The Austrian Solution

0:00The title of my article is The Austrian Solution, and of course that solution is related to the economic crisis that we find ourselves in here in the United States and around the world, so it's really the perfect topic to come to a finale here. We've looked at Ludwig von Mises, his contributions to the origin of money and various other things, and then the nature of money and then ultimately what that leads into is discussions of the business cycle, boom and bust, and economic crisis. On the one hand, we should consider the question of who cares what the Austrian solution is.

0:48We're big here in Auburn, but not so much in the economic profession. We are a very significant minority within the economics profession. There are anywhere from 100 to 1,000 mainstream economists for every one Austrian economist. So we're a very small minority. However, we are the oldest ongoing school of economics and we're also the fastest growing school of economics. So while we're small and can be disregarded by a lot of people, we're also a very energetic, very growth-oriented and very young average school of economics.

1:37And the reason we should pay attention and that you should pay attention to what the Austrian solution is, is because we were the only school who saw this crisis coming. You can go back on our webpage and look this up, but Austrian economists were writing about about the housing bubble in the United States and around the world in 2003. I myself mentioned it in early 2004, and I wrote an article about it extensively later in 2004. I was having this discussion with my brother on the phone, and he was in the mortgage lending business, online mortgage lending business, and he said, brother, I can give these people and Police Loans, they can put $50,000 in their pocket, reduce their interest rate, reduce their payment.

2:29He said, it's almost too good to be true. I thought, oh dear, it is almost too good to be true. So Austrians were writing about this very early on. Whereas if you were watching the news or the newspaper, you'd be seeing Dr. Ben Bernanke, and Vice Chairman of the Fed, and who is now Chairman of the Federal Reserve, he was telling us that he was investigating the mortgage lending business, that he had a whole team of people looking into this, and he found not only were things okay, but they were better than ever. That the requirements for reporting, the safety requirements in the mortgage lending business were better than ever.

3:17Okay, so that's just a little groundwork here for the Austrian approach to things. We have a distinctive theory of the business cycle, the Austrian business cycle theory, or ABC theory. In large part that's due to the fact of Ludwig von Mises, his early work that Danny was referring to, the theory of money and credit, where he first broached this idea of a theory of of the Business Cycle, Why it Occurs, How it Occurs. So what are the ABCs? Well, the first A is that central banks have a tendency to loosen credit within the economy. That they have the ability in their control over the money supply and the interest rate to make lending conditions looser or easier.

4:10So you get easy credit in the economy. They get lower interest rates in the economy. They give money to banks, so banks can give money to the rest of us. Okay, and that's a bureaucracy. The Federal Reserve is a government bureaucracy, so you guys know what that is. They're not perfect. They can't be perfect. They're always hit and miss, too much or too little. I know you're all very familiar with that problem. It's always never quite right. No matter how hard they try, no matter how smart they are, there's too many shoes and not enough socks. Too many cannons, not enough bullets. So we start out with that premise that central banks can't hit the correct market target of what's necessary, what's rational.

5:01And that for political purposes, they very often will loosen credit. That means that banks have more credit available. So, the B part of the ABC theory is banks. Banks have more money available to lend. They lower the interest rate. That means they have to find customers for those loans who have poor credit worthiness of necessity. You can't just snap your finger and say, oh, there's a bunch of really credit-worthy borrowers. So the Fed increases credit, banks increase loans, and the third part is entrepreneurs go out and invest more money in the economy.

5:51So there's more investment as a result. The Fed, the banks, the entrepreneurs. Not only do investors invest more, but consumers actually consume more. Interest rates are lower, so there's less incentive to save, more incentive to spend. So this sets the stage. Entrepreneurs are investing more, they're buying more capital, they're hiring more labor, and consumers are saving less and spending more. The upshot of that is, or the result of all that is, that there's a boom in the economy. So that's an explanation of why you get the first phase of the business cycle, which is the boom. In Austrians, Austrian economists see that as a problem.

6:40That's a mistake. Everybody else loves it. It's good times for everybody, but in our view, it's a mistake. Because ultimately you're going to get some secondary results. You can't invest more and save more, excuse me, you can't invest more and save less. You can't invest more and consume more. There's something not right about that. What are the secondary results? Well, ultimately entrepreneurs find that there's not, there's just not enough resources in the economy to complete all their projects. If entrepreneurs are investing more and there's more entrepreneurs on stage investing in and other projects, then ultimately there's not going to be enough resources available to complete all those projects.

7:29So entrepreneurs are going to have to bid up the prices of resources. They're going to have to bid up wage rates. They're going to have to bid up the price of raw materials. They're going to have to bid up the price of capital equipment in the economy. Therefore, the cost of production are going to be higher than expected. This is why we see, for example, oil prices rising steeply in certain phases leading up to the boom in the economy. A secondary result is that when all these projects are completed, the supply of their output is going to be greater than the expected demand. There's going to be overcapacity in various parts of the economy.

8:17And as a result of that, the expected prices, excuse me, the prices are going to be lower than expected. Revenues are going to be lower than expected. So for example, we often see this in the price of computer chips, where there'll be phases where all the computer chip companies are building new facilities, new machines, and they all come online at a certain point in time in the business cycle, and the price of those computer chips falls below what the expected price was. So the secondary results, that as we go through this boom in the economy, and then we get these secondary results, there's higher cost of production, more than entrepreneurs expected, and there's lower revenues from the sale of their production than they expected.

