AUSTRIAN ECONOMISTS PREDICTED THE FINANCIAL CRISIS?: CRITIQUE OF THE AUSTRIAN BUSINESS CYCLE THEORY (Part I)

1. Austrian Business Cycle Theory and the financial crisis

The global financial crisis is, without doubt, the most important economic event of our time. Its depth, extent and duration have led many people to put into question the free market and capitalism. This, of course, has resulted in a very heated debate about its causes (and possible solutions). On one side are those who call for more regulations, institutional improvement and implementation of Keynesian policies and, on the other side, those who argue that the current crisis is the fault of governments and Central Banks because they, and not the market, created the “financial bubble” that eventually had to burst. In the view of this group, the crisis is not sample of the failure of neoliberal capitalism but rather of the interventionist paradigm, the unregulated free market is still the perfect way to organize the economy and if there are problems is not because the market doesn’t work but because the State has not allowed it work. Among those who advocate this position are obviously the Austrian economists. In fact, this view is at present strongly promoted by prominent Austrians such as Ron Paul and Peter Schiff, who claims to have predicted the crisis.

The theoretical basis of these economists to support their position is on the Austrian Business Cycle Theory. According to this theory, originally proposed by Ludwig von Mises and Friedrich von Hayek, crises are the result of “distorting action” generated by the State to intervene in the market. So, as the coordination capacity of the market is destroyed, is necessary a painful process of “adjustment” to restore the “spontaneous order” and, consequently, the crisis comes.

This is in a very general and abstract level. However, the most interesting formulation of the Austrian Business Cycle Theory is about the crises caused by “credit bubbles”. Here the “spontaneous order” is the correspondence between actual savings and investments of private agents. In this context, the State, through the Central Bank intervenes in the market to “stimulate” the economy by relaxing credit conditions. To do this is applied a monetary policy that determines a rate of interest below the “natural rate of interest”, that is, the one that would be configured under conditions of absolute free market. In this new “artificial economy”, consumers have access to more loans and entrepreneurs make more investments with respect to what would occur merely on the basis of actual savings and then the bubble begins to emerge. At some point, as already said, this bubble has to burst and the economy will have to “adjust” itself, and the crisis occurs. All this does not happen through the fault of free market but rather through the fault of the State intervention.

Like most economists, Austrians developed their analysis of the mechanism of causation of the crisis taking as main reference the U.S. economy. Specifically, they argue that the financial crisis was caused in 2001 when, precisely in the context of economic depression and loss of confidence after the attack on the Twin Towers, the U.S. Federal Reserve, to “stimulate” the economy, reduced the interest rates from 6.5% to 1.75% and then to a minimum of 1% in 2003. Also in June 2002 the U.S. government announced would guarantee to the companies Fannie Mae and Freddie Mac to help create liquidity in a secondary market for mortgages so that the vast majority of families can access the “American dream” of own home. This, argue the Austrians, was what created the credit bubble which would trigger the financial crisis in 2008.

This is the Austrian view of the crisis. The liberal Spanish economist Jesus Huerta de Soto, the most famous representative of the Austrian School in Spanish-speaking countries, puts it this way: “Economic depression is not a crisis caused by the market economy. This is something we have to remove of our mind definitively. The crisis is not a crisis of the market, it is a crisis of state intervention, state intervention which produced the current banking system and credit expansion, which has deceived entrepreneurs, which has distorted the production structure (...). Therefore, in a free market economy does not have to exist economic depressions”. (1)

The implicit assertion that “the market is always and necessarily perfect, and the State always and necessarily is at fault” is too radical and deserves to be examined. And this is the subject of this article: make a critical analysis of the Austrian Business Cycle Theory in the context of the current financial crisis.

To be continued...

References:

1) Jesús Huerta de Soto, “Una interpretación liberal de la crisis económica”, Estudios de Economía Política, Unión Editorial Press, Madrid, 2004, p. 157.

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ECONOMY AGAINST HAPPINESS: THE GREAT PARADOX (Part 4)

The issue of “relational goods”

In fifth place is argued that as our income increases, or precisely because we strive to have more and more things, the consumption of so-called “relational goods” is reduced. Indeed, in an effort to make us richer,  our friends and the time we dedicate to our family are reduced. A perfect example of this we can find it in Mr. Burns, sinister personage of the famous series “The Simpsons”, immensely rich and miserable who has no family, no friends, only his assistant, Mr. Smithers, whom is often undervalued and ignored by him.

