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Economic theory as a guiding light for government action in this crisis

10 March 2009

Economic theory as a guiding light for government action in this crisis. But which theory? The dominant Keynesian economic theory, or that of the Austrian School?  (see the links at the end for background information about each).

Here is an excerpt from the Drobny Global Monitor of 5 March 2009, by Andres Drobny (see his bio at the end).   It not only provides a major expert’s perspective on our situation, but also illustrates the complexity and limitations of today’s economic theory – factors often lost in the politicized discussion about the appropriate public policy response to this recession (or depression).


One of the debates out there is whether the governments should keep ‘bailing out’ institutions to prevent a cascade of defaults. Or, just let them go bust, let the ‘haircuts’ fall where they fall, get it over with and then allow firms to restructure and start again. Avoid the Japanese mistake of prolonging the misery.

It is sometimes suggested that the former idea is somehow ‘Keynesian’. And, the latter is often described as ‘Austrian’.

Now, it is true that some Keynesians argue in favor of ‘bailouts’. And, Governments generally seem to be following both a bailout strategy and the more traditional Keynesian idea of fiscal stimulus during a slump. It is also true that some famous Austrians have been known to favor the default strategy.  Yet, this discussion misses the point. None of this is actually what the various theories suggest. There’s a profound difference between policy prescriptions associated with a theoretical perspective, and the underlying theories themselves.

And, looking back at the simple principles of Austrian and Keynesian theories provides some clarity of what we are currently living through, how the policy debates fit in, and what is evolving in financial markets. It also helps us assess the increasingly popular ‘bond bubble’ concept that has been circulating this year.

The Austrian theory was perhaps best elaborated by a guy named Knut Wicksell. His analysis of business cycles was premised on the relationship between the cost of money, the real rate of interest, and the rate of return on physical capital, the real rate of return.  A ‘Wicksellian equilibrium’ occurs when the real rate of interest equals the real return on capital. When the two are the same, the economy will likely be on a steady growth path. This is often referred more generally as a ‘steady state’.

The steady state is, of course, merely a benchmark. An ever-changing world fluctuates around this relationship. From this, a rough theory of business cycles emerges. And, a theory of slumps.  In particular, when the real rate of interest is below the real return on capital, then according to Austrian theory you can get a boom. There is an incentive to borrow, take on debt and invest in new capital. That, in turn, spurs more spending and investment.

Two factors should serve to dampen the boom.

  • First, the returns to capital should diminish as more and more physical capital is produced and put to work.
  • And, second, increased borrowing should place upward pressure on the real rate of interest. Both factors should combine to produce a narrowing in the spread between the real rate of interest and the real rate of return on capital, serving to dampen and eventually break the spending boom.

This simple idea is exceptionally powerful. It allows us to understand, for example, how a period of innovation raises the rate of return on capital and can produce a longer period of growth.

Or, how the process of inflation, which pulls down the real rate of interest (but not necessarily the productivity of capital), can also serve to prolong an upcycle. Of course, the inflation-based upcycle is inherently less healthy than a boom based on enhanced innovation. Innovation helps sustain a higher rate of profit; inflation doesn’t.

The theory also helps us see why the low real rate of interest that existed over the past 10-15yrs likely distorted the business cycle. And, why, we ran into excess debt and excess leverage.

But, let’s not go through the history of this sorry mess. Especially since most of the great Austrian theorists understood that, in the real world, the process would often be associated with excesses and nasty adjustments. It was a theory of business cycles, of booms and busts. Not one necessarily of smooth adjustment.

So, a cyclical downturn occurs when the real return on capital falls below the real rate of interest. In such a situation, there is little incentive to invest in productive capital. The economy slows, the demand for labor drops, and unemployment rises.  Now, in principle, this process should also be self-correcting. A drop in capital spending, combined with an aging and decaying of existing capital equipment, should raise the rate of return to new investment over time. And, reduced spending also means less borrowing, thus placing downward pressure on the real rate of interest.

Now, this is where things can get very interesting. And, dangerous. It’s where Keynes comes into the discussion.  What happens if goods price deflation emerges, thus limiting how far the real interest rate can fall? That’s when you can fall into Keynes’ liquidity trap. The authorities can’t get nominal interest rates down enough to spur more spending.

