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I only drink coca-cola.

US economy and recession: theory and counter theory
Gerard Jackson
BrookesNews.Com
Monday 1 March 2004

Although the causes and course of the recession are still being hotly debated, with some focusing on monetary factors, the overwhelming number of commentators still haven't got it right ? including the Democrats, who couldn't care less anyway.

Regular readers know that I have continually stated that Austrian analysis easily explains what really happened. Armed with the Austrian approach one could only predict recession.

However, there is still considerable confusion regarding the role of money in causing the recession, with most commentators even denying that monetary expansion had anything to do with it. One reader sent me a lengthy e-mail in which he argued that Ralph Hawtrey?s monetary approach was superior to the "overinvestment analysis that the Austrians us".

From the references he used I presume he had drawn on Gottfried Haberler's Prosperity and Depression for his information. Fortunately I too have read Haberler.

Hawtrey explained booms and busts in pure monetary terms. An inflationary monetary policy (credit expansion) triggers the boom while depression is caused by a reduction in expenditure. This view led him to argue that stabilising the price level is all that is needed to eliminate the so-called trade cycle.

Therefore the central bank can tame recession by keeping general prices from either rising or falling by adjusting the money supply accordingly, which really meant implementing a 'cheap money' policy. But as Benjamin M. Anderson wrote in his Economics and the Public Welfare: "Cheap money plays no such dominating role as Keynes and Hawtrey and their followers would have us believe."

What Hawtrey's supporters do not realise is that his stabilisation policies will also trigger the so-called boom-bust cycle. His great error was in failing to understand that money is not neutral. This failure led him to declare: "The American experiment in stabilisation from 1922 to 1928 showed that an early treatment could check a tendency either to inflation or deflation . . . [and that] the American experiment was a great advance upon the practice of the nineteenth century."

And while Hawtrey was lauding the Fed's price stabilisation policy Hayek and Mises were warning that the very same policy would result in a severe depression.

Because the Austrians understand that money is not neutral they fully realise the microeconomic consequences of inflation. They are the only ones to explain that expanding the money supply affects individual prices in a way that distorts the pattern of production.

The effect is particularly pernicious when the monetary expansion consists largely of credit expansion, which is usually the case. Hawtrey's assumption, therefore, was that monetary expansion only affects the general price level while leaving the structure of prices unchanged.

Now Haberler greatly erred in presenting the Austrian explanation for the trade cycle as being an "overinvestment" theory. It was nothing of the kind, something that Haberler of all people should have known. As Mises pointed out in Human Action:

"It is customary to describe the boom as overinvestment. However, additional investment is only possible to the extent that there is an additional supply of capital goods available?. The boom itself does not result in a restriction but rather an increase in consumption, it does not procure [emphasis added] more capital goods for new investment. The essence of the credit-expansion boom is not overinvestment, but investment in the wrong lines, i.e., malinvestment on a scale for which the capital goods available do not suffice."

In other words, credit expansion causes relative overinvestment, meaning excess investment in some lines of production at the expense of other lines, most of which are at the lower stages of the production structure. The idea of general "overinvestment" struck the likes of Mises and Hayek as absurd ? and they were right.

The Austrians are the only school of economic thought to provide a satisfactory explanation of the trade cycle. The only one whose theory adequately explains why the boom starts in manufacturing and why manufacturing is the first to suffer the effects of an emerging recession.

Manufacturing, not consumption, retail sales or the stock market is the real leading indicator. To sum it up, Austrians would say that that though the recession had monetary roots it still consisted of real factors, something that a purely monetary explanation would ignore.

This reader also wondered whether money substitutes vitiated the Austrian theory. Not at all, is the answer. It ought to be noted that the rapid growth of money substitutes follows rapid credit expansion. Rather than causing the boom, they are one of its misbegotten products.

When the boom finally comes to an end many of the money substitutes will become virtually worthless, their claims having as much value as those issued during the South Sea Bubble by a "company for carrying on an undertaking of great advantage, but nobody to know what it is."

Gerard Jackson is Brookes' economics editor

Reverse pschology? Don't think so.

Just superior arguements.