But the problem is that it is not only our ambition but also the inevitable development of technology what condemns us to this situation since every step toward technological progress transforms our dependence on other human beings in dependence on machines. “The devaluation of the human world grows in direct proportion to the increase in value of the world of things”, said Marx concisely (1).

Technology begins to offer us substitutes for human relationships: children do not need parents to raise and educate them as they have to television, computer, internet and video games; families no longer need to come together to share a nice meal because the microwave oven allows everyone to warm your own food and eat separately, the person who wants to have children does not need to meet and fall in love with a special someone, or build a nice family and get married, simply he may resort to artificial insemination or a “surrogate mother”.

But the most tragic thing is that we have realized too late that the love and human warmth so necessary for happiness, are not products that can be manufactured by a company or created by technology and it is very difficult to find the return path.

The problem of moral and spiritual degradation

Finally, and even more serious from a transcendent point of view, economic progress (in the way in which we live it) by their very dynamic tends to undermine the moral and spiritual conditions in which man can achieve his happiness. For how could a system based on boundless ambition, envy, selfishness, emulation and competition create a society of “good and happy men”? How could a “progress” which systematically encourage and justified as “rational” all these vices be the solution to the problems of man and be the way to a happiness necessarily linked to conditions of peace, love, solidarity and virtue? To pretend such thing would be like to believe that the best way to expel demons is to invoke Beelzebub, who is the prince of demons.

In this point is likely that someone thinks that I am demonizing economic progress. But that is not what I want to do. It makes no sense to oppose the economic development in itself because it can also become a powerful tool to deliver man from his material and moral poverty. But we must resist the current model of economic progress as being carried out today mainly in Western countries as it requires countless human sacrifices to the “god” of Development. It is time to understand that progress by itself, the mere economic efficiency, never bring peace and prosperity to man but rather can only do so if this progress is oriented. And this orientation must come from within us through a deep ethical and social consciousness.

So maybe we should not pay much attention to what Keynes had said about that, to reach the desired welfare, “we must pretend to ourselves and to everyone that fair is foul and foul is fair; for foul is useful and fair is not. Avarice and usury and precaution must be our gods for a little longer still. For only they can lead us out of the tunnel of economic necessity into daylight” (2). Rather we should seek a more human economic progress, based on qualitative things rather than quantitative things, and pay attention to messages as this one by John Paul II when he said: “It is not wrong to want to live better; what is wrong is a style of life which is presumed to be better when it is directed towards ‘having’ rather than ‘being’, and which wants to have more, not in order to be more but in order to spend life in enjoyment as an end in itself. It is therefore necessary to create lifestyles in which the quest for truth, beauty, goodness and communion with others for the sake of common growth are the factors which determine consumer choices, savings and investments”. (3)

References:

1) Karl Marx, Economic and Philosophical Manuscripts, Madrid, 1970, p. 105.

2) Quoted by E.F. Schumacher, Small is Beautiful, Orbis Press, Barcelona, ​​1983, p. 24.

3) John Paul II, Centesimus Annus, 1991, nº 36.


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ECONOMICS FOR HERETICS: DEBUNKING THE MYTHS OF ORTHODOX ECONOMICS Excerpt from Chapter 5 – “The Myth of Competitive Markets”

(Are welcome the guidance and indications -emails, web addresses, name of head of area publications, etc. - about publishing houses and institutions that could publish the book).

Redemption failed: The “false messiah” of the successive approximations

Let us turn now to the issue of unrealism of the model of perfect competition. What orthodox economists say about this lack of realism? Simple: they minimize it by saying that all scientific models are in some measure unrealistic. However, as already mentioned, the model of perfect competition is not a simplification of reality but rather is openly at odds with reality . But orthodox economists have an answer yet. They say: “This model is only the basis and principle of our research program. After, starting from this we will develop other models of imperfect competition more realistic, with market power, product differentiation, barriers to entry and uncertainty. The student only needs to be patient. Little by little as he progresses in his courses, will go looking models more and more realistic”. Here we have, therefore, the grand means of redemption that has neoclassical theory to its unrealism: the method of “successive approximations”.

