The March 2009 Mont Pelerin Society Focused on Whether the Great Recession Was Best Explained by the Austrian School

An important conference put on in March 2009 by the Mont Pelerin Society focused on whether the Great Recession was best explained by Austrian economic analysis or that of another school, Keynesian or otherwise. In a seminal paper, Axel Leijohnufvud (2009) examined whether the downturn was one best analyzed by an income-expenditure model, i.e., in terms of economic flows. He concluded that it was not. Instead, he declared it to be a classic balance-sheet recession, and one best analyzed by Austrian analysis.

All of the macroeconomic policies implemented in the Great Recession ignored its character as a balance-sheet recession. When households and businesses are trying to restore their balance sheets and rebuild savings, creating massive new federal debt is counterproductive. But creating future tax obligations for households and businesses is precisely what the stimulus did. There were also other, deleterious microeconomic effects that put more of the burden of adjustment on the private sector. Much of the federal spending went to prop up state government spending on public-sector workers. That forced the private sector to bear more of the adjustment costs.

Many chide Austrian economists for not having a positive policy to cushion against the effects of the Great Recession. They did have a policy. It was to facilitate and not to impede the adjustments in asset markets.

First, do no harm. The macroeconomic response was largely harmful. In the second half of 2008, the Federal Reserve responded appropriately to provide more liquidity. After that, its various QEs were misbegotten. The economy was not suffering from a lack of liquidity, but the aftermath of a severe collapse in the prices of many assets. Financial institutions and other firms were insolvent, not illiquid. Additionally, the Federal Reserve policy of very low interest rates (negative in real terms) distorts capital allocation and creates new malinvestments.

—Gerald P. O'Driscoll Jr. and Mario J. Rizzo, introduction 2014 to Austrian Economics Re-Examined: The Economics of Time and Ignorance, Routledge Foundations of the Market Economy 33 (London: Routledge, Taylor and Francis, 2015), 8.

Home Mortgages Were Financed by Short-Term Credit, Even Overnight Funding, Made Famous by Lehman Brothers

The financial crisis began with the Panic of 2007, and continued into 2008 with multiple crisis events involving, among others, mortgage giants Fannie Mae and Freddie Mac; failed investment banks like Bear Stearns (bailed out) and Lehman Brothers (not bailed out); and many financial firms whose solvency was in doubt at some point (e.g., Citigroup and Morgan Stanley). The Panic involved a great housing boom financed by innovative financial instruments. After the housing boom ended there was a crisis in housing finance involving actual or perceived insolvency of firms at the center of housing finance.

The crisis occurred in the midst of a period known as the Great Moderation. It was a period in which the growth rates of monetary aggregates moderated. Macroeconomic flow variables, like real GDP,  became less volatile. But it was also a period of a great expansion in the velocity of the M1 monetary aggregate.

The increase in velocity, or decrease in money demand, accompanied the rise of “shadow banking,” in which housing loans (and other bank lending) were securitized. Long-term debt, like home mortgages, was increasingly financed by short-term credit, even overnight funding as was so famously the case with Lehman Brothers. A credit pyramid was erected upon a narrow base of bank money. The possession of Treasury securities or other eligible collateral financed transactions in repo (overnight repurchase agreements) markets. Gorton succinctly described the process.

Another important feature of repo is that the collateral can be rehypothecated. In other words, the collateral received by the depositor can be used — “spent” — in another transaction, i.e., it can be used to collateralize a transaction with another party. Intuitively, rehypothecation is tantamount to conducting transactions with the collateral received against the deposit. There is no data on the extent of rehypothecation. (Gorton, 2010, p. 44)

—Gerald P. O'Driscoll Jr. and Mario J. Rizzo, introduction 2014 to Austrian Economics Re-Examined: The Economics of Time and Ignorance, Routledge Foundations of the Market Economy 33 (London: Routledge, Taylor and Francis, 2015), 4-5.

Insisting on a Virtually Infinite Degree of Complexity in Capital Theory Reflects Mises’s Insights on Economic Calculation

Capital goods are related to one another, some as substitutes, some as complements. This fact would suggest that a theory of a capital-using economy must, at a bare minimum, allow for three distinctly different capital goods. (A two-good model of the capital sector could not allow for both substitutability and complementarity.) To allow for both intertemporal and atemporal substitutability and for both intertemporal and atemporal complementarity, the number of different capital goods must be multiplied. And allowing for various degrees of substitutability and complementarity requires still further multiplication. In its richest form, the capital theory introduced by Menger and developed by Böhm-Bawerk, Mises and Hayek cannot adequately be modeled by a three-good capital sector or even by an x-good capital sector where x is some determinate number. The Austrian theory of capital is based instead on the concept of a complex structure of production made up of a wide assortment of capital goods. The rejection of determinate models of the capital sector is consistent with the rejection of input-output models of the economy in general. The insistence on allowing for a virtually infinite degree of complexity reflects the insights of Mises on the problem of economic calculation (Mises, 1966 , pp. 200–31), and of Hayek on the use of knowledge in society (Hayek, 1945).

—Roger W. Garrison, “A Subjectivist Theory of a Capital-Using Economy,” in Austrian Economics Re-Examined: The Economics of Time and Ignorance, by Gerald P. O'Driscoll Jr. and Mario J. Rizzo, Routledge Foundations of the Market Economy 33 (London: Routledge, Taylor and Francis, 2015), 191-192.

Roger W. Garrison on the Ideas Subjectivist Capital Theory Strives to Elucidate and Systematize

Conceiving of competition as a discovery procedure — as a set of institutions that facilitate the discovery of profit opportunities — draws our attention away from the comparison of alternative equilibrium states and toward the workings of market processes. The shift in focus from timeless equilibria to market processes having an explicit real-time dimension creates a special role for the theory of capital. Capital goods, after all, bear a certain temporal relationship to the consumption goods that they help to produce. Expectations (and changes in expectations) on the part of entrepreneurs about future supply and demand conditions for consumption goods have implications about current choices made and actions taken with respect to the corresponding capital goods. Equivalently, consumption activities that extend over time are reflected in the constellation of capital goods that exist at a particular point in time.

While the capital goods themselves are the concrete objects of valuation and exchange, the ultimate basis for their valuation and exchange is future consumption activity, which, in turn, serves as the basis for production plans. Of course, the continually changing demands for consumer goods imply a continual revaluation of capital goods used in their production. Further changes in the valuation of particular goods result from the discovery of inconsistencies between the production plans of different entrepreneurs. And such discoveries are themselves the result of the market process that guides production towards the ultimate satisfaction of consumer demand. These are the ideas that subjectivist capital theory strives to elucidate and systematize. The theory maintains its subjectivist quality by highlighting the plans of entrepreneurs or other market participants (the subjects of the economic activity) rather than the capital goods themselves (the objects of their actions).

—Roger W. Garrison, “A Subjectivist Theory of a Capital-Using Economy,” in Austrian Economics Re-Examined: The Economics of Time and Ignorance, by Gerald P. O'Driscoll Jr. and Mario J. Rizzo, Routledge Foundations of the Market Economy 33 (London: Routledge, Taylor and Francis, 2015), 185.