate labor, liquidate stocks, liquidate the farmers, liquidate real estate…. [The depression] will purge the rottenness out of the system. High costs of living and high living will come down. People will work harder and live a more moral life. Values will be adjusted, and enterprising people will pick up the wrecks from less competent people.”¹

Quote from Ludwig von Mises who is one of the founding members of the Austrian economic school.  Mises was the chief economist for Englebert Dollfuss, the austrofascicst Austrian Chancellor from 1932 to July 1934.² “Mr. Hoover met the challenge of the Great Depression by acting quickly and decisively. Indeed, almost continuously throughout his term of office, putting into effect the greatest program. The US had never attempted a greater attack on depression. Bravely, he used every modern economic “tool.” Every device of progressive and enlightened” economics, every facet of government planning, was used to combat the depression.”

Hoover initially responded by voluntarily discussing the situation between businesses. He went on to reduce taxes and supported the Smoot-Hawley Tariff Act. The Tariff Act widened and deepened the Great Depression. Other nations retaliated with their tariffs, further hobbling international trade. Hoover was summarily voted out of office in 1932. His name was used for the homeless shantytown encampments that came to litter the American landscape. They were called “Hoovervilles.” Had anyone known the source for the macro theory, they likely would have called them “Austrianvilles” instead.