Economics is not Science

Last week Garth over at America's Outback posted some criticism of Austrian economics. I've been wanting to respond to it, but I haven't made the time. Well, enough of that - do what you can.

I'll take the last question first, as I think it is illuminating:

Austrians, were is all the math to back up your views? You seem light on models. So far my reading has seemed more like philosophy than economics.

Yes, precisely. In the Austrian view, economic knowledge can only come from two places: reason and introspection. This is a radically different methodology (they call it praexology) than mainstream economics. On the face of it, it is crazy-talk. And I don't completely accept that one should do completely without data, models, and all the other physics envy. Still, when you think about it there is something to recommend it. People's tastes and desires are not open to our examination; indeed they are impossible to measure in any absolute way. We can get relative information about people's tastes (via revealed preference: "I'll trade you the orange for the apple."), but we can never get any absolute information. ("I like the orange three utils more than the apple.") It is hard to get honest information from people - only by watching them act with real money (goods, value in general) on the line, can we see what we think are honest actions. Furthermore, people are not always rational, either because of lack of information, because they are stupid, because we have built-in irrationality (that we can in theory characterize), or, in the worst case, just because we are ornery. Building any theory based on this slippery substrate is difficult at best.

I think that trying to test theory against reality is, even if extremely difficult, worth trying. But there always comes the problem of how to interpret what you find. History is problematic that way, because it only happens once. We can't rerun it, varying the conditions each time, the way we'd like to (from the scientific POV). Ultimately, I find it much more satisfying to look at things like money from the Austrian standpoint than to try to figure out what is going using econometric data. Malinvestment is a logical consequence of money creation. That much is true in all possible worlds (given certain assumptions). How large of an effect it has - that, theory tells us nothing about. It is not logically safe to identify any feature of the real world with the theory. In particular it is not sound to say that the predicted "business cycle" is in fact the business cycle that econometric data see. Still, that is my odds-on bet. But that's going to be an awfully hard thing to prove.

Proving causation in the real world in something as large as the macro economy is hopeless. That's why we need economic theory, and why praexology makes a certain kind of sense. So, to take one example, there's there issue of who to blame for the 90's tech bubble:

Where do I lay the blame? The private sector’s misallocation of capital as was clearly evidenced by massive investment in firms whose P/E ratios were infinite. Remember the “new paradigm” where old measures of value were discounted, cash flow was considered a meaningless concept, and the Dow was going to 36,000? Fed policy did not create any of this, a mania did.

Yes, but who created the mania? Perhaps central banking did; perhaps not. We can't tell. What we do know is that Greenspan et al were creating a boatload of money. Connecting the two we simply cannot do with any logical rigor.

As an Austrian, I look at it this way. A shady character was seen lighting a match in the vicinity of a building that later burned down. Was it arson, or just irrational flame exuberance? In the case of the economy, we know that the Fed was (and is) creating lots of money, which must cause malinvestment And we know there was a bubble. I choose to connect the two. It's not a hard connection to make, just hard to prove anything about.

But let's run with it, anyway.

The argument... is that economic recessions; the recent bubble in tech stocks; and all manner of horrors are the fault of the Federal Reserve making interest rates artificially low thus encouraging mal-investment. Presumably this all has to do with the failings of “fiat money” and the inefficiency of the public sector in comparison to the private sector in allocating capital.

The banking system is not exactly public, nor is it completely private. I would not place the blame for the malinvestment on that: it's not that there is necessarily a certain amount of bungling of investments. Rather, it is that there is too much investment. No matter who is running it, public or private, you simple cannot channel more money into capital goods than the market wants, without creating a lot of useless factories. That's what the theory says: the interest rate has a communicative function. It signals entrepreneurs as to the overall level of future demand. If you communicate massive future demand falsely, then you will induce a lot of people to borrow and build stuff that won't actually be fully utilized in the future.

Here’s what seems so weak about the Austrian theory of the business cycle: it assumes that businesses, entrepreneurs, financiers, and other investors take their cues solely from current Fed interest rate policy and without an ability to forecast a future realignment of those interest rates.

No. This reverses cause and effect. The interest rate does not cause people to borrow money. Rather, it is people borrowing money that creates the interest rate. It is a statistical construct; the reality is a million loans of various sizes, rates, etc. The Fed is shoveling money into banks (who loan it out, multiplied); it is the finding of enough borrowers that affect the interest rate. The point here is, people will be found. Yes, perhaps some or even many in the market anticipate higher interest rates. Perhaps everyone smart does. So what? The bankers will keep lowering the interest rate until they are fully loaned out. They do this because their license to print money is conditional: they only get free money as loans, not outright. If they have to find shady borrowers to take the money, they will. In fact the more "smart entrepreneurs" there are, that disbelieve the interest rate, the worse the resulting borrowers will be. That is the problem.

It is odd that the theory ... seems to assume that all long-run decisions are based on short-term, government interest rates when in fact (and I know this from a practitioner’s perspective) long-term investments are made based on the credit markets long-term interest rates.

It is not the short-term interest rate only that is forced down. This would be the case, if we imagine that the Fed would sometimes create money, sometimes destroy money. But they don't, at least in the longer run. They always expand the money supply. That's why the dollar is worth 1/4 of what it was in 1970. So bankers getting new funds coming in have no incentive to retain reserves against Fed deflation.

Furthermore, while Garth has experience with big borrowers, those are not the only borrowers in the market that fractional reserve lenders are trying to reach. There's also credit cards, home loans, car loans, small business loans, etc. These tend to be shorter term loans, in the case of credit cards, as little as a few weeks. So short term rate should apply to the extent that any do. Further, it's worth pointing out that consumers are notoriously less savvy as "entrepreneurs" than big business. Expecting everyone with a credit card to be a proto-Austrian who will discount the discount rate due to the Fed's evil influence is just silly. They're rationally ignorant. All they see is that if they refinance their house, they can take out $10000 in equity and buy a boat! Oooh!

The vast majority of credit in the economy is not created by the Fed, it is rationed by the private sector. Austrians argue that the banks are a collective cartel whose lending is artificially stimulated by Fed actions and desires. This completely ignores the tremendous amount of credit created by other actors in the economy such as General Motors which is not a bank, is not regulated, is not a part of the cartel yet which I believe (at least until recently) creates more credit than any bank in the system.

I would hope that the Fed has not yet crushed all private savings, and that is true. Private savers - including GM - certainly do play a part in the credit economy. But the point is, they should. That's the private market in action, is all. Nothing to see here. Sure, the Fed and the banks only create some fraction of the money. So what? They are still causing malinvestment. As such they must necessarily destroy wealth, causing business failure.

The thing to focus on is not credit creation, per se. Credit creation is a perfectly moral and rational behavior. Rather the problem is a particular species of fraud, fractional reserve banking, in conjuction with a particular species of immoral coercive action by the state, central banking. Fractional reserve with no moderating central bank was bad, not only because it would have bank runs, but because it was inflationary. Central banking would be wrong regardless of whether or not they allowed fractional reserve.

I will certainly agree that the combination of the two is more stable that the former system. However, solving a problem with a greater violation of liberty is, IMO, not the right solution. Rather, the whole business of fractional reserve should never have been allowed. Further, I don't think that creating a massive banking cartel somehow creates a crash-proof bank. What it does is to insure that the entire system fails in unison. It has not failed. Not yet. However, for a system to stand for 70 years is not proof of eternity.