Last month the FT’s Martin Wolf asked a simple question, “Does Austrian economics understand financial crises better than other schools of thought?” After admitting that neo-classical models did “a poor job in predicting the crisis and in suggesting what should be done in response”, he points out that the following Austrian arguments have held up well: “inflation-targeting is inherently destabilising; that fractional reserve banking creates unmanageable credit booms; and that the resulting global ‘malinvestment’ explains the subsequent financial crash.”

Unfortunately Wolf goes on to make the error of confusing the causes of the crisis to the policy debate regarding the recovery: “Austrians also say – as their predecessors said in the 1930s – that the right response is to let everything rotten be liquidated, while continuing to balance the budget as the economy implodes. I find this unconvincing.”

Firstly, if you are looking towards Austrian business cycle theory to provide a complete theoretical explanation for (i) the artificial boom, (ii) the economic recession and (iii) the appropriate policy response to generate new growth, you may well be disappointed. But if it is unreasonable to expect one (relatively unknown) school of thought to unambiguously settle each of these issues, it is also unreasonable to reject the parts that do stand up to scrutiny purely because they don’t explain everything.

The Austrian insights are predominantly a theory of unsustainable credit-induced booms. Therefore they are not equally applicable to all “boom-bust” cycles, and originally didn’t even attempt to investigate the recovery process (Hayek labelled this part the “secondary deflation”, implying that something else – the malinvestment of capital goods – was the primary problem). The famous “Austrian” histories of the Great Depression were more concerned with the boom than the bust – Lionel Robbins’ The Great Depression was published in 1934, and Murray Rothbard’s America’s Great Depression stopped at 1932. I would suggest that Wolf stops viewing Austrian ideas as substitutes for all other explanations, and takes a more opportunistic view – Austrian ideas explain the boom, Keynesian and monetarist ideas are also required to explain the bust.

Secondly, Wolf misrepresents what Austrians do say about depressions. The “liquidate” thesis is false, since many Austrians acknowledge that avoiding a monetary contraction would prevent a deflationary spiral leading to depression. Because of the complexity of this policy, the argument tends to shift from monetary policy to monetary regimes, as Austrians do have a positive programme for banking reforms that would prevent future crises. The problem is that only Austrians confront head on the harsh economic reality that there is no such thing as a free lunch. Once malinvestments are made, they are costly to correct. This does not imply that politicians “do nothing” necessarily; just that efforts are concentrated around the ability of markets to function as they should.

Indeed, consider Paul Krugman’s response to Wolf’s question, “why isn’t there similar unemployment during the boom, as workers are transferred into investment goods production?” Well there is unemployment during the boom – according to a recent study, 2.65m private sector jobs are lost every year in the UK (but we don’t tend to notice because even more are being created). Focusing on the “aggregate” level of employment misses the relative adjustments that are being made, as people move between jobs due to changing economic conditions. Indeed Krugman also seems to be implying that the “boom” should correspond with “overinvestment”. Whilst this isn’t entirely incorrect, the Austrian argument is that it leads to “malinvesment” – subtleties that aggregate variables gloss over.

The problem is that neoclassical economists believe in a circular flow model that abstracts away from time. Austrians, by contrast, appreciate that capital investment occurs over time. As Roger Garrison says, “the specificity and durability of the long-term capital does not allow for a general timely reversal.” Or as Arnold Kling says, “booms are slow and crashes are sudden” (note that John Hicks made the same error in his criticism of the Austrians; it seems that Krugman is unaware of this and the secondary literature it has generated).

In short, whether Austrian ideas have something to add depends on whether you view the pre-crisis economy as fundamentally sound. As Garrison points out, there are two alternative views: “did the collapse occur (a) in the midst of a period of healthy growth because of sheer ineptness of the central bank or (b) near the end of a policy-induced boom that was unsustainable in any event and in the midst of confusion about just what the problem was and how best to deal with it?”

If you answer (a) you’re a monetarist, and there’s no surprise that Austrian ideas seem alien. But if you believe (b) then I would encourage you to learn more about the economic theory that explains economic crises so majestically.