EKIP– Expert Club for Economics and Politics A Different Opinion
Author: Kristiyan Korelov
It had been more than a decade since one of the greatest stock market panics in the United States. Credit markets had completely stopped functioning (Gorton, 2008), and the situation was very similar to that of the panic of 1907, when banks were in massive need of liquidity and a large number of them were on the verge of bankruptcy. About a century later, in August 2007, the scenario facing most financial institutions in the United States was the same, and the financial crisis that emerged thus grew to the scale of a global economic recession, spreading its effects overseas and affecting all of Europe. There was no doubt among academic circles that the greatest financial and economic crisis of the last seventy years had occurred. A fact noted at that time by experts such as Eichengreen and KH O'Rourke (2009), and some such as Joseph E. Stiglitz (2008) go even further by declaring that it is more severe and more acute even than the Great Depression (1929 - 1933), with the specific arguments being the presence of more complex financial instruments - derivatives (also called "weapons of mass destruction" by Warren Buffett) and the extremely large scale of today's global financial markets.
It can be said with a great deal of conviction that there is unanimity regarding the seriousness and scale of the Global Economic Crisis of 2008-2009. There is hardly an economist who would deny that, together with the Great Depression, it tops the list of the most severe economic crises of the past century. However, there is no consensus on the generators that caused the economic collapse of the stock exchanges. The chaos among the capital markets also carried over as chaos into the understanding and interpretation of the origin of the crisis among academic circles. Economists from different schools are still in the process of a "fierce battle" taking place in magazines, journals, conferences, forums, round tables, etc. It is no coincidence that there is talk of a crisis of economic theory, because, in addition to finding it difficult to give an unambiguous answer to the causes of the crisis, it is also experiencing difficulties in proposing adequate measures to overcome it. This also had an impact on the duration of the recession and depression in many developed and developing economies. The recovery of the Bulgarian economy, for example, lasted a full six years, as reaching the pre-crisis level of GDP according to NSI data from the beginning of the recession in 2009 became possible only at the end of 2014 (Ganev, 2015).
Without much difference, most economists agree on the following conditions that led to the global financial crisis: expansionary monetary policy in the United States between 2002 and 2007; excess liquidity caused by low interest rates on loans; a construction boom and rising prices; a large number of risky loans that are securitized; misallocation of investment and savings worldwide; expansion of the financial sector without production or sale of real goods; low savings, and in the United States even negative.
A cornerstone for academic circles is the identification of the main generators that enabled the growth of such processes. Most economists gravitate around two main theses: the first circle of economists, such as Joseph E. Stiglitz (2008) and Acad. Ivan Angelov (2010), advocate the thesis that there is a lack of state regulations, excessive freedom in the markets and even blame the very nature of the market economy (here they are mainly representatives of the Keynesian direction in economics and the Marxist heterodox trend); the second circle of economists defends the opposite thesis, which is that it is precisely state intervention in the credit markets and the mistakes of regulatory authorities that lead to the generation of the mortgage bubble and the subsequent unprecedented economic collapse in the summer of 2007. The defenders of the second thesis can be identified as all economists of one of the heterodox economic schools – the Austrian School of Economics. Its contemporary representatives are: Israel Kirzner, Robert Higgs, Walter Block, Mark Skousen, David Gordon, Hans-Hermann Hoppe, Jesús Huerta de Soto, Mark Thornton, Peter Boettke, Peter G. Klein, Joseph T. Salerno, Steven Horwitz, Adrian O. Ravier, Robert P. Murphy, David Hannibal, Roger W. Garrison, Filipp Bagus, Jörg Guido Hülsmann, etc. It would be an omission if we did not mention the names of Bulgarian economists, such as Stefan Kolev, Nikolay Gerchev, Stefka Koeva, Krasimir Petrov, Pencho Penchev, Nikolay Nenovski, etc. However, most of them work on the problems of the Austrian School of Economics in foreign universities abroad.
The defenders of the Austrian School of Economics were among the few economists who accurately predicted the bursting of the mortgage bubble in the summer of 2007. For this reason, it is worth paying attention to the statements in which they present their analyses of the business cycle. The present paper aims to examine the Austrian theory of the business cycle and the critical remarks regarding the global economic crisis of 2008 made by the representatives of the heterodox Austrian School of Economics.
