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Dear Professor Becker:

I was pleasantly surprised to see you seriously entertain the notion that "depressions"—for younger readers, the term economists used to use for what we now call "recessions"—might serve a socially useful function. This is a crucial issue, as the government has already committed more than one trillion dollars, and assumed incredible powers, in an attempt to skirt the current slump. Virtually every financial commentator takes it for granted that boom periods are good while recessions are bad, and that government policies ought to foster booms while minimizing recessionary periods.

The Austrian School of economics rejects government intervention in economic events altogether. As we will explain below, the Austrians do not accept the standard view—held even by famous proponents of the free market, such as Milton Friedman—that the business cycle is a normal feature of capitalism. On the contrary, Ludwig von Mises and subsequent Austrians developed the theory that the business cycle is an unintended consequence of government intervention in the monetary and banking system. Specifically, the central bank (the Federal Reserve in the United States) pushes the interest rate down below its "natural" level by injecting new money into the banking system. This artificial stimulus sets in motion an unsustainable boom period of illusory prosperity.

During the subsequent (and inevitable) recession, resources are reallocated in light of the "malinvestments" made during the boom. Far from being "bad," the recession is part of the process of recovery, where entrepreneurs make the best of the untenable situation created during the boom. It is in this sense that Austrians say that recessions are a good thing. They are the recognition of the previous mistakes that entrepreneurs have made investing scarce resources, when they were misled by the distorted price signals reverberating from the Fed's interventions.

If the Austrians are right in their diagnosis of the boom-bust cycle, then the typical policy prescriptions offered by most economists are harmful. These "countercyclical" measures try to prevent the recession from unfolding, by stamping down on unemployment and propping up insolvent businesses. Yet these actions simply prolong the agony, and ensure that even more resources are squandered while the economy tries to adjust to a sustainable configuration. To adopt a biological metaphor: Of course nobody likes vomiting. But if someone has ingested poison, throwing it up is a good thing. Efforts by physicians to numb the person's gag reflex and settle his stomach will lead to disaster.

Becker Misunderstands the Austrian Claim

As the introductory remarks indicate, this is some important stuff. Imagine the tragic irony, if the traditional Keynesian "remedies" actually kick the economy when it's already down! Unfortunately, Professor Becker, the following excerpts from your blog post reveal that you've misunderstood the Austrian position:

Some older theories of business cycles—usually associated with the "Austrian" school of economics—claimed that recessions and depressions were useful in helping to remove the poison from an economy that builds up during good times. For example, weaker companies are the first to go when the demand for an industry's product falls during recessions. Employees who are allowed a lot of slack during good times are forced to work harder during recessions in order to keep their jobs. Positive effects such as these may be somewhat important during very mild downturns, but they are overwhelmed during major recessions and depressions by the negative effects…Economists have underplayed the cost to individuals of mild to severe recessions in part because they have neglected the cost of the "fear" generated by bad economic times….In the present crisis…consumers and workers have multiple fears due to various kinds of uncertainty. Homeowners fear that they may lose their homes after having used most of their savings as down payments on their homes. The employed fear that they will be laid off, while the unemployed fear that its duration will be quite long, and that they eventually will only get jobs that are much inferior to the ones they had. To be sure, some of the unemployed in many countries will receive unemployment compensation, but many unemployed American do not qualify for this benefit. Moreover, unemployed workers in this country usually receive much less than their earnings while employed, and after a while they run out of benefits, although benefits get extended during recessions… Surveys of reported happiness find that workers who become unemployed are less happy than they were, and persons whose incomes have fallen reported a decline in their happiness, at least initially. Divorce rates and even suicide rates also tend to rise during major recessions, as does crime, discrimination against minorities and immigrants, and pressure toward greater protectionism. Relative to these major costs, the alleged benefits of a recession to the United States seem quite small… So my bottom line in discussing the question whether depressions have a silver lining is that any such lining is very thin and small compared to the major costs to households, workers, and small businessmen. (emphasis added)

To repeat, Professor Becker, you have misunderstood the Austrian claim concerning the "benefits" of a recession. This alone doesn't make the Austrians right, of course, but my point is that you can't accurately assess their position if you don't understand it.