9:12The result, of course, is that companies sustain losses. And as a result, what we find is that there's a cluster of entrepreneurial errors in the economies. So in the recent business cycle that we went through, that we're going through in the United States, home construction companies, their input suppliers, banks, mortgage companies and so forth, all of a sudden, they went from a phase where they were all doing quite well to a phase where they were all going out of business, they all made errors in a systematic fashion. And in Austrian economics, we expect entrepreneurs to go bankrupt. In every industry, pretty much all the time, there's going to be new companies coming in and trying out their approach, and there's going to be companies that are failing.

10:05We see this in restaurants all the time. New people coming in and old people, you know, no longer making it in terms of profits. The unique thing about the business cycle is that all of a sudden you get this cluster of errors where most of the companies in particular industries go out of business. So that's the Austrian theory, which explains why we knew that this boom-bust cycle was was going on back in 2002, 2003, 2004 when everybody else was saying, everything's just fine. You can't lose money in real estate. Housing prices never go down. And Ben Bernanke saying that things in the mortgage lending business are better than ever.

10:52Now the solution, what's the solution? Well, let's take a look at what the other economists, The mainstream economists think the solution is to our problem. And it's a big problem. Europe's in trouble. India, the economy's shrinking. China, the economy's shrinking. Japan has been knocked off because of various problems, the earthquake and so forth. A lot of countries, there's a lot of political unrest. So it's a big, big problem. But as far as the mainstream economists go, So their biggest fear is deflation, that prices are falling everywhere in the economy, and they basically have a fear of this deflation, that the economy would somehow get into a black hole and be crushed by the gravity of the black hole and that we would sink and never be able to come out of that black hole.

11:51So therefore they say, stimulate the economy, pass a stimulus package, borrow money and and have the government spend it, keep interest rates down, increase the money supply and of course in the United States interest rates are already ridiculously low. The Fed is lending money to banks at 0.25%, a quarter of 1%. I got a mortgage, a 30-year mortgage for 3.25%, obviously they didn't check my credit rate, That's the mainstream, keep interest rates low, keep the money supply increasing, provide unemployment, insurance for everybody for however long period of time, bail out industries, bail out firms, bail out the banks, bail out construction, have public works projects to keep those guys going, deficit spending, it doesn't matter, they're talking about it today, cut taxes, increase spending, borrow the money, have the government borrow the money, galore. That's not the Austrian approach at all. In fact, it's quite opposite of that. For Austrians, deflation is not a black hole. We are not afraid of it. Deflation is actually not a black hole, it's a shock absorber for the

13:08economy. And so our solution has a lot to do with letting deflation do its work, letting the price system do its work, allow markets the freedom without any intervention to adjust their prices so resources can be reallocated to the way So let's take a look. I mean, the mainstream economists look at the price level. They look at CPI, they look at aggregate statistics. Austrians don't. We think that relative prices are much more important than the price level. So if we break down prices from an aggregate of the whole economy into capital goods, into labor, into consumption goods, What do we find happening during an economic crisis? What do we find happening during a downturn in the economy?

13:56So if we break that down into the three categories of types of goods, what we find is that capital goods in a crisis will fall dramatically. The price of land, the price of capital equipment, the price of stocks in the stock market, they'll all fall dramatically. During the Great Depression in the United States, stock prices fell by 95%. On the other hand, labor is less susceptible to dramatic falls in prices. So typically what we find in an economic crisis is that the price of labor will fall by 10% to 33%. It's not unemployment necessarily, it's the whole thing. Because there are plenty of people who are still employed in the United States who are earning a lot less money.

14:44In fact, a big chunk of the US workforce and the workforce around the world remains employed but earns less money. They have less patients. They have less clients. They have less sales. They have so on and so forth. So labor falls by less and consumption goods fall relatively little because consumers are are unlikely to adjust their patterns of buying for food, clothing and shelter very much. If you lose your job, you don't necessarily turn off your cable. You don't turn off your internet. You've got to find a job. You don't turn off your power. You don't stop eating. So consumption goods fall by the least amount.

15:30So what does that tell you? Anybody? Consumption is still high. Are there any entrepreneurs in the audience? Yes, that's exactly right. And the way you invest in consumption goods is you hire labor and capital to make those consumption goods. So as prices are falling, with capital and labor falling more than consumption goods, profit opportunities start to emerge. And so entrepreneurs get back into the business of Hiring Capital and Labor. So as we allow prices to fall, entrepreneurs come in and snatch up those resources to make profits by producing consumption goods. So the entrepreneurial reaction to deflation is to reallocate our resources to produce goods that consumers want.

16:20So Austrians don't want to keep prices high, we don't want bailouts, bankruptcy is fine, We want to balance the government budgets with wage cuts and budget cuts, we want to deregulate the economy as much as possible, we want freer trade, we particularly want to remove barriers in labor markets. So the Austrian solution is to allow the marketplace the room to allow prices to adjust, to reallocate resources away from what had been going on during the boom and reallocating back to where they should be. Thank you very much.