Exhibition
In 1871, the economist Carl Menger initiated a new school of economic theory by writing his magna opus, “ Principles of Economics.” The method he and his followers used was economic subjectivism. The center of his research was man and his economic activity. The economic categories that Menger used claimed to be suprahistorical; they were seen as eternal, logical laws of economic activity, locked in the psyche and consciousness of man. Thus, Menger created the Austrian School of Economics, to which other economists such as Eugen von Böhm-Baverick and Friedrich von Wieser also belonged. One of the main contributions of the representatives of the Austrian School of Economics at that time was that they were among the pioneers of the “marginalist revolution” in economic theory.
It is characteristic of the apologists of the Austrian School that there is no point in isolating microeconomics and macroeconomics into two “watertight” sections. On the contrary, economic problems should be studied together on the basis of interdependence, without distinguishing between their micro and macro components (Huerta de Soto, 1998). But another prominent economist of that time had a different opinion. It was after the Great Depression (1929 – 1933) that J. Keynes and his magnum opus appeared – “ The General Theory of Employment, Interest and Money”. A work that gave rise to the division in economic science into microeconomic and macroeconomic theory. The subsequently emerging Keynesian trend in the theory of economic analysis remained as mainstream economics in scientific circles for about four decades until the early 1970s.
It is precisely the non-recognition of macroeconomic analysis as a separate branch of economic science that gives the Austrian School a place among the heterodox currents in economics (Boettke, 2009). Remaining in the shadows among academic circles, its apologists, especially in the person of Ludwig von Mises and Friedrich von Hayek (second wave Austrians), did not cease to be so critical of mainstream economics, even between the 1930s and the 1970s. A period known as the “golden years” and characterized by rapid economic growth, almost without interruption, until the beginning of stagflation in 1972. A process that was unknown during those years among academic circles and difficult to explain by Keynesian economics.
The economic crisis of the early 1970s gave rise to a new understanding of monetary theory and the theory of the economic business cycle. Thus, there was renewed interest among academic circles in schools that could provide an answer to the inexplicable processes involving both high inflation and low employment (Meijer, 1995). A turning point for the supporters of the Austrian School of Economics was the moment in 1974 when its greatest defender at that time, namely Friedrich von Hayek, became the winner of the Nobel Prize in Economics, as a merit for his work on monetary theory and the theory of the economic business cycle.
Hayek's contribution consists in supplementing the works of his teacher Mises and systematically summarizing and deriving the theory of the economic cycle through the prism of the Austrian School. Or as it is known in the scientific literature - the " Austrian theory of the business cycle ".
Hayek's analysis begins with the market. For him, it is an institution of spontaneous social order. Free, spontaneously arising markets and free will to exchange are mutually bound and conditioned. As he himself states – “freedom is a situation in which individuals do not depend on the arbitrariness of others” (Hayek, 1948).
For Hayek, the role of information and knowledge is very important, since they are the main driving forces of market processes. He assumes that economic agents do not have perfect information when participating in market processes, which is why it can be argued that there is not always a correspondence between expectations and reality. When market participants find that they have made mistakes, they experiment in an attempt to adapt to the market and improve the conditions for themselves. This is done on the basis of improving the knowledge and information they have, but again through the market itself, as Hayek strongly emphasizes, and not through public regulatory bodies and other state institutions. Regulation should be done only through the market itself and on the market itself.
In this way, he further develops the theory of market equilibrium of Leon Walras, who assumes that it is static with perfect information of market participants. Hayek adds that equilibrium is a dynamic category, due to the condition of incomplete information and the need for adaptation of economic agents to the given situation. It is the dynamics of equilibrium that suggests that this is a process in which discrepancies between demand and supply are constantly created. This leads to the study of fluctuations in economic processes or the so-called "business cycles".
The Austrian School advocates gravitate towards the view that money is what causes imbalances between supply and demand and is the main generator of cyclical fluctuations. According to them, the alternation of economic booms and economic "busts" (depressions) can only be avoided through appropriate and timely control over the size of the money supply.
However, Hayek emphasizes more on the secondary effect of the monetary policy of the central authorities, namely the discrepancy between the structure of production and the propensities to save among society. Such a discrepancy necessarily leads to cyclical fluctuations in the economy. The allocation of resources between the production of capital and consumer goods in the economy is related to the saving habits that society has, and which determine the structure of production. Hayek explains the new type of stagflationary depression of 1972 precisely with a violation of the dynamic equilibrium in the structure of production.
