The Austrian school of economic thought has returned to Europe after an American renaissance. French economist Pascal Salin represents a new generation of European "Austrians." They are trying to explain to an audience that is still generally hostile to economic freedom that capitalism didn’t cause the recent crisis in the world economy. Grégoire Canlorbe sat down with Professor Salin to discuss Austrian business cycle theory (ABCT) and how to promote economic thinking to a skeptical public. Salin is a professor emeritus at the Université Paris-Dauphine and a specialist in public finance and monetary economics. He is a former president of the Mont Pelerin Society (1994–1996).
Grégoire Canlorbe: How would you present the Austrian school of economics to the layman?
Pascal Salin: The purpose of economic science is to study how human societies work — that is to say, the way human beings behave and interact with each other. However, it is undeniable that thinking precedes action. Man is endowed with reason, which means that each and every action is actually a thinking process above all. This point is particularly highlighted by the great Austrian economist Ludwig von Mises, whose magnum opus is titled Human Action. Any economic science, any social science ignoring these facts of nature, faces the risk of giving an erroneous interpretation of the economic and social facts. The reasoning method of the Austrian school’s followers consists in starting from assumptions that can be objectively verified — the assumption of human rationality, for instance — and in deducing the consequences via a rigorous reasoning thread. It may be that we reach conclusions that are not verifiable empirically, but these are nevertheless acceptable. Indeed, only one part of human activity expresses itself in measureable phenomena: the value of exchanged goods once expressed in objective exchange ratios or prices, for instance. But as a thought process, human action is fundamentally subjective and thus cannot be measured or easily communicated to an external observer.
The methodology of the Austrian school is somehow the opposite view of the methodology belonging to the physical or natural sciences that has contaminated the vast majority of economists. This methodology — as particularly made systematic by Karl Popper — starts with nonverifiable assumptions but looks for realistic consequences that can be checked by experiences, measurements, and confrontations with measurable phenomena. It is this methodology that leads Keynesian economists, for instance, to build a sort of global mechanical system using macroeconomic variables conceived ex nihilo and most of the time without any coherence with regard to the general principles of human behavior. This is also the methodology adopted by the neoclassical economists — a strange phenomenon at this point. Their reasoning starts indeed with a study of individual behavior and individual preferences. But in the course of their reasoning, they omit the subjective foundation, and, probably by introducing ad hoc hypotheses, they focus on measurable magnitudes: prices, income, the money supply, etc.
In our opinion, only the Austrian methodology is coherent with human reality.
Grégoire Canlorbe: Are you a “hard-core” Austrian, or do you also have harmonizing lines with some authors outside of the Austrian movement?
Pascal Salin: I had never heard of the Austrian school during my studies. But when I read a small book of Friedrich Hayek, I immediately understood that it was the approach I was rather confusedly in need of. I then carried on with my readings of Hayek, Mises, Rothbard, and other “Austrians” without ever being disappointed. I think I can say I am a “hard-core Austrian,” but I believe that on specific topics it is possible to build bridges with other approaches, in particular with authors like Milton Friedman and Robert Mundell, but also with authors like James Buchanan and Gary Becker. As a result, Friedman’s critique of the Phillips curve, the relationship between unemployment and inflation, is prominent and compatible with the “Austrian” works. The monetary approach of the balance of payments developed by Mundell can also be considered an important contribution to economics and cannot be overlooked. And I could mention many other examples of important contributions made by economists who are not, formally speaking, followers of the Austrian school.
Grégoire Canlorbe: The Austrian business cycle theory, developed by Ludwig von Mises and F.A. Hayek, is supposed to explain the global crisis of 2008 as well as economic crises in general. The emphasis is laid on the determination of the rate of interest by the central bank, a phenomenon presented as the major cause of the 2008 crisis, the spark that ignited the powder keg. Most of the non-Austrian economists consider Fed policy between 1999 and 2004 to be a minor factor at most, one cause among many.
Why is it necessary to focus on the role played by the Fed’s monetary policy in the 2008 crisis?