The first thing we must say about this is that it is a big scam. In effect, during the first years of study is said to economics students that they will study models more and more realistic, but later, already explained the models of imperfect competition (monopoly, oligopoly and monopolistic competition), economic theory courses become much more unrealistic and abstract. Anyone can check this by reviewing any advanced economics textbook. For this reason, Martin Shubik, in his famous article “Curmudgeon's Guide to Microeconomics”, says: “There are very few textbooks that indicate to the students that there are several forms institutionally different in that a company can operate. Insofar more elemental is the textbook, it is more probable that contains information on various forms of organization. However, as soon as our study becomes advanced, we do not bother to differentiate between General Motors and a small candy store. There are several institutional forms the basic text by Samuelson, but not in its Foundations” (1).

But even setting that aside, we must say that the proposal of successive approximations to reality starting from unrealistic models is a terribly misguided strategy because, in doing so, ends up turning to the reality in a sort of “special case” of theory!

And not only that. The method of successive approximations, while it may be appropriate for systems in which the parties are not intrinsically interrelated, it is never for complex or holistic system, in which the elements are intrinsically interrelated and display emergent properties. Well, this is exactly what happens with the market structures. In them the information, risk, uncertainty, technology and the relative power of the participants should never be considered as exogenous elements that may be introduced into the system after keeping intact the basics of the above structure because when the system has a holistic structure emerging properties as soon as a new element is added, the system is fully reconfigured.

It is precisely due to this that the orthodox theory can never build realistic models even through his method of successive approximations. By keeping the same structure always deterministic, the neoclassical economics can never build “open models”, can only move from a closed system to another slightly larger closed system. The mathematical formulation, although allows us to play to the theoric ping-pong and formulate fun exercises, sterilizes any attempt to holistic analysis, which is what really should to the market structures. So Shubik, referring to the model of duopoly (competition between two firms with market power), notes that: “Personally, I like the theory of duopoly. I like it more that the crossword puzzles. However, if I forget the distance that separates highly simplified models that I study and real markets of our society, would cause a lot of damage to myself and to my students” (2).

Finally, regarding the method of successive approximations should also be pointed that in the process of building new models (supposedly more realistic) frequently are maintained many of the false previous assumptions and what is worse, are added new false assumptions in order to secure the deterministic-mathematical “closing”  of the new system. Thereby falsehood is placed over falsehood and promise to eliminate false assumptions is never fulfilled. Therefore, the method of successive approximations, or successive closings, maybe it should be called "method of successive falsehoods". But what is sure is that it is a "false messiah" because it does not "redeems" to the orthodox theory of its lack of realism. And neither redeems to young students of economics who wish to understand well the reality and end up getting scammed by their teachers (who in turn were scammed when they were students).

References:

1. Martin Shubik, “Curmudgeon's Guide to Microeconomics”, Journal of Economic Literature, vol. VIII, nº 2, june 1970, pp. 405-434.

2. Martin Shubik, “Curmudgeon's Guide to Microeconomics”, pp. 405-434.


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ECONOMY AGAINST HAPPINESS: THE GREAT PARADOX (Part 3)

The phenomenon of the expansion of needs

It’s also sustained the argument of the “expansion of the needs” according to which in the measure that the levels of income and consumption of the people increase also increase their needs so that, paradoxically, the gap of dissatisfaction or of unsatisfied needs tends to grow up instead of diminishing.

In fact, the Greek philosopher Platon had observed this more of two thousand years ago and for it he said that “poverty is not caused by the decrease of wealth, but rather for the multiplication of desires”. So, one can be miser in between opulence, a poor man in luxury; because while the poor person’s hunger can be been satisfied with by bread, the rich person’s hunger is insatiable and, what is worse, grows up as more it tries to satiate it. The rich person that seeks to be happy consuming everyday more and more goods tends for it to create for himself more needs and, therefore, to feel more dissatisfaction. In order to illustrate this with an analogy we could say that he is like a thirsty man that seeks to calm his thirst drinking salt water or that he is like a hamster that tries to get ahead of the wheel that he himself is triggering with his own forces.

