Institute of Economic Affairs
By: Roger Koppl
Date: 15 August 2014
From Crisis to Confidence: Macroeconomics after the Crash
The recent economic crisis has destroyed some of
the supposed ‘certainties’ of economic theory and policy. Both are in
question as we try to understand the Great Recession and the long slump
that followed. Something has gone terribly wrong and we need to mend our
ways. To some it looks like market failure, which suggests the need for
more command and control. But if the crisis is a tragic example of
government failure, then we had better move away from command and
control and toward freer exchange.
In the IEA monograph From Crisis to Confidence I argue that the Great Recession and long slump were both consequences of policy mistakes. But to see how and why we need a more or less ‘Austrian’ theory that has not been part of mainstream macroeconomics in the recent past. Some of this Austrian theory is well established and some new.
The Great Recession was a classic Austrian trade cycle. A mistaken loose-money policy drove interest rates to inappropriately low levels. These ‘artificially’ low interest rates encouraged investment. They told investors that the public had become thriftier, that they had released resources for investment. This stimulus to investment is strongest for the most ‘interest sensitive’ sectors such as housing.
At the same time, however, those low interest rates discouraged the very savings they seemed to reflect. In this way, a loose money policy by the government’s central bank created inconsistencies between the plans of savers and investors. For a while everything seemed to be fine and we got a booming economy with growing output. But because of those plan inconsistencies, the boom could not have lasted. The ‘unsustainable boom’ had to end in a bust. That’s one way recessions can happen, and that’s what happened in the Great Recession.
Mainstream macroeconomics has not had room for the ‘interest rate mechanism’ that tells us the boom was unsustainable. It cannot adequately explain, therefore, the recent recession. Many mainstream economists have seen clearly, however, that the Great Recession was a matter of ‘sectoral shifts’ driven by inappropriately low interest rates. Mainstream macroeconomics may be ready absorb this piece of more or less Austrian macroeconomics. Today’s mainstream theory, however, does not seem to have an explanation for the long slump that followed the bust. Here too, Austrian theory can help.
A healthy economy recovers relatively quickly from a recession. This time, however, the recovery was slow. We have had a series of policy innovations and interventions intended to bolster the economy’s health. But the patient languished under the doctors’ care and we got the long slump, with employment low and growth slow.
The problem has been a series of policy innovations, which created economic policy uncertainty. Careening from one improvised policy to the next created uncertainty and knocked confidence out of the system. Mainstream macroeconomics today has been able to spot the empirical connection between an anaemic economy and economic policy uncertainty. But it has no solid theoretical explanation. In From Crisis to Confidence I outline a theory of confidence that helps to explain why recovery from the Great Recession has been so slow and painful.
The ideas I discuss in the monograph are rooted in an economic theory that rejects the mechanistic models of recent mainstream macroeconomics in favour of a more human vision of the economy and of economic theory. If people and particles are different, we need a theory about people to avoid the tragic policy errors that gave us the Great Recession and the long slump.
In the IEA monograph From Crisis to Confidence I argue that the Great Recession and long slump were both consequences of policy mistakes. But to see how and why we need a more or less ‘Austrian’ theory that has not been part of mainstream macroeconomics in the recent past. Some of this Austrian theory is well established and some new.
The Great Recession was a classic Austrian trade cycle. A mistaken loose-money policy drove interest rates to inappropriately low levels. These ‘artificially’ low interest rates encouraged investment. They told investors that the public had become thriftier, that they had released resources for investment. This stimulus to investment is strongest for the most ‘interest sensitive’ sectors such as housing.
At the same time, however, those low interest rates discouraged the very savings they seemed to reflect. In this way, a loose money policy by the government’s central bank created inconsistencies between the plans of savers and investors. For a while everything seemed to be fine and we got a booming economy with growing output. But because of those plan inconsistencies, the boom could not have lasted. The ‘unsustainable boom’ had to end in a bust. That’s one way recessions can happen, and that’s what happened in the Great Recession.
Mainstream macroeconomics has not had room for the ‘interest rate mechanism’ that tells us the boom was unsustainable. It cannot adequately explain, therefore, the recent recession. Many mainstream economists have seen clearly, however, that the Great Recession was a matter of ‘sectoral shifts’ driven by inappropriately low interest rates. Mainstream macroeconomics may be ready absorb this piece of more or less Austrian macroeconomics. Today’s mainstream theory, however, does not seem to have an explanation for the long slump that followed the bust. Here too, Austrian theory can help.
A healthy economy recovers relatively quickly from a recession. This time, however, the recovery was slow. We have had a series of policy innovations and interventions intended to bolster the economy’s health. But the patient languished under the doctors’ care and we got the long slump, with employment low and growth slow.
The problem has been a series of policy innovations, which created economic policy uncertainty. Careening from one improvised policy to the next created uncertainty and knocked confidence out of the system. Mainstream macroeconomics today has been able to spot the empirical connection between an anaemic economy and economic policy uncertainty. But it has no solid theoretical explanation. In From Crisis to Confidence I outline a theory of confidence that helps to explain why recovery from the Great Recession has been so slow and painful.
The ideas I discuss in the monograph are rooted in an economic theory that rejects the mechanistic models of recent mainstream macroeconomics in favour of a more human vision of the economy and of economic theory. If people and particles are different, we need a theory about people to avoid the tragic policy errors that gave us the Great Recession and the long slump.
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