That’s a situation that calls for fiscal stimulus. Arguably, that’s what happened in 2001-03, when aggressive rate cuts seemed to fail to stimulate activity after the stock market crash. It was only after the 2nd and biggest of the Bush stimulus packages was passed, in Q2 2003, that the economy and financial markets turned around.

But, what’s worse is when a broader debt/default cycle emerges and generalized asset price deflation takes hold. This is when the ‘perceived’ rate of return on capital can plummet. One of the many innovations in Keynes’ General Theory was to talk about the return on physical capital as based on expectations of future demand, and hence the importance of confidence and ‘animal spirits’. Expectations of the future.

In this type of extreme environment both sides of the Austrian equation cause problems. You get a liquidity trap when the demand for cash becomes extreme and so monetary provision is simply soaked up by the private sector. The velocity of circulation of money collapses. Narrow money grows rapidly, but broad money growth stagnates.

And, at almost the same time you get a drop in animal spirits. There is a tendency to want to pay back debt rather than borrow to invest. The perceived rate of return of new investments collapses as the view of future demand deteriorates. In this case, even if there isn’t a liquidity trap, the real interest rate can’t fall far enough or fast enough to keep up with the drop in the expected rate of return on capital.

In such circumstances, monetary policy again becomes impotent. They can’t get rates low enough. But, its also one where fiscal stimulus alone may also not be successful, unless the financial system is also somehow re-lubricated. It’s a very tricky situation to remedy. It is arguably what happened during the Great Depression, and what may also be happening now.

Now all of these things – the policy prescriptions, the underlying analysis, and of course the characterization and description of Austrian theory presented here – are highly controversial. You know the old story of getting two economists together and producing three or four opinions!

But, what shouldn’t be so controversial is the implication for real interest rates in all this. They need to come down!

If the expected real return on capital is collapsing; if, as the pessimists argue, China is headed for real trouble due to excess capacity; or if as many of us fear, a cascade of defaults loom ahead, then the real rate of interest will be under downward pressure, not upward pressure. Almost regardless of supply conditions.

This analysis has several implications. First, it suggests that this ‘bond bubble’ idea; the bear case for Government bonds premised on the notion of excess supply seems to essentially rely on the idea that a recovery will emerge within some visible time period.

That the Obama fiscal boost will be successful. Or, that China will succeed in promoting domestic and global growth. Otherwise, the demand for cash and near cash will stay high. And, that means the demand for Government bonds.

For example, consider the argument for a bond bubble made by none other than the great guru, Warren Buffett, in his latest annual letter to shareholders. He argues that ‘holding government bonds … is almost certainly a terrible policy if continued for long‘ (emphasis mine). He goes on to suggest that the idea that those that ‘proclaim “cash is king” even though that wonderful cash is earning close to nothing will surely find its purchasing power eroded over time‘ (again, emphasis mine).

Oh wow. Of course the guru is right. Over time. And, under the assumption that price inflation will be positive. That is, he assumes a negative real interest rate!

And, as we are witnessing, in extreme conditions of debt default it can be real hard to real rates down. But, according to Austrian theory, down they must come, one way or another. Whether it takes direct Government intervention in bond markets or not.

… How does this theory fit in a more international context? What about countries like Iceland where real rates had to rise as the slump emerged? Doesn’t that contradict this story? How does the ‘Austrian’ theory apply in a more global context?

Well, it certainly makes things trickier, but here’s an imperfect stab at the issue. If the currency gives, then suddenly the Government interest rate becomes more of a credit, than a domestic cost of capital.  That’s why vulnerable currency countries, debtors like Iceland earlier (but not now that it is in slump, has a cheap currency and a C/A surplus!), and perhaps Hungary or South Africa today, may have to raise interest rates into a slump.

Another way to think about this in Austrian terms is that currency depreciation means the (currency adjusted) real rate of interest has already fallen pretty sharply. The recent big shift in currencies has kept inflation relatively high in weak currency countries.

Take a look at the recent numbers out of Australia, South Africa or even Sweden. So, some downward adjustment in the real interest rate has already taken place via extreme currency depreciation (what economists like to call the ‘ex ante’ real rate, based on expected rather than actual inflation). As an smart guy recently pointed out, it is not at all clear how the S Africans are going to get rates down as much as priced into the forwards given ongoing currency weakness.