But it is important to have in mind that the above not only is valid for the individuals but also for the groups and nations because, as to the famous North American economist John Kenneth Galbraith explained in his book The Affluent Society (1958), “in the measure that a society become more opulent, needs keep on being created more and more all by the same process that satisfies them” (1). In this sense, the market has passed from be a mechanism for the satisfaction of the needs to become in a producer of needs.

Only economists (specially neoclassics) ignore this uncontrovertible reality because they are afraid to verify the falseness of their religion when looks refuted the sacred dogma of the consumer’s sovereignty. But it is enough with to observe how the market of cellular phones has evolved to come to realize how the reality has refuted this theorem completely. Initially cellular phones were acquired by important executives of large firms with needs of communication. A short time after they became cheaper and began to offer services like hour, alarm, text messages and notebook, all relatively reasonable. Next they began to offer services of enjoyment such like radio, games, player of images, camera of photos, video player, internet, bluetooth, touch screens and so on. Thus, the innovation began to sophisticate themselves more and more create us many “superfluous needs” as to know the luck in the horoscope daily, to have personalized pornography, to receive advices of how to kiss, to have sex, to be infidel and a lot of things more.

Thus, the cell went from being a mere object of use to become a powerful weapon to exploit the "needs" of individuals by subjecting them to a terrible dependence on fashion and technology and making them live in a constant state of anxiety and tension as they no longer consume to be satisfied but rather to escape from dissatisfaction. It seems that rather than the production of companies serve consumer needs are the needs of consumers those that serve the production of companies, as if they were wagons of a frenetic train moved from side to side by fashion, technological change and the desire for profits.

References:

1. John Kenneth Galbraith, The Affluent Society, Ariel Press, Barcelona, 1984, p. 204.


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ECONOMICS FOR HERETICS: DEBUNKING THE MYTHS OF ORTHODOX ECONOMICS Excerpt from Chapter 4 – “The myth of profit maximization”

(Are welcome the guidance and indications -emails, web addresses, name of head of area publications, etc. - about publishing houses and institutions that could publish the book).

Maximize profits or minimize losses?: the problem of risk

The problem of uncertainty we have just analyzed inevitably leads us to consider another important business decision problem: the problem of risk. This essentially means that entrepreneurs, by always acting under conditions of uncertainty, are constantly faced with the possibility that their actions do not achieve the expected results. In other words, their decisions always involve risk.

The consequences of this for the orthodox model of business rationality are truly destructive because, in conditions of risk, the rationality of businessman will consist more on ensuring a minimum level of profits or minimize losses than in maximize profits. And this for three reasons:

First, by the direct relationship between benefit and risk. Entrepreneur are well aware that if they want more benefits will have to take greater risks. Therefore, seek maximum profits would imply also assume the greatest risks. But because practically no one wants to do that we will have that entrepreneur do not necessarily be governed by the maximum possible but rather will accept a net income in accordance with the conditions (think in the cases of economic crisis). There is no reason, therefore, to believe that the entrepreneur has to act in a position of maximum, that is only a theoretical possibility.

Second, due to the stability that businesses require to plan. In effect, every company needs to maintain a minimum level of income to carry out their plans. Otherwise, if you search always maximum profit, the company may end up having a level of profit too fluctuating and therefore, it will be extremely difficult to make long-term plans due to financial uncertainty. So not only must take into consideration the profit but also the stability and security. That's why Japanese economist Shigeto Tsuru, after reviewing several cases of real companies, refers that: “It became clear that the determinant essential criterion of the behavior of the company was rather that of stabilize the benefit for a period of time long enough. Even more recently, it has been suggested an amendment in the sense that the goal of the companies should target to “maintain position of stability for a long period”. In other words, it means that in the description of the behavior of the company, the term maximization of security is more accurate than the term maximization of profit” (1).

Third, because the managers are more punished for incurring losses than rewarded for make profit. Effectively, given the context of separation between management and ownership, managers are more interested in avoiding losses than in achieve the maximum profit. Why? Because while managers and executives do not receive the benefits that may result from assume higher risks (shareholders take these), they may be dismissed if incur significant losses. Therefore, they will seek carry out their work efficiently obtaining for shareholders an acceptable profit level, but not necessarily will seek the maximum profit because this could also endanger their own job security.