Although each economic crisis has its own specific features and characteristics, for most Austrian economists the generators are always the same. The cyclical destabilization caused by the monetary policy of the central authorities at a later stage reflects a change in the structure of production, incompatible with the specific saving rate in society. Changes in the money supply by the Central Bank lead to a real impact on the market economy. In this way, money plays an important role in the emergence of the business cycle and periodically causes mismatches between demand and supply in the economy.
The development of the World Economic Crisis (2008-2009) is similar for the supporters of the Austrian School. In response to the economic crisis of 2000-2001 in the technology sector in the USA, the Federal Reserve responded with a highly expansionary monetary policy. The period between 2002 and 2007 was characterized by rapid economic growth and rising real estate prices. These features, according to Austrian economists, were caused by the extremely serious intervention of the US Central Bank, which reduced the key interest rate from 6.5% in 2001 to 1% in 2003. According to some studies (Taylor, 2007), it has been established not only that there is a serious correlation between the increase in construction in the USA and the movement of the key interest rate, but also that the main generator for this is the Federal Reserve as the regulator of the money supply.
The policy of “easy money” results in a deviation of the main interest rate from its natural market level. The more persistent this policy is, the more serious deviations it causes in the behavior of market entities. According to an analysis by Andre Ravier (2011), the Austrian, monetary and Keynesian schools simultaneously come to the same conclusion that the incentive monetary policy generates favorable conditions for the development of the economy in the short term. However, unlike the Keynesian school, the Austrians warn that in the long term, attempts by central authorities to achieve good economic results by changing the interest rate, which plays the role of the main source of information for market entities, inevitably lead to a financial collapse of the economic system.
The artificial change of the key interest rate by the Central Bank leads to systematic errors that entrepreneurs make in their assessments of investment projects with different risks and implementation periods. In addition, the incorrect information that the interest rate provides also results in a change in the consumer propensity to consume and to save. The interest rate causes market entities to act irrationally, since the information that it provides in practice leads to incorrect conclusions and decisions about saving or investing.
At first, the expansionary monetary policy results in overconsumption of consumer goods. This is caused by the artificially low interest rate, which discourages households from saving. At the same time, however, as a result of the low interest rate and cheap loans, banks willingly lower their criteria for financing various projects and/or purchasing real estate. In this way, prerequisites are created for increasing the production of capital goods and for the implementation of investment projects that would not seem economically justified and/or profitable at the natural interest rate. This entices many people who are not entrepreneurs to become such, which is reflected in an increase in the demand for capital goods and an increase in their prices. And all these actions are caused by a discrepancy with household savings, which are small precisely because of the artificially low interest rate initiated by the monetary policy being implemented.
A similar process could be observed in the US housing market over the past decade (specifically between 2001 and 2006). The policy of easy money and the irrational investments it generated ultimately lead to a distortion of the structure of production. Investments are made in productions that bring the greatest profits, which includes all real estate transactions.
In the short term, the Central Bank's expansive monetary policy undoubtedly produces the desired effects - rapid economic growth and economic revival. However, in the long term, things are different. The mismatches in the structure of production with the saving tendencies of society, resulting in overconsumption and overinvestment, lead to the generation of an economic "bubble", such as the housing market in the USA in 2007.
After the bubble burst, a recession begins, a decline in production is observed, which leads to an increase in unemployment. The reverse trends of a decline in consumption and investment appear, i.e. we are already talking about a shortage in demand for both consumer and capital goods. Savings increase, especially in highly liquid assets such as cash, gold and other precious stones. Construction companies stop their activities and many of them declare bankruptcy. The market clears out all unprofitable production through its most powerful tool - deflation.
A huge part of the private sector feels let down by the actions of regulators and state control bodies. The loss of confidence in one's own entrepreneurial powers leads to a "secondary deflation" (Mises, 1998, p. 548). On this occasion, entrepreneurs orient themselves towards saving in highly liquid assets and are even inclined to give up favorable investment opportunities in which they would have invested in another situation, before the economic crisis.
Conclusion
In conclusion, we can express the opinion that the generators of the emergence of the World Economic Crisis of 2008-2009 through the prism of the Austrian School are rooted in human and regulatory errors. Thus, the representatives of this heterodox trend in economics are trying to counter the ever-growing speculation that the financial crisis is the result of excessive freedom of markets and even of the very nature of the market economy. The initiative to conduct an expansive monetary policy in the long term belongs to the US Federal Reserve. This is a decision of a state institution, not a market institution. Adequate understanding of the genesis and generators of economic crises will also help to conduct the correct economic policy to mitigate the consequences of the recession.
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