Pascal Salin: It is absolutely striking to realize that what happened at the beginning of the 21st century matches exactly what the ABCT describes. Moreover, no other theory matches the course of events during this period. As a result, there is no real business cycle theory in Keynesian economics except for the arbitrary hypothesis that, for an unknown reason (the investors’ animal spirits), investments decrease all of a sudden. The equilibrating force between investments and savings is driven by the rate of interest, as rightly mentioned by the classical theory. But in order to arbitrarily eliminate this market process, Keynes uses ad hoc hypotheses that are completely unrealistic, such as inelasticity of investment toward the rate of interest and the liquidity trap. It would result in excess savings, therefore generating an insufficient consumption level in order to maintain aggregate demand. From this comes the Keynesian prescription consisting in pushing up aggregate demand via deficit spending, consumption, or exports. But this was not the situation during the last years, which did not prevent governments from adopting Keynesian measures — obviously completely unsuitable — in order to try and exit the crisis, bearing in mind that it is all too easy for governments to increase public spending!
The Austrian theory explains that the fall of the interest rate due to expansionist monetary policy encourages investors to make investments whose yields would be too low or whose risks would be too high to start under normal conditions. Those investments do not reflect the breakdown desired by individuals between savings and consumption, which introduces considerable distortions in the economy. This explains why people were overinvested in real estate with regard to what was sustainable in the long term. When the distortions became too great, the crisis broke out.
Of course, other factors played a role in the financial crisis, but no one factor could have existed or at least been generated without the considerable and irresponsible monetary and credit expansion policy led by the central banks, in particular in the USA, in Europe, and in Great Britain.
Grégoire Canlorbe: What is the specific contribution of the ABCT in terms of understanding the reasons for the 2008 crisis compared with the analysis provided by the monetarist or Keynesian orthodoxy? What are the shortfalls of the concurrent explanations, and how does the ABCT address such shortfalls?
Pascal Salin: The other approaches are global approaches, which focus on aggregates such as national income, total investment, the money supply, and the general price level. The great uniqueness of the Austrian theory is that it focuses on production, consumption, and price structures. As a result, it does not give any particular attention to the general price level, but focuses on the distortions in the price and interest rate structure and therefore on the distortions in the corresponding production structures caused by the instability in monetary policy. This theory is therefore much more realistic. It makes it possible to understand the evolution of the crisis as well as the reason why it is absolutely vain to believe that pushing up aggregate demand is enough to exit the crisis, whereas the real problem is to go back to production structures and price structures that correspond to the needs and wants of individuals. In addition, it is utterly wrong to believe that aggregate demand can be stimulated by increasing public spending, for instance, because such a policy only consists in shifting resources from private demand for consumption or investment to the public sector, which obviously does not use them as efficiently as the initial owners of the resources that have been transferred.
Grégoire Canlorbe: Paul Krugman criticizes the ABCT by claiming that total spending in the economy, including public spending, is necessarily equal to consumption plus investment. He believes that this equality implies that during the contraction phase — when investment goes down — we should have more consumption in order to offset the increase of unemployment. Is it a relevant criticism, in your opinion?
Pascal Salin: Krugman, as a devoted Keynesian, is incapable of thinking in anything other than aggregate terms. What he is interested in is aggregate demand, and from this point of view, the demand for investment goods and the demand for consumption goods are equivalent. He therefore ignores the fact that, from an Austrian perspective, the problem is of a structural nature. The expansionist monetary policy created distortions in the production and price structures, and it takes a while for the markets to effect the necessary adjustments — on the condition that they are left free to do so and that no new distortions are introduced via state interventionism, for instance, through a deficit spending policy followed by an austerity policy.
In fact, we could turn this argument around. Keynes imagines totally artificial and unrealistic assumptions in order to reach the hypothesis that consumption does not make up for the decrease in investment — hence his prescription of deficit spending.
Grégoire Canlorbe: Bryan Caplan, a former follower of the Austrian school, has criticized the Austrians for accepting that artificially stimulated investments necessarily end up in malinvestments. Addressing Murray Rothbard in particular, Caplan writes, "Why does Rothbard think businessmen are so incompetent at forecasting government policy? He credits them with entrepreneurial foresight about all market-generated conditions, but curiously finds them unable to forecast government policy, or even to avoid falling prey to simple accounting illusions generated by inflation and deflation… Particularly in interventionist economies, it would seem that natural selection would weed out businesspeople with such a gigantic blind spot."