This stab at internationalizing this simple version of the Austrian story suggests that a bear story for US bonds is more likely to be relevant in an environment of chronic US dollar (USD) weakness, rather than during a period of strength in the USD. A drop in the USD and/or signs of a recovery in economic activity seem much more likely to prompt an unwindof the ‘bondbubble’ than the problem of increased Government bond issuance.

Finally, if this is wrong, and real bond yields go up significantly despite the slump and without signs of recovery, then this will simply add to the downside to economic activity. You don’t need to be an Austrian to see that the last thing the economy needs is tighter financial conditions due to increased supply of Government bonds. That would serve to undermine the stimulus programme, and add to deflationary pressures.

Reposted with permission.   Copyright © 2009 DrobnyGlobalTrading, LP. No reproduction, transmission or distribution permitted without consent of the copyright holder.

About the author

Andres is DGA’s moderator, economist, strategist and all around smart guy. Andres is the thought leader of the DGA membership circle helping to keep the discussion intellectually honest, highly focused and profitable.

Before starting Drobny Global Advisors in 1999, Andres Drobny served as Chief Strategist and proprietary trader at Credit Suisse First Boston in London and NY from 1992-1998. While at CSFB, Andres was also on the Global FX Management Committee and a partner in the Leveraged Investment Fund. Prior to CSFB, Drobny was Chief Economist and Head of Research at Bankers Trust London. Before entering the financial markets, Andres was an academic economist at Cambridge and the University of London.

Andres Drobny holds a PhD in Economics from King’s College Cambridge, a Masters from London School of Economics and a Bachelors from Tufts University. When not in front of his Bloomberg, Andres can be found playing soccer or hanging out with friends at his compound in Venice Beach.

For another perspective on this

(1)  Wikipedia entries about Keynesian economics, the Austrian school of economics and Kurt Wicksell.

(2)  “Wasting Away in Hooverville“, Jonathan Chait, The New Republic, 18 March 2009 — A powerful rebuttal to the historical revisionism of Amity Shalaes about the Great Depression, which has become so popular among conservatives.

(3)  “From Central Bank to Central Planning?“, J. Bradford DeLong(Professor of Economics, Berkeley), September 2008 — I recommend reading it!  Excerpt:

According to the followers of Knut Wicksell, the central bank must keep the market rate of interest near the natural rate of interest. No, said the followers of John Maynard Keynes, it must offset swings in business animal spirits in order to stabilize aggregate demand. On the contrary, said the followers of Milton Friedman, it must keep the velocity-adjusted rate of growth of the money stock stable. In fact, if you do any one of these things, you have done them all, for they are three ways of describing what is at bottom the same task and the same reality.


Please share your comments by posting below.  Per the FM site’s Comment Policy, please make them brief (250 words max), civil, and relevant to this post.  Or email me at fabmaximus at hotmail dot com (note the spam-protected spelling).

For information about this site see the About page, at the top of the right-side menu bar.

For more information from the FM site

To read other articles about these things, see the FM reference page on the right side menu bar.  Of esp interest are:

Posts about the work of John Maynard Keynes:

  1. The greatness of John Maynard Keynes, our only guide in this crisis, 4 December 2008
  2. About the state of economic science, and advice from a famous economist, 8 December 2008
  3. Words of wisdom about the global recession, from the greatest economist of our era, 29 December 2008
  4. Some thoughts about the economy of mid-21st century America, 12 January 2009
  5. Economics is not a morality tale, 14 January 2009

Posts about Austrian economic theory:

  1. Geopolitical implications of the current economic downturn, 24 January 2008
  2. “A depression is for capitalism like a good, cold douche.”, 17 December 2008
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19 Comments leave one →
  1. 10 March 2009 1:13 am

    The bank bailouts seem anti-Keynesian to me, that is at least from my College Econ class idea of spending to increase the velocity of money. With bank bailouts we sell US bonds in exchange for cash which is then removed from the world economy. We take those dollars and bury them into bank balance sheets where they exist only to prop up lending that’s already taken place. I’d expect the bank bailouts to be amplify deflation.
    Fabius Maximus replies: Not even remotely correct. Velocity is determined by many factors. Asset prices and change in leverage (both lenders and borrowers) are among the major factors — which is why bank capital is critical. Getting them to lend both helps end the credit contraction (which is driving down prices) and directly increases velocity. Cash in circulation is a minor factor. In “Essays on the Great Depression” Bernanke notes that there was abundent liquidity during most of depression — but falling assest prices drove debt defaults.

