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Wednesday, August 11, 2010

Cause, Effect, and the Current Depression

Sorting it out.

Every semester I assign the first chapter of Carl Menger’s Principles of Economics to my MBA economics students, and I make sure they understand the very first paragraph:

All things are subject to the law of cause and effect. This great principle knows no exception, and we would search in vain in the realm of experience for an example to the contrary. Human progress has no tendency to cast it in doubt, but rather the effect of confirming it and of always further widening knowledge of the scope of its validity. Its continued and growing recognition is therefore closely linked to human progress.

This is not trivial stuff, even though I suspect people are quick to say something like, “Well, yeah, I guess we have cause and effect.” The reason is, all too often people confuse cause and effect, claiming the effect really is the cause.

For example, a fever is not the cause of an illness; instead, it is the effect of an infection, which the body attempts to fight through heat. Thus treating a fever, though it will grant temporary relief, does not stop the illness.

Unfortunately, in the discussion of economics, and especially regarding the current depression, it is common for people – including trained academic and business economists – to confuse cause and effect. As one who reads a lot of commentary, I would say that the most frequently cited “cause” of the recession is “lack of spending” by individuals and businesses.

This explanation, I admit, sounds perfectly natural, and I believed it myself when I was a budding newspaper reporter more than 30 years ago. People stop spending and the economy goes into the tank, so government must take up the slack. That has been the mainstay of what economist Robert Higgs calls “vulgar Keynesianism,” and it dominates the columns of Paul Krugman and the editorial pages of the nation’s most elite newspapers.

However, there seems to be a problem. The federal government has spent at unprecedented rates these past few years and run gargantuan deficits, yet it is clear  the economy is stuck. Some, like Krugman, believe government spending was not high enough, which made the alleged recovery stall.

But what if the Keynesian cause-and-effect patterns are wrong? Do recessions occur because people are spending less, or are people spending less because the economy is in recession? This is not a frivolous point. If recessions occur, as Austrian economists believe, because the previous boom created a number of unsustainable malinvestments that must be liquidated before a recovery can begin, then government tricks to try to get people to spend more money simply won’t improve the economy.

I will go one step further: If the Austrian approach is correct, the “stimulus” so heralded by economists and others actually would have a negative effect on the economy precisely because such a “stimulus” would exacerbate the present malinvestments that caused the problems in the first place. Trying to prop up the economy by showering it with new money actually makes things worse.

All things, including economies, are subject to the law of cause and effect. However, to properly interpret this law we have to understand what is a cause and what is an effect. Unfortunately, too many academic economists cannot tell one from the other, and what naturally follows are bad policies that prevent a real recovery.

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