Introduction to the Austrian School of Economics - Part Two

Chapter I, Part 2*

You can read the first part HERE

Life is a series of ups and downs.

In economic theory, there are similar analogous reversals - the constant alternation of a strong economic boom and an almost equally long economic decline.

There are different opinions, theoretical and practical explanations for the emergence of business cycles. According to “mainstream” economists, for example, the leading factor is aggregate demand, and a change in any of its components (consumption + investment + government spending) has a strong effect on production and employment. [3] They say that fear and greed are dominant factors in financial markets. This is also the position of Keynes, who emphasizes that the so-called “animal spirits” drive investor confidence and consumer activity. Drawing a scenario in which a sudden refusal to consume is taken as the starting point of Keynesian reasoning, the need for government intervention is expected to become the endpoint and the easiest solution for the economy to exit a period of recession.

On the other hand, the representatives of the Austrian School of Economics have a clear and consistent analysis in which they explain the essence of the business cycle. For them, the leading factor and cause of its occurrence is precisely the intervention of the state, in particular the central bank, in its capacity as a monopolist over the money supply. When the central bank artificially reduces the interest rate, market signals are confused, leading to distortion of the production structure and economic processes. This is because the interest rate is not a random variable that can be fixed, calculated or modeled by a few great minds. It is a reflection of time preferences; an important indicator for business, signaling when there are enough savings in the banking system and when it is profitable for entrepreneurs to take out a loan to invest in the production process for future production. Low interest rates on deposits, for example, are a sign that there are enough funds in the banking system, i.e. currently consumers are saving more than they consume. If an entrepreneur wants to get a loan to invest in future production, he wants to make sure that consumers have enough savings to buy and consume future production. [4] The problem is that interest rate cuts do not always happen naturally. When the central bank increases the money supply and creates the conditions for credit expansion, the economic picture changes radically. Artificially lowering interest rates creates the illusion that there is more capital available for investment than there actually is. In other words, consumers do not actually save, but consume, and for investors, the bad signal turns out to be a bad investment. Initially, the lack of good coordination between production and consumption plans leads to an economic boom, but it soon turns into a severe but cathartic crisis. The greater the accumulated imbalances, the more severe the economic downturn will be and the longer the recovery will take. Economic recovery is a long-term process that requires cleaning up the system of misinvestments, adapting the production structure to consumer desires, and accumulating more savings and fresh capital resources to compensate for losses. Unfortunately, however, Austrian economic thought is often ignored and everything continues the way it started – with ever-increasing state intervention.

Inflation and deflation – two different monetary phenomena

It is generally understood that inflation is an increase in the price level. However, this definition is quite controversial, as it confuses the essence with the consequence of the problem. Its incorrect understanding brings with it many misinterpretations.

Mainstream economists do not focus so much on the nature of inflation, but on the danger posed by the reverse process, widely known as a decrease in the general price level. Classical economists consider deflation to be a dangerous monetary phenomenon, assuming that falling prices create an incentive to postpone consumption in anticipation of even lower prices in the near future. For them, the danger of a decline in aggregate demand, which could become the cause of many subsequent bankruptcies and episodes of recession, comes to the fore. To avoid such a scenario, supporters of this idea believe that the central bank should implement an active monetary policy and maintain a “moderate” rate of inflation. Unlike mainstream economists, representatives of the Austrian School of Economics do not consider deflation to be necessarily evil if it is the result of an increase in productivity in an economy. The postponement of consumption by economic agents for a longer period of time is an important condition for the accumulation of savings necessary to finance investment activity and the production of goods and services. Another issue is that consumers cannot stop all their purchases (for example, for food products) in order to benefit from lower price levels in the short term.

“Austrian” economists present inflation as an increase in the money supply, or the amount of money in an economy. The increase in prices is only a side effect of the monetary policy pursued. Moreover, the additional amount of money reaches the real economy unevenly, which means that the prices of goods and services offered do not change to the same extent, direction, and time. By printing an unsecured amount of paper money, the central bank and the government have the privilege of having the first to dispose of it. The government can take advantage of the instruments of monetary policy to devalue its debts or increase its public spending. In both cases, the hands of politicians are free to take actions that they otherwise could not. If state planners decide to finance the construction of sports fields and facilities, for example, contractors and workers in this industry will enjoy additional funds for the services they provide, while at the same time the prices of the goods and services they buy will not yet be affected by inflation. This also applies to subsequent producers, whose goods and services the previous ones will prefer to buy. In this line of thought, fewer and fewer people will benefit gradually along the chain, while the last - those with fixed incomes - will feel only the decrease in the purchasing power of the monetary unit. Inflation benefits the first, who reach the new money at the expense of the last, creating anonymous redistribution and secret plunder of the population by the political elite. [5]

We observe economic development where there is a market economy, not a planned economy.

In a system of private property, the current prices of the means of production are formed as a result of the actions of those entrepreneurs who have most successfully anticipated the desires of consumers. Every small step towards satisfying consumers is equivalent to obtaining additional funds with which economic agents have the opportunity to continue competing for scarce resources and directing them in a given production process. Moreover, the realization of a profit or loss is not just a financial result, but an indicator of whether the factors of production are directed efficiently or are wasted unjustifiably. [6]

In a state-owned system, however, the situation is fundamentally different. When the government sets a marginal price for a given material resource and, on the basis of this decision, tries to combine the factors of production and calculate future costs, it relies on the fact that it can always overcome a possible loss by increasing the tax rate or the amount of money in circulation. Even if the intentions of political actors are good, they cannot offer a product or service that satisfies the diverse desires of their fellow citizens, since they are faced with the lack of sufficient information about the individual needs of each individual. The impossibility of carrying out economic calculation (a fundamental problem first highlighted by Ludwig von Mises in Economic Calculation in the Socialist Commonwealth) does not allow for feedback on whether scarce resources are being directed in the right direction or are being diverted much further from it. Imagine that you want to get to a certain place, but you do not know the route. You are walking on a road without road signs or signposts. You pass through intersections, cross streets, main roads, but you do not know whether turning left will get you there faster than turning right. You do not even know whether you will be able to find the desired place in this way, let alone whether there is more than one route to reach the final destination. The absence of market prices, which, like road signs, guide entrepreneurs in what to invest in to satisfy the desires of consumers, makes it impossible to record a certain financial result (profit or loss), thus calling into question the possibility of achieving normal economic progress. It is naive to expect that the government can be a good manager. On the one hand, it does not have its own funds that it can invest and risk in order to realize a profit. On the other hand, it inevitably faces the fundamental problem or the impossibility of carrying out economic calculation.

Sources:

[3] – http://www.econlib.org/library/Enc/KeynesianEconomics.html;

[4] – https://www.youtube.com/watch?v=Tq8wk_bnvaU;

[5] – 2008, Deflation and liberty, Jörg Guido Hülsmann, Auburn, Ala.: Ludwig von Mises Institute;

[6] – 2002, Economics for real people, Gene Callahan, Auburn. Ala.: Ludwig von Mises Institute

*The article is part of a project to create a collection of basic postulates of the Austrian School of Economics, which we will publish periodically. You can download and read the entire first chapter HERE

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