What can you reply to Caplan?
Pascal Salin: In an ironic tone, I am inclined to reply that entrepreneurs and bankers made wrong forecasts because they were not schooled in Austrian economics! Austrian economists make the right assumption that individuals are rational, but that does not mean they are perfectly informed. It is a fact that the monetary authorities have spread the belief that low interest rates can be maintained endlessly. It is also a fact that some harmful theories, such as Keynesianism, have spread the idea, which has taken root in minds and hearts, that the economy could be stimulated by an expansionist monetary policy, and therefore by lowering interest rates.
In the political world we are living in, such a belief — permanently repeated by statesmen, whether left-wingers or right-wingers — eventually gained credibility. I can remember a conversation I had with a managing partner of a large French investment bank in the early 2000s. He told me it was great that there was such an abundance of liquidity so that he could finance anything. I replied that it could not last, but he completely disagreed with me.
Grégoire Canlorbe: Blogger Cyril Hédoin, on his website Rationalité Limitée (Limited Rationality), criticizes Austrian theory for crediting central banks with too much power. He says that interest rates are more influenced by private, commercial banks. He writes, “The ABCT casts the blame of business cycles on the shortfalls of governments and their monetary policy. Obviously, the present financial crisis is the result of market pitfalls from the banks that undervalued risks to the financial institutions that took unnecessary risks because they were encouraged to do so or because they were poorly informed.”
In your opinion, does Hédoin get it right?
Pascal Salin: It is obvious that the interest rates determined on the market are not identical to the rates set by central banks, but they are undeniably influenced by central banks. When a commercial bank knows it can endlessly get refinancing at a very low cost, it is encouraged to increase its loans because any additional loan is an opportunity for an additional profit. The only thing that could hold back the bank would be the correlative increase of risks. But this control system no longer works when the central bank acts as a lender of last resort, that is, the implicit guarantee by the central bank that it will save commercial banks from going bankrupt, whatever the risks they may have taken. This is what has been going on lately.
Grégoire Canlorbe: How do you explain that, beyond the circle of economists, so many people are convinced that the 2008 crisis is essentially the result of deficiencies inherent to the market, instead of the central bank’s monetary policy?
Pascal Salin: It is undeniable that most people — at least in France — believe that the crisis was provoked by market deficiencies. There are three reasons for this.
First of all, there is a large, anti-capitalistic mentality spread all over France, which leads to the hatred of capital and financial institutions in particular, the latter being erroneously considered the symbol of the former. Banking echoes in people’s minds as the power of money, the arrogance of the rich — although this does not deter the vast majority of people from applying for loans with their banks.
The second reason is to be found in the appalling misunderstanding of economic and monetary mechanisms, in particular in a country like France, where various studies have highlighted the fact that the knowledge level of economic phenomena was especially low. The banks’ difficulties and bankruptcies are a visible phenomenon, although monetary policy is poorly understood by most people. People cast the blame of the crisis based on what they see and not based on what they do not see.
The third reason stems from the fact that the public authorities play an important role in the formation of public opinion in a highly politicized society like ours. And obviously, said public authorities do their best to run away from their responsibilities and cast them on other parties. The media are keener to relay striking statements made by Nicolas Sarkozy — as well as statements by François Hollande — on the instability of capitalism than they are to quote an “Austrian” economist explaining the true causes of the crisis.
Grégoire Canlorbe: What strategy could popularize the ABCT and help the public better understand the causes of the 2008 crisis?
Pascal Salin: The best strategy is not obvious. It may be to seize any possible opportunity to get things right about economic analysis. And, of course, an organization such as Institut Coppet or the Foundation for Economic Education can and should contribute to this end.
On an optimistic note, one may think that the rigor of “Austrian” thought will finally be acknowledged and will prevail. Experience shows that those who are confronted with this line of thought, which they had never heard of in the French schools or in universities, get a big intellectual shock. Let us keep the faith!
Thibaut André translated this interview.