Thus, if, as often happens, the maximization of profits increases the risk of losses, the manager will not accept the bet for basic considerations of interest. And more even if it is a large company with market power. It's no wonder that Paul Samuelson himself accepts that “as the company gets to have significant size and to have some control of prices, it can afford to loosen up a bit in its maximizer activity” (2). Or that the orthodox economist Carl Kaysen says: “While in the very competitive market the company has no choice but to seek maximum benefits, because the alternative to it is a insufficient benefit to ensure the survival, in the less competitive market the company can choose between seeking maximum profits or conform with a profit “aceptable” and pursue other goals” (3).

References:

1) Shigeto Tsuru, “¿Ha cambiado el capitalismo?”, in: ¿A dónde va el capitalismo?”, Oikos Press, Barcelona, 1967, p. 47

2) Paul Samuelson, Economics, McGraw-Hill, New York, 1976, p. 508.

3) Carl Kaysen, “The Corporation: How much power? What scope?”, in: The Corporation in Modern Society, Edward S. Mason ed., Harvard University Press, Cambridge, 1959, p. 90.


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ECONOMY AGAINST HAPPINESS: THE GREAT PARADOX (Part 2)

The “hedonic adaptation”

A second explanation is based on the hypothesis of “hedonic adaptation” which maintains that individuals quickly adapt to new circumstances so that, after enjoying higher consumption and income levels, they return to their initial state of satisfaction (or dissatisfaction?).

Think, for example an individual who wins the lottery. He goes crazy, jumps, calls all his friends, makes a big party... Shortly after he gets used to his new standard of living, moving house, has other friends and can have parties every week. What he previously only dreamed is now a reality. But with time he gets used to it. Everything returns to normal and nothing is special, so that now he is fascinated less by that lifestyle and even it comes to seem to him more and more boring. Think too in the children of this “lucky” man who, given his level of wealth, can afford to satisfy every whim of them. His little son constantly requests a sophisticated toy which he has seen on TV and his daughter, one fashion jean. The father buys on Christmas Day and the children are happy at the time, but for New Year they forgot these gifts.

The satisfaction threshold

In third instance is the proposal based on the threshold of satisfaction or “comfort line”. According to it once the individual reaches a certain level of income or consumption no longer increases his happiness. In economic terms, in so far as his income and consumption tend to level of comfort, the marginal utility he gets from them tends to zero.

Could be said that this is a particular application of the “paradox of value” raised by Adam Smith, being that the marginal utility of consuming one more unit of good in a situation of opulence is almost null. And that is when our level of income increases we tend to consume increasingly superfluous goods which do not really need and, to get used to that lifestyle, having those goods is almost indifferent while not having them would be catastrophic for us.

We ourselves can check this if we go and say to a child of the street that we invite him to eat at McDonalls. We will see how his eyes shine with joy. Then we can go and say the same to a child of a prestigious (and expensive) school and he will answer that does not mind because he goes with his dad every week to places like this and much better yet. But the irony is that this same child who rejects our invitation would feel very bad and would make a tremendous tantrum if any week his daddy refused to invite him to some of those places.

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ECONOMICS FOR HERETICS: DEBUNKING THE MYTHS OF ORTHODOX ECONOMICS Excerpt from Chapter 3 – “The myth of theory of distribution”

(Are welcome the guidance and indications -emails, web addresses, name of head of area publications, etc. - about publishing houses and institutions that could publish the book).

Do the free and competitive labor markets exist?: the institutionalist criticism

Until now we have assumed that exist so-called “labor markets”, ie spaces (not necessarily physical) in which entrepreneurs and workers come together to transact the employment levels and wages in a free and competitive context. Well, now we will criticize this assumption. Are there in the reality free and competitive labor markets? We think that do not, and in this position supports us the institutionalist school. Let us consider its arguments.

First we have the phenomenon of collective bargaining and labor unions. Regarding it is interesting to note the context in which it originated labor institutionalist approach. Institutionalist theory of labor markets emerged during the 1940s in the United States at a time when the unions were growing rapidly in the country and centralized collective bargaining was spreading. This prompted some economists to consider that the orthodox theory of wages had ceased to be realistic and relevant. Why? Because the collective determination of wages in the presence of labor unions was very different than the competition. This difference was primarily qualitative and not merely quantitative. And is that unions are institutions primarily political, not economic, which operating in a context of “game of pressure” between the government, employers and workers themselves following a logic of negotiation rather than of optimization.