Contrary to the two examples you listed, the Austrians are not making some type of Darwinian argument about weeding out relatively weak firms, nor are they making an argument about incentives and scaring the lazy employees into working harder. Rather, the Austrians are saying that the "good times" preceding the recession are unsustainable. What your blog post has demonstrated is that it would be preferable if the good times could continue indefinitely. I agree, but that is not physically possible, as we'll see in the next section.

It seems your blog post is considering a recession as an optional episode: Do we want a recession or not? Well, on the plus side, a recession would cause those smart-aleck teenagers at the fast food joints to get in line. On the down side, we'd have a bunch of divorces and a few stockbrokers jumping out of windows. All in all, I vote for no recession.

But this weighing of the pros and cons is entirely moot; if the Austrians are right, then a recession is inevitable following an artificial boom fueled by injections of new money from the central bank. Further "stimulus" efforts can postpone the recession, to be sure, but that just means that when it does hit, it will be all the more severe. Using fiscal and monetary policy to stave off an impending downturn is the economic analog of giving another fix of heroin to an addict in order to avoid the painful period of withdrawal. Such treatment isn't doing the patient a favor, and only ensures that the adjustment back to a sustainable lifestyle will be all the more difficult.

The Importance of Capital Theory

Mainstream economists often have a hard time grasping the Austrian theory of the business cycle because it relies on a theory of the complex capital structure in a modern economy. Most mainstream economists, in contrast, usually think of the "capital stock" encapsulated by a single value, K. Relying on the framework of the Solow growth model, mainstream economists usually interpret the Austrian theory as one of "overinvestment" during the boom.

Yet this isn't accurate. In the world of the neoclassical models with capital stock K(t), if government policies caused a larger-than-optimal investment I(t), the only downside would be that the flow of consumption over time would be suboptimal in light of individuals' subjective preferences. C(t) would be lower than the optimal amount (because investment was nudged higher by the government's policies), but total output in period t+1 would be higher than it would have been in the optimal arrangement. There would never be a "recession," and in fact at some point consumption would be permanently higher than it would have been in the absence of the government distortion.

In the world of standard neoclassical models, which have a simplistic capital structure, people can be hurt by overinvestment only in the way that it would hurt a man if gangsters called him up and said, "However much you had planned on saving this year, you'd better triple it, or else we'll break your kneecaps." It's true, the man is subjectively worse off because of this new constraint on his financial decisions, but this situation is obviously not at all analogous to what happens during a boom-bust cycle in a market economy. If anything, it's the opposite: the gangsters' threat causes the man to consume less upfront, to experience an initial period of privation, in exchange for enjoying higher income in the future.

In order to even comprehend the Austrian claim, the mainstream economist needs to discard the simplistic homogeneous notion of the capital stock, and seek a richer framework that reflects the time structure of production. In a modern economy, if we picked a random consumer good off the store shelf, it would probably have a "life history" going back many years, and involving thousands of workers handling resources originating in dozens of countries. (Leonard Read's wonderful essay "I, Pencil" is apposite.)

Economists have come up with different ways to illustrate the Austrian conception of the structure of production. In his contribution to the Cambridge capital controversy, Paul Samuelson came up with a very clever example of an economy switching between different techniques of producing the same consumption good. Although Samuelson picked nice round numbers to ensure that every worker always had something to do, even during transition periods, if you skim his paper you will see that in general, workers can't be instantly shuffled from project A to project B. There will be a lag period, where the appropriate tools and semifinished goods necessary for project B are first assembled. (I sketch a very simple illustration of this concept for a hypothetical island of 100 workers in this article.)

If you are willing to devote 15 minutes to the inquiry, the single quickest way for you to absorb the Austrian view of the boom-bust cycle is to step through Roger Garrison's PowerPoint presentations. He specifically translated the Mises-Hayek theory into a neoclassical framework complete with a production-possibilities frontier and a diagram of the market for loanable funds.

Mises's Example of the Master Builder

The single best analogy for the Austrian business-cycle theory comes from Mises himself, and I will take some creative liberties with his original exposition for our purposes. Imagine a master builder. He has at his disposal the labor of many workers, as well as a collection of bricks, shingles, panes of glass, and so on. Mises then asks us to suppose that the subordinate in charge of counting the available supply of bricks inflates the number by 10 percent. Thus the master builder draws up the blueprint for the house, erroneously thinking he has more bricks to work with than he really does. Because of this error, he embarks on a building plan that is unsustainable; there are not enough bricks to finish the house as it is designed on the blueprint.