  2. 10 March 2009 4:53 am

    It doesn’t matter whether banks are bailed out, nationalized and re-privatized; or just nationalized and kept running as State Bank of America Group for some time.

    I hope Government of India smartly continues to avoid stockpiling US Treasuries and Agencies, etc. That way, in a few years, we can leave the Chinese and Japanese holding the buck when the US Sovereign defaults. A Sovereign default is in the offing for the US Treasury, since the US dollar is no longr going to be only major reserve currency.
    Fabius Maximus replies: India runs both trade and a current account deficits, so it should not stockpile US Treasuries. In fact, their fx reserves have been falling since Summer 2008. For more on this see “The global crisis and Indian finance“, Business Line, 10 March 2009.

  3. Jack permalink
    10 March 2009 5:25 am

    Somehow the idea of Austrian vs. Keynesian as two opposing views for how to run a centrally planned economy doesn’t compute. I think somebody is missing some first principles, at least on the Austrian side.
    Fabius Maximus replies: Centrally planned economy? You must be kidding. The author is a major expert in Austrian economics, so I suspect the mistaken computation is on your side.

    The government has had a major role in the US economy since our first Secretary of the Treasury, Alexander Hamilton. Government has had a massive role in the US economy since the New Deal. In neither of these periods has the US been considered a “centrally planned” economy.

    This myth of the golden days without government interference was demolished by Charles Beard in his classic “The Myth of Rugged Individualism“, Harpers Monthly, December 1931.

  4. 10 March 2009 5:51 am

    FM:”Getting them to lend both helps end the credit contraction (which is driving down prices) and directly increases velocity.”

    Alright, but if banks are massively underwater, the first some-odd trillion to restore the balance sheet just fills the hole. New lending doesn’t occur until you get the balance sheet up in the positive range. (At least in the simple case.)

    FM:”Bernanke notes that there was abundent liquidity during most of depression — but falling assest prices drove debt defaults.”

    Yes, like now. Even if today banks can lend because we look the other way about the balance sheet, because the value of collateral is collapsing the good credit risks are rare. All the more reason why for now paying money into bank balance sheets will not speed up the velocity of money. We need the value of collateral of borrowers hits bottom (end of deflation), and borrower balance sheets restored first.

    Meanwhile we’re pulling capital from the world economy into our bonds at low interest rates while investors wait for the economy to bottom out. That wealth that was in other sovereigns and private investments is new being sucked into US bonds instead.
    Fabius Maximus replies: Still not quite right. I am not sure why you comment so often about things that appear outside your range of knowledge. That would be like me commenting about art or music (about which I know almost zip).
    * Yes, we need to rebuilt bank balance sheets (I suspect everyone is clear about that by now).
    * No, now we do not have abundent liquidity — as shown by a wide range of market metrics.
    * No, only crazy people want to passively wait for falling asset prices to wreck the economy before acting.
    * No, we are “pulling” decreasing amounts of money from the world economy into the US — as seen by our falling current account deficit and rising US dollar. The trade deficit might even go to zero if the recession is long and deep.

  5. 10 March 2009 6:46 am

    FM:” No, we are “pulling” decreasing amounts of money from the world economy into the US — as seen by our falling current account deficit and rising US dollar. The trade deficit might even go to zero if the recession is long and deep.

    I’m referring to this article here which describes pretty clearly how capital is coming to USA and being invested in bonds.

    PETER S. GOODMAN:”The pursuit of capital suddenly seems like a zero sum game. A dollar invested by foreign central banks and investors in American government bonds is a dollar that is not available to Eastern European countries desperately seeking to refinance debt. It is a dollar that cannot reach Africa, where many countries are struggling with the loss of aid and foreign investment.”

