Ignoring the Austrians Got Us in This Mess

Their ideas warned us of the bubble; their prescription for the bust is too harsh, however.
(..)


On the latter score, Minsky was indeed almost completely unknown by the current generation of economists. When I wrote of the economy having a "Minsky Moment" as the credit crisis first erupted in 2007, the name was met by a blank stare except from a few. Now, Minsky is widely cited as having discerned the link between market crashes and the economy.

But to say that anyone who is a serious student of economics is not thoroughly familiar with Keynes' ideas beggars credulity. The standard construct of the economy used by virtually all forecasters, from the Federal Reserve on down, is basically Keynesian, with varying opinions about how the model works. That none of them predicted the current crisis is telling, and indeed damning of the approach.
(..)

The Austrian prescription, of course, was rejected first by the New Deal of Franklin D. Roosevelt, and now by massive response by both the purportedly conservative Bush administration and now the Obama administration. First came the $700 billion TARP last year to stabilize the financial system, followed by the $787 billion fiscal stimulus enacted last month. Across party lines, it's accepted that government's role is to prevent the economic pain that would come of "liquidate, liquidate, liquidate."

But the Austrians were the ones who could see the seeds of collapse in the successive credit booms, aided and abetted by Fed policies, especially under former chairman Alan Greenspan. While he disavows (again) the responsibility for the boom and bust, most recently on Wednesday's Wall Street Journal Op-Ed page ("Fed Policy Didn't Cause the Housing Bubble," March 11), monetary policy played a key role in creating successive bubbles and busts during his tenure from 1987 to 2006.

Greenspan always contended that monetary policymakers can neither predict nor prevent bubbles in asset markets. They can, however, clean up the after-effects of the bust -- which meant reflating a new bubble, he argued.

That had a profound effect on risk-taking. Knowing that the Greenspan Fed would bail out the markets after any bust, they went from one excess to another. So, the Long-Term Capital Management collapse in 1998 begat the easy credit that led to the dot-com bubble and bust, which in turn led to the extreme ease and the housing bubble.

Austrian economists assert the current crisis is the inevitable result of the Fed's successive efforts to counter each previous bust. As the credit expansion pumped up asset values to unsustainable levels, the eventual collapse would result in a contraction of credit as losses decimate banks' balance sheets and render them unable to lend. That sounds like an accurate diagnosis of the current problems.