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I recently attacked the Keynesian view of economic depressions and its recommendations for recovery.  Unfortunately, despite its obvious crude implications and its tendency to view an economy as a single “blob,” the Keynesian theory rules both academe and the investment markets.

The Austrian school of economics, however, has long pushed an alternative theory, developed by Ludwig von Mises and F. A. Hayek.  Unlike the Keynesian view (what economist Robert Higgs calls “vulgar Keynesianism”), the Austrian theory actually looks at the economic fundamentals and their relationships to one another.

Austrian business-cycle theory states that when government monetary authorities follow an aggressive expansionary policy, the artificially lower interest rates entice entrepreneurs and business owners to expand lines of production.  The new money flows into the economy and sets off a boom, especially in those businesses most positively affected by lower interest rates.

However, the boom is unsustainable, a fact that only the Austrians point out.  (Keynesians believe that a boom must be sustained at all costs, which means that government spending must replace private spending in order to “fill the hole,” as Paul Krugman calls it.)  After declaring the Austrian theory to be “as worthy of serious study as the phlogiston theory of fire,” Krugman declares:

Recessions are not necessary consequences of booms. They can and should be fought, not with austerity but with liberality—with policies that encourage people to spend more, not less.

The question, of course, is simple: Spend more with what?  The answer that Krugman and other “vulgar Keynesians” give is that government either should borrow in large amounts, print more money, or both.  Governments then should spend on special projects or give the money to state and local governments and let them spend on whatever they wish – as long as they spend, spend, spend.  Thus, we have the “intellectual underpinnings” of the current “stimulus.”

Unfortunately for the Keynesians, there is a problem in the analysis; the booms launched via government’s “expansionary” policies cannot be sustained. It is not a government choice but rather a simple reality.

The reason booms must run aground is because the spending habits of consumers will not sustain the investment activity that has created the boom in the first place.  For example, in the “dot-com boom” of the late 1990s, hundreds of billions of dollars poured into the newly begun Internet-based companies that supposedly were going to revolutionize how people purchased goods. Firms like WebVan, Pets.com, and E-Toys made a huge splash when they first appeared, but it soon was apparent that consumers did not prefer to use these firms as their founders and investors had anticipated, and most dot-coms went bankrupt.  The stock market bubble that accompanied this boom also popped, as stock prices were well out of kilter with the actual performances of these firms.  In other words, fundamentals mattered.

Likewise, the recent housing boom went bust because the huge increase in housing prices could not be sustained relative to incomes.  (As Peter Schiff has pointed out, the typical house payments at the height of the boom were substantially higher than rents, which meant the housing fundamentals were out of balance.)

Simple supply-and-demand (something “vulgar Keynesians” usually ignore) could not permit these booms to continue since there was nothing to support the accompanying inflated asset values.  Vast increases in government spending would not be directed (nor could they be directed) toward the specific areas where asset prices have collapsed.

The economic damage can be repaired only by the liquidation of the malinvestments so that the economic fundamentals again can be put into balance.  Government “stimulus” programs not only ignore this fact, but actually keep that realignment from occurring.  Thus the “stimulus” only prolongs the downturn and ensures that a future day of reckoning only will be worse.  We cannot understand the boom and bust cycle unless we understand the role of malinvestment, and only the Austrians demonstrate that understanding.

William Anderson
William Anderson

Dr. William Anderson is Professor of Economics at Frostburg State University. He holds a Ph.D in Ecconomics from, Auburn University, Economics. He is a member of the FEE Faculty Network.