    The rising dollar is caused by that capital trying to come back to the USA to buy dollar bonds, not by a sudden demand for US corn, or something like this. Currency levels are affected by both the flow of capital and the trade deficit.

    “American investors are ditching foreign ventures and bringing their dollars home, entrusting them to the supposed bedrock safety of United States government bonds… These actions are lifting the value of the dollar…”

  6. Rune Kramer permalink
    10 March 2009 7:15 am

    “… a bear story for US bonds is more likely to be relevant in an environment of chronic US dollar (USD) weakness, rather than during a period of strength in the USD…”

    Could one interprete that view as a recommendation not to negotiate a lower dollar vis a vis China and other nations which peg their currencies to the dollar; given that it may increase the real rate of interest?
    Fabius Maximus replies: No. Economic policy cannot be steered by considering a single metric. Should a doctor treat you to raise or lower your temperature? It depends on the circumstances, of course. Similarly, the real rate of interest should match the current state of the economy. Lower is not always better. Both Keynesians and Austrians agree on that.

  7. mclaren permalink
    10 March 2009 11:48 am

    Drobny omits enough of Buffett’s wording to qualify as a deceptive misquote. It’s worth taking the time to read the full passage from which Drobny selectively (mis)quotes in its entirety:

    Clinging to cash equivalents or long-term government bonds at current yields is almost certainly a terrible policy if continued for long.

    The crucial phrase here being “at current yields”, a point which Drobny conveniently omits. {snip}

    FM note: Discussion of investments is not allowed on this site. They tend hijack the thread, which in this case is about economic theory as a guide to public policy. Mclaren is responding to something in the text (the Drobny Global Monitor discusses investments, after all), but off-topic nonetheless. Also, he misunderstands Drobny’s context. To professionals like Drobny “at current prices/yields” is understood — that’s all there is. When prices and yields change (in fact or prospectively) than one’s investments change.

  8. 10 March 2009 3:20 pm

    The real problem with bank bailouts is political. It appears as if the government is taking money from poor people, since the bonds used to get the money for the bailouts will have to be paid off with tax revenue, and giving it to rich people to make up for the rich people’s greed and stupidity. They used to call economics “political economy” for a reason. Beyond the economic arguments over how to stimulate the economy are political arguments over who gets to spend the stimulus money and on what will it be spent.
    Fabius Maximus replies: I agree. By continuing the Bush Administration’s policy of vast transfers of public funds to banks, the Obama team is
    (1) creating expectations of similar bailouts for everybody else (impossible to fulfill),
    (2) burning away their poltiical capital while accomplishing nothing, and
    (3) arousing public anger, as people understand that this is just theft.

    For more on this see these posts about theft pretending to be solutions:

    * Slowly a few voices are raised about the pending theft of taxpayer money, 21 September 2008
    * The Paulson Plan will buy assets cheap, just as all good cons offer easy money to the marks, 30 September 2008
    * A reminder – the TARP program is just theft, 24 November 2008
    * A solution to our financial problems: steal wealth from other nations, 2 February 2009
    * Stand by for action – more theft of our money being planned in Washington, 4 February 2009
    * Update: yes, the Paulson Plan was just theft, 14 February 2009

  9. seneca permalink
    10 March 2009 4:08 pm

    In economics, we are all outside our range of knowledge (ref to FM comment on #4 above). Fortunately. Drobny’s explication of Austrian theory is clear for a few paragraphs and then becomes simply a muddle of contingency piled on contingency. I think CM may be right whether she’s within her range of knowledge or not. Further, FM’s remark:

    “Getting them to lend . . . helps end the credit contraction” is both redundant and only half the picture. The other half is demand. Easing credit for someone who’s lost a job isn’t going to make him buy a new car. The only way to restore demand is to restore employment.
    Fabius Maximus replies: That is a common sentiment about complex subjects, in effect “I don’t understand it so nobody understands it.” It’s not true of physics, and not true of the far less mature field of economics. Perhaps you just don’t understand what he’s saying.

    Your second paragraph is false on several levels.

    * There are many businesses willing to borrow but unable to find lenders. This has a severe contractionary effect. Much of Fed policy during the past 6 months has been directed at this problem. Ineffectually, IMO, but they’re trying.

