Economic theory is not a field with too many dissidents. The teachings of John Maynard Keynes have broadly stood unopposed as the foundation of modern economic policies, except for some of the monetarist ideas which were popular mainly in the 1980ies. Austrian business cycle theory, on the other hand, is virtually unknown; it is not even mentioned in a conventional economics curriculum at university, and you will be hard pressed to run into a politician who have ever heard of the father of Austrian economics, Ludwig von Mises. But as we shall see, Mises’ ideas were not only theoretically sound, they seem to have the power to explain actual economic developments quite successfully. Somehow, however, they have lived a life on the fringes, failing to wield any significant influence on policymaking anywhere, despite one of its key protagonists, Friedrich Hayek, winning the Nobel Prize in 1974.
But why? How come Keynesian theory has so comprehensively outshone that of Mises and the Austrians? The two schools of thought are very different, both in the analysis of the causes of why an economy gets into trouble and in the proposed remedies. Mises published The Theory of Money and Credit in 1912, in which he explained economic growth as driven by savings and production. At the heart of the theory lies the concept of the business cycle, in which context an economic crisis can be explained: expansionary monetary policy by the central bank leads investors to misinterpret the actual supply of capital, as low interest rates erroneously signal an abundance of funds available for investment. The result is a boom as capital is allocated in error to what Mises called malinvestments, which must necessarily be liquidated when the bust happens.
Keynes’ theory, which he put forward in his Treatise of Money published in 1930 and further elaborated in 1936 in The General Theory of Employment, Interest and Money, sees economic growth as a function of demand; it describes how a lack of equilibrium between savings and investment is the root cause of an economic crisis and a surge in unemployment, and prescribes that the government steps in to address the imbalance. In fact, Keynes offers little in the way of explanation of why an economy would suddenly experience such “insufficient aggregate demand”, other than to contend that psychological factors could make investors lose the confidence needed to put their capital at risk or cause consumers to stop spending.
As it turned out, in the time between the two economists published their respective works, the world would see a boom and a bust of epic proportions. Business was tough across the world after the end of the first World War, as a number of smaller recessions hit, but soon the roaring 20ies were in full swing. Nonetheless, the Federal Reserve system under the Coolidge administration initiated an enormous credit expansion consisting of low interest rates and an expansion of open market operations (buying bonds to inject liquidity into the banks). In 1924 it was primarily in an attempt help Britain to return to the gold standard, and in 1927 it was in response to the signs of a slowing economy. Similar policies were pursued in other countries. Stocks and property boomed. Then, in 1929, the crash happened – just a Misesian theory would predict.
It is often contended that the Hoover Administration prolonged the depression by pursuing laizzes-faire policies, allowing the crisis to deepen while sitting idly by. The truth, however, is very different. Hoover may have gone against Keynes’ ideas by raising taxes, but he presided over a massive fiscal expansion nonetheless, in line with what Keynes would have prescribed. The government ran budget deficits of more than 52.5% of total expenditure in 1931 and 43.3% in 1932, and government spending in 1933 was almost double that of 1929 in real terms. The Fed cut rates from 6% to 1.5%. From February 1932, when the Glass-Stegal act was passed, to the summer of that year, the Fed purchased $1.1bn treasuries in open market operations. Government intervention, which was a cornerstone of Keynesian theory, was indeed pursued during the Great Depression, alas with disappointing results: real GDP fell by almost 30% from 1929 to 1932 and only recovered to its pre-depression level in 1936.
So why did Mises’ theory, which had accurately predicted the 1929 crash, come to be almost forgotten? How did Keynes’ ideas, despite its shortcomings in describing what had just happened, end up laying the foundation for economic policy throughout the world in the years after the Second World War? Why did Keynesianism, and not the Austrian School, become the conventional wisdom?
The sad truth is that it is not being correct which is the most important quality of an idea which is to become universally popular. The term “conventional wisdom” is often attributed to the American economist John Kenneth Galbraith, who in his book The Affluent Society offered a definition as well:
The ease with which an idea is understood + the degree to which it helps one’s personal wellbeing = Conventional Wisdom.
In other words, when a constituency is presented with a simple idea which promises to be of benefit to a majority of its members, it is likely to become generally accepted as true. And Keynesian economics and the policies prescribed by it did just that. Keynesian theory tells politicians that when the economy is in a downturn government policy should be “counter-cyclical”; the state should pursue expansionary policies to replace private spending which has disappeared. This demand-led explanation of economic cycles, the real cause of which frankly can be difficult to understand, is intuitively appealing: the state plays the role of smoothing out the bumps in the road. It is economically alluring as well. It allows struggling companies to keep trading, and through investments in infrastructure and similar projects creates jobs for people who have been laid off as a result of the downturn. It puts money in the hands of people who would otherwise have had to curtail their spending. In short, it allows everyone to pretend that things are not that bad. And with its prescription for an interventionist government Keynesian theory put power in the hands of the elites. They were always going to like that.
Contrast this with how Mises and the Austrians would argue: that monetary expansion leads businesses to make mistakes, that the slump in the economy was the inevitable bust which must follow an unsustainable boom, and the solution is a re-allocation of resources currently tied up in unprofitable ventures. Certainly, this is both slightly opaque and most definitely painful (Paul Krugman called it a “counsel of despair”), thus violating both rules of what makes conventional wisdom.
There are other reasons for the Austrian school’s lack of mainstream success, not least its praxeological method which did poorly in an academic environment where all subject matters, inspired by the success of the natural sciences, were going in a quantitative direction. Also, when Keynes died in 1946 he was elevated to an iconic status, which made his theories difficult to disown. But regardless of reason, the fact remains that for decades Austrian Economics led a quiet existence on the fringes of economic theory, while Keynesianism became the mainstay of economic policy across the world.
So what of the future? There are signs that Austrian theory have become more popular in the aftermath of the 2008 financial crisis, due to the remarkably poignant example of a credit induced boom and bust which was experienced. A number of Austrian economist called the bubble years before it burst; no-one took much notice at the time, but after the crash even mainstream media were hard pressed to ignore it – though a new bubble in housing and stock markets, fuelled by continuous easy monetary policy, makes it convenient to forget about a necessary, but painful, cure to an as yet untreated underlying condition. What the Austrians need is to maintain the momentum, which will always be difficult in a world where politicians and academics alike are bound to resist. Austrian theory calls for a complete rethink of how economic policy is conducted everywhere; for an end to the power of central banks and politicians to orchestrate the economy. It wants to return power to the people, and let monetary conditions be directed by market forces rather than political decree. And that is difficult. What Milton Friedman called “the tyranny of the status quo”, the phenomenon that future policy is overwhelmingly debated only relative to current policy, infers that the current world order is somehow broadly correct and that only minor adjustments are required. As such, a dramatically different approach to economic policy, as Austrian theory would imply, is a hard sell. And returning power to the people is unlikely to prove popular amongst the elites. The establishment is not looking for a revolution.
There is some comfort to be found in history though, as the current world order is not the first to have been thought by insiders to be the end of history; the optimal state of organising society which was bound to last forever with only marginal adjustments needed. Ancient Egypt, Athens, Rome and every other empire in history had similar ideas and eventually found their belief in their own superiority shattered. The bad news, of course, is that they all learned the hard way.