It's not hard to understand why so many people drop economics after taking an introductory mainstream course in the subject. The theory and the practice just don't fit. It doesn't make any sense. They think it's their fault — that they're not clever enough to understand it. So they abandon it and take their talents elsewhere.

Had they taken an introductory course based on Austrian economics I daresay the outcome for most would have been different. What the Austrians say, in a nutshell is, cut intervention to a minimum and then just leave the thing alone.

Unfortunately, government intervention in free markets leads to unseen problems down the line which leads to more intervention, more unseen problems, more intervention and so on. Most of the difficulties and complications in economics arise from trying to explain just why intervention in free markets makes things worse.

What has become clear to me is that at the heart of Austrian economics lies the Austrian Business Cycle Theory (ABCT).

When I first came across it I encountered the same problem which many find with mainstream economics — reconciling the theory and the practice. In particular, Bryan Caplan gave me something to think about when he said that ABCT …

” … requires bizarre assumptions about entrepreneurial stupidity in order to work: in particular, it must assume that businesspeople blindly use current interest rates to make investment decisions."

I struggled here. A great deal of reading followed until I came across this article by Bob Murphy. Then I understood the problem. The reason I was having trouble was because I didn't really understand ABCT. I didn't understand ABCT because I didn't understand Austrian Capital Theory (ACT). This article saved me so much time — not just because of the article itself but in particular because of the references he provided. I read all of them and more. By the end of it the conundrum posed by Bryan Caplan and much else besides was resolved.

Investment decisions are made by people running real businesses in the real world, not academics. Because of government intervention no one knows what the "true" rate of interest should be. Even if a business knows that rates have been artificially lowered by government are they likely to do nothing as competitors grab this cheap money and put it to work on interest-sensitive investments? Hardly, they fear that they'll be running the risk of being put out of business — so they pile in too.

The point is made here in a quote I lifted from this gem of an article by Gottfried Haberler:

"May I be allowed to quote an example given by Mr. Keynes in a lecture before the Harris Foundation Institute last year. u2018No one believes that it will pay to electrify the railway system of Great Britain on the basis of borrowing at 5 percent. . . . At 3 1/2 percent it is impossible to dispute that it will be worthwhile. So it must be with endless other technical projects.'" (Emphasis added).

The real benefit of all this reading was to bring home the utter complexity of the production process and the time elements involved. Also, understanding the sheer folly of government intervention and the short-term benefits it yields.

In retrospect, the most useful reading for me was firstly, "Money and the Business Cycle" by Gottfried Haberler — this is where all the pieces came together. Secondly, this PowerPoint presentation by Roger Garrison — in a word — excellent! And thirdly, Murray Rothbard's "Economic Depressions: Their Cause and Cure" — this pulled everything together by putting the whole thing in a historical perspective.

The reading was hard work and took time but was necessary in order to understand what is going on right now. Governments are busy trying to re-inflate their economies. They appear to want to avoid deflation at all costs.

But we've been here before. The problems we are facing are not new. The solutions which are being tried are not new. That these solutions will not work is not new. So why on earth are governments doing something which they know will only make things worse later on?

The only sense to be made of it is that it has little to do with economics and everything to do with governments staying in power.

Deflation is visible and it's horrible — businesses fail, people lose their jobs, relationships come under pressure, marriages break, crime rates rise and so on — it also leads to governments being kicked out of office!

Inflation is different — it's not as easy to see or understand and the blame can be shifted away from governments:

"Define inflation as rising prices and … you'll think that oil sheiks, credit cards and private businesses are the culprits … Define inflation in the classic fashion as an increase in the supply of money and credit, with rising prices as a consequence, and you then have to ask the revealing question u2018Who increases the money supply?' " — Lawrence W. Reed

Here's a quote from Gordon Brown last week:

“If the monetary system is not working as well as it should; if there’s no likelihood of huge inflation in the next period of time; if you are not crowding-out private investment then government must play its role.”

The wrongness of what is being said here is now clear — in fact, it can be seen visually thanks to Roger Garrison's PowerPoint presentation. I'll leave it to others better qualified than I to explain what is wrong about this and other such statements. Just in the last few weeks alone this has been done by Frank Shostak, Thorsten Polleit, George Reisman, Ed Bugos and, almost inevitably, Bob Murphy, here and here. Of course, I must not forget Gary North — his writing is so even and so clear — his latest article here is a very good example of what I mean.

As long as writing of the above calibre continues the message will get across — carried by all the people who increasingly read it on the internet. Maybe the process has already started. In this reference, following the recent G-20 summit, there is one recommendation which could easily be missed. Under the section "Tasking of Ministers and Experts" there appears the following — it refers to governments …

"[m]itigating against pro-cyclicality in regulatory policy."

Pity they couldn't say it in plain English. But, if I understand it correctly, is this an admission by government officials that booms and slumps are in fact caused, or made worse, by government intervention?

January 24, 2009

The Best of Chris Clancy