    * Focusing on the tiny fraction of the US economy represented by the unemployment may be rhetorically satistfying, but is economically bogus.

    * You’ve confusing a part with the whole. I said “helps end”, not “does end”. Ending the credit contraction is one step towards the larger goal of restroing aggregate demand. Every incremental step towards doing so can be mocked by saying it does not by itself fix the situation.

  10. Duncan Kinder permalink
    10 March 2009 4:36 pm

    If we didn’t need capital, then it wouldn’t matter whether banks were bailed out or not. Which begs the question of why do we need capital. To the extent that people – say – use open source software, enjoy tenancy in common of their means of production, and – yes – inhabit yurts, then their capital needs would be fairly small.
    Fabius Maximus replies: No doubt, we could lead the lives of happy poverty like those in the third world! After all, the past 4 centuries of western civilization built on this economic system have contributed nothing of value compared to that of simple sustenence level societies.

  11. Erasmus permalink
    10 March 2009 5:14 pm

    “The only way to restore demand is to restore employment.” That does seem to be a key aspect if not the bottom line.

    But I think part of the reason we are in the midst of a Big Muddle right now is that money itself has become increasingly the driving factor in most economic endeavours, be they ‘goods’ or ‘services’ and in the process our Great Progress seems to have been ‘growing’ populations with increasingly lower productive skills – shades of Charlie C tightening bolts in the factory? – be they of the manual or intellectual ilk.

    For example, few of us moderns can grow their own food (let alone cook it well!), make their clothes, build shelter, provide protection etc. etc. (Collectively we do make great bombs, however!)

    So in terms of getting back to work/productivity, this begs the question: ‘doing what?’ Clearly we are not going back to a bucolic DIY Luddite past, but unless a new wave of technology or other innovation sweeps through, it would appear that there is increasingly less and less for people to contribute work-wise, especially since the Chinese are more than capable of making just about anything we need for less than a dollar!

    I believe this decrease in ordinary ‘real-world’ productivity is part of what has been driving the over-emphasis on finance just as the latter has been driving the former. It’s a vicious circle and one seemingly not addressed by most politico-economic analysis.

  12. Erasmus permalink
    10 March 2009 5:21 pm

    Duncan, I’m sorry but I just can’t buy all this yurt business. I carefully examined their site – and plan now to buy several and maybe plant some in Detroit for rental income – but I think you are taking FM’s bulldozing suggestion a tad too far.

    I know we have learned since 9/11 that life goes on after certain Very Large Structures have been reduced to rubble, but really: imagine following your suggestion to bulldoze our Capital cities and replacing them all with yurts.

    I really don’t think you should be contributing to issues about which clearly you have so little understanding! That said, it would provide employment so maybe not such a bad idea after all….

  13. mal permalink
    10 March 2009 5:27 pm

    Have you read this article? Fed’s Hoenig: “Too Big Has Failed

  14. seneca permalink
    10 March 2009 6:24 pm

    Thanks to FM for carefully rebutting my comment above, rather than just calling it uninformed. But truly, if any science deserves to be called religion (which FM frequently does about climate science) it is economics. The value of Drobny’s explanation of Austrian economics is that it’s clear and complex, but that does not mean it can be simply applied to the real world. Same for Keynesian theory. Theories are maps or guidelines, useful for selling policy, or pointing it in a direction, but not for predicting what will happen.

    I disagree with FM’s characterization: “tiny fraction of the US economy represented by the unemployment (figures?)”. 15% (the real, not official, rate) is not a tiny fraction. And it’s certainly heading for 20% +. If nothing else, this is a social/political problem that must be addressed.

    Finally, doesn’t the approach of “easing credit” sound a bit like the way we got here?

    Erasmus @ #12 raises the important question — what do we want our economy to produce when we do get it going again?
    Fabius Maximus replies: I love it when people make up stuff about what I say. It’s usually much more entertaining than my actual text. And it provides exercise to my self-control to avoid telling me what I think of them for writing such slander.

    “But truly, if any science deserves to be called religion (which FM frequently does about climate science)”

    As I have said dozens of time on this site, the writing by laypeople about climate science displays belief patterns like those of religious thought. The contempt for science is displayed on this site by the pro-global warming comments (see some examples here).