Now obviously, the sooner the builder learns of the mistake, the better. If he finds out immediately after the excavators have dug the hole for the foundation, the waste will consist merely of the extra labor and gasoline needed to use the earth movers to put back some of the dirt and make the hole smaller.

But suppose the builder doesn't find out until after he has already laid the foundation and erected the frame of the whole house. Now of course the waste is much worse. Given the materials at his disposal—and we assume that he can't go onto the market and buy more—the builder must now make some very tough choices. He probably will decide to leave the foundation as is, even though it is bigger than he would have designed it, had he known the true number of bricks from the beginning. He will have to redo the blueprints, naturally, and scale down the size of the house, though keeping the same size foundation. Some of the lumber already used might be salvageable, though some will have to be torn down and discarded. And of course, the finished house will be inferior in quality to the house the builder would have designed originally, had he known the true amount of his various supplies.

Now consider the scenario where the subordinates realize their mistake, but the master builder has not yet discovered it. They decide to deceive him as long as possible, by using tarps to cover up gaping holes in the stockpile of remaining bricks. "After all," they convince themselves, "look at how happy everyone on the site is, coming to work in the morning and building this fine house! Imagine how furious the master would be, if he learned that we don't have as many bricks as the blueprint calls for! Why, whole teams of the construction crew might be thrown out of work if that happened! He's got three guys alone working on the paneling for the third-floor balcony, but there might not even be a third floor in the revised plan. So let's just keep the good times going as long as possible, lest we end up with a bunch of guys standing around with nothing to do."

In Mises's story, it is clear that the builder's error is not overinvestment, but malinvestment, of resources. It isn't a question of how many bricks should be used on the house as a whole. Rather, the mistake is that the builder allocated too many bricks to the first floor. With each subsequent brick that his men put in place, following the original (and flawed) blueprint, the options for salvaging the project become narrower and narrower. In the worst-case scenario, the builder would only learn of the inflated brick count the moment he had laid the last brick—at this point, no subterfuge by his subordinates could deny the fact that they were physically out of bricks. And at that horrible point, the builder would have to survey the remaining materials littering the yard, hoping to be able to at least seal the unfinished house to keep the rain out. Whatever the outcome, the builder would have sorely preferred learning of the brick shortage much earlier.

Our Present Crisis

The relation to today's situation should be clear. During the housing boom, Americans racked up large debts to foreigners by consuming imported goods. At the time, this seemed prudent, because the increasing indebtedness was counterbalanced by rising US asset values in real estate and the stock market. Now that these bubbles have popped, Americans find themselves in the position of the master builder who has just seen the true supply of bricks after the wind blows the tarp away.

The rational response to this horrible realization is to cut consumption (what the press calls "spending"). This is analogous to the builder reducing his vision for the finished house he is building; the new information regarding the available bricks will cause him to redraw the blueprints for a much more modest dwelling.

Another necessary adjustment for the US economy is that particular businesses need to shut down completely and lay off their workers. This is analogous to the builder telling his men to stop working on the paneling for a deck that is not retained in the revised blueprint. Other projects too must be abandoned, because they cannot be sustained in the more modest design necessitated by the smaller brick count.

And as with the house analogy, so too with the actual US economy: efforts to avoid the agony of recession—policies that seek to prop up insolvent firms and maintain employment—will only ensure that more resources are squandered in unsustainable lines. It is impossible for the world to continue with the production and consumption patterns of the 2001–2006 period. If governments would get out of the way, individuals in the private sector could make the best of a bad situation. Government efforts to stymie this necessary readjustment simply ensure that the band-aid is pulled off verrrrry slowly.

Conclusion

In closing, Professor Becker, I once again express my appreciation that you entertained the little-credited notion that economic downturns might have a silver lining. But before you reject this Austrian view, I urge you to acquaint yourself with what the Austrians are really saying. One last thing, to give you an added incentive to take them seriously: there were several Austrians who accurately forecasted the current mess years before other economists had any idea of the trouble. See these articles (1, 2, and 3) for some very prescient examples, and see this incredible compilation of analysts mocking the warnings of Peter Schiff, who subscribes to the Austrian School of economics.