As a consequence of the foregoing, the wage becomes more a administrated wage than a market wage. And in effect, given this context of collective bargaining, the wages turn into the result of conscious human decisions and no longer of impersonal market forces. Or in any case, as the institutionalists say, rather than the wage conforms to the supply and demand of labor, the supply and demand of labor conform to the wage.

The second critique from the institutionalist school to orthodox theory of distribution is based on the famous theory of dual labor market. According to this theory, originally raised by Doeringer and Piore (1) - there are two types of well differentiated labor markets: “primary” and “secondary”.

Primary labor markets are, by definition, those where the jobs are "good". Its features are: 1) stability and security, 2) high and increasing wages, 3) opportunities for ascents in the scale of positions, 4) utilization of advanced and capital intensive technology, and 5) existence of effective and efficient labor unions.

By contrast, secondary labor markets are those where the jobs are "bad". Its features are: 1) instability (because of the high labor rotation), 2) relatively low and stagnant wages, 3) scales nonexistent jobs or with few opportunities for promotion, 4) utilization of outdated technologies and labor intensive and 5) absence or weakness of labor unions.

Why this is so problematic for orthodox economics? Simple: because it contradicts that postulate according to which it “proves” the righteousness of capitalist distribution, meaning that to each worker is paid according to his productivity. For if indeed there duality in the labor markets (or, at least, in the most of them) we will find that wages are no longer unique and primarily determined by the productivity of workers but rather by the type of labor market to which they belong (primary or secondary).

Perhaps an orthodox economist can object at this point that even accepting the existence of duality in the labor markets is not necessary to deny labor mobility because it may well be the case that a worker pertaining to a secondary labor market increase his productivity and come to the primary market. Obviously this case can be given, and sometimes occurs. But it is the exception, not the rule. And even more so when the features of secondary labor markets are interrelated and feed back each other. In effect, because of the low level of wages paid in this type of market, entrepreneurs have no greater incentive to introduce labor-saving technology and, consequently, the productivity of workers, along with their wages, stagnates (and this to say nothing of the case in which this technology is incorporated but wages do not rise to obtain higher “profits”). And not only that. The presence of a stagnant technology decreases the opportunities and incentives for workers to improve their skills. Therefore, it is not so easy that a worker of these conditions can "climb" to a primary labor market.

Finally, the third line criticism of institutionalist is related to the existence of so-called internal labor markets. An internal labor market can be defined as an administrative system of the firm which is regulated by a set of intra-institutional rules and procedures to determine prices and allocations of labor.

Thus, according to this approach, even if we accept the orthodox theory of wage setting via supply and demand we would have to say that its validity ends at the door of the company, ie, precisely where this theory should enter. Why? Because of the door inwards the very "universal" and "apodictic" laws of supply and demand are immediately replaced, as we have said, by a series of rules and procedures to fix the positions and salaries of employees.

Any economist who has had the opportunity to meet real firms will realize that the existence of these so called internal labor markets is not a mere “bureaucratic anomaly” but rather it is a widespread phenomenon in the organization and enterprise management. The main reason is the need of the companies (especially medium and large) of reducing employee turnover. First, because the costs of recruitment are usually pretty high (not think only the monetary costs) and, secondly, because when entrepreneurs invest in specific qualifications of their workers are aware that they must stabilize the employment for obtain better performance by these investments in human capital.

Therefore, talk of “free” and “competitive” labor markets in the sense that it does orthodox economics is nothing more than a theoretical fiction that has nothing to do with reality. And this is well known by university professors of economics who, on the one hand, in the classroom, talk about sacrosanct "free" and "competitive" labor markets and, on the other, to leaving the classroom, are not daily at the prospect of being displaced from their jobs for another person equally capable and willing to work for lower wages. Thus, in the practice, neither they believe what say orthodox theory...

References:

1. Peter Doeringer y Michael Piore, Internal Labour Markets and Manpower Analysis, Ed. Lexington, 1971.


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