    “15% (the real, not official, rate) is not a tiny fraction.”

    I think he is refering to the U-6 number, the broadest measure of unemployment: “Total unemployed, plus all marginally attached workers, plus total employed part time or economic reasons, as a percent of the civilian labor force plus all marginally attached workers.” We don’t have a long history for that data series, so cannot compare it with the high unemployment 1970′s — let alone the 1930′s. So the meaning of this is difficult to assess. My point remains, however. The core economic activity lies in businesses and the vast majority with income.

    “Finally, doesn’t the approach of “easing credit” sound a bit like the way we got here?”

    If you have a fever, do you demand that the doctor reduce your temperature to zero? Heat is bad! Has nobody heard of the golden mean?

  15. sjilcott permalink
    10 March 2009 7:25 pm

    Fab Max says: “There are many businesses willing to borrow but unable to find lenders. This has a severe contractionary effect. Much of Fed policy during the past 6 months has been directed at this problem. Ineffectually, IMO, but they’re trying.”

    An Austrian would say that the past oversupply of easy credit has resulted in mal-investment (e.g., houses). All this capital has been tied up in uses that are unproductive, and that’s why business that are willing to borrow (and would actually be profitable) now can’t find lenders. The bad investments are getting negative returns, and voila, our capital is gone.

    Even though I’ve read Keynes, I could never understand how capital could be “created” by government fiat – capital is due to savings, innovation, and productivity.

  16. Duncan Kinder permalink
    10 March 2009 7:29 pm

    Duncan, I’m sorry but I just can’t buy all this yurt business

    Perhaps it would be more realistic to barter for it. But if you would prefer wigwams, that would be ok.

  17. 10 March 2009 7:52 pm

    Drobny:”This stab at internationalizing this simple version of the Austrian story suggests that a bear story for US bonds is more likely to be relevant in an environment of chronic US dollar (USD) weakness, rather than during a period of strength in the USD. A drop in the USD and/or signs of a recovery in economic activity seem much more likely to prompt an unwindof the ‘bondbubble’ than the problem of increased Government bond issuance.”

    I’m trying to parse this also. I think by the ‘bond bubble’ what he’s talking about is the worldwide movement of capital to US government bonds, which goes hand in hand with US government stimulus and other spending. Here he’s stating his opinion that increased deficit aren’t going to cause the collapse of US bonds (rise in interest rates). Maybe he’s right. It’s possible all the bonds the USA is selling won’t cause interest rates to rise — that’s the case so far. With luck we hit a recovery first before this happens.

    The sentence about a drop in the USD or a recovery just is outlining the other kinds of events that would cause interest rates to rise.

    Drobny:”Finally, if this is wrong, and real bond yields go up significantly despite the slump and without signs of recovery, then this will simply add to the downside to economic activity. You don’t need to be an Austrian to see that the last thing the economy needs is tighter financial conditions due to increased supply of Government bonds. That would serve to undermine the stimulus programme, and add to deflationary pressures.”

    And now here he’s stating the opposite case. He’s not sure, and he admits it, which adds to his credibility. I like this guy. That if the sales of all these US bonds end up raising interest rates, what happens is the return on bond investments will rise above the return on capital from private investments and so the stimulus crowds out real investment.

  18. 10 March 2009 9:13 pm

    What is the problem for a sapling competing for resources in an old growth forest? The main problem is mature trees are blocking the sunlight from reaching the forest floor. Another problem is mature trees roots grow deep, and brief drought is no problem for them, but devastating to puny saplings. Eventually, there are few saplings, just dead wood is found on the floor of the forest. What this invites is of course a wild fire.
    The wild fire fixes most of the sapling’s problems, even sewing the seeds for new saplings by bursting pine cones. If you replace investment capital for sunshine, and companies like GM and GE for the old growth trees, and innovators with new products and business models for saplings, I think you have a better starting point for theoretical analysis. Economies are very much like eco-systems. They crash when diversity is lost. One way to lose diversity is for the old institutions to crowd out the young innovative ones. This is how a “Depression”/”Wild fire” is different from a recession/drought.


  1. An important and politically significant guide to the Great Depression « Fabius Maximus

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