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Austrian economics and the fallacy of deflation

with 19 comments

Recently I’ve been engaged in an online discussion with Christopher Pang of the New Asia Republic here. Christopher wrote an article on some supposed economic myths and his attempts to debunk them. My comments on his stand and opinion may be read over there. Personally I feel that much of it is heterodox Austrian economics which is questionable theory. As I and another commentator Fox have said, Austrian economics conflates between consumer price inflation and monetary inflation, the former being a general increase in consumer prices but the latter being an increase in the money supply. But here I would like to address one particular claim, that deflation might be a good thing. This is a favourite talking point of Austrians which comes up quite often so it’s worth devoting an entire post to debunking that argument.

According to the Austrians, deflation is not necessarily a bad thing. Deflation is defined as a fall in the overall level of prices in the economy, generally a fall in the price of a consumer basket of goods/services tracked. Intuitively it may be a good thing because it helps to lower prices and wages until they become affordable again. This runs counter to what is normally understood in everyday conversational economics and introductory courses. Personally I am of the opinion that in general, falling prices across the board are a bad sign, but this statement requires some clarification and qualification.

To understand why deflation is normally thought of as being undesirable, here’s the standard explanation by Nobel Prize winning liberal economist Paul Krugman:

So first of all: when people expect falling prices, they become less willing to spend, and in particular less willing to borrow. After all, when prices are falling, just sitting on cash becomes an investment with a positive real yield – Japanese bank deposits are a really good deal compared with those in America — and anyone considering borrowing, even for a productive investment, has to take account of the fact that the loan will have to repaid in dollars that are worth more than the dollars you borrowed.

A second effect: even aside from expectations of future deflation, falling prices worsen the position of debtors, by increasing the real burden of their debts. Now, you might think this is a zero-sum affair, since creditors experience a corresponding gain. But as Irving Fisher pointed out long ago (pdf), debtors are likely to be forced to cut their spending when their debt burden rises, while creditors aren’t likely to increase their spending by the same amount.

Finally, in a deflationary economy, wages as well as prices often have to fall – and it’s a fact of life that it’s very hard to cut nominal wages — there’s downward nominal wage rigidity. What this means is that in general economies don’t manage to have falling wages unless they also have mass unemployment, so that workers are desperate enough to accept those wage declines. See Estonia and Latvia, cases of.

Sounds persuasive right? But here’s what the Austrians say. They claim it isn’t bad when prices fall, because falling prices are observed in the computer and technology industry. While the personal computer used to cost about $3,000 in the US back in 1982, today’s Windows-compatible PC prices are typically much cheaper, at about $600 for the cheapest basic ones. The computer industry has gone from strength to strength and has experienced nothing of the kind of economic disaster so often warned about when prices decline.

Secondly, to quote from a Austrian rebuttal the world has seen falling prices, most notably during the Second Industrial Revolution during a period of economic prosperity:

For example, both the U.S. and Germany enjoyed very solid growth rates at the end of the 19th century, when the price level fell in both countries during more than two decades. In that period, money wage rates remained by and large stable, but incomes effectively increased in real terms because the same amount of money could buy ever more consumers’ goods. So beneficial was this deflationary period for the broad masses that it came to the first great crisis of socialist theory, which had predicted the exact opposite outcome of unbridled capitalism. Eduard Bernstein and other revisionists appeared and made the case for a modified socialism. Today we are in dire need of some revisionism too – deflation revisionism that is.

Is this really true? A commentator pointed out that prior to 1913 there was no CPI data for the US, so the claim can’t quite be verified using official statistics. Secondly what matters is that the fall in prices are prices tracked by the basket of consumer goods, rather than other goods which may not be purchased by consumers. But more importantly, the fatal flaw in the Austrian argument that deflation may be a positive thing lies in a failure to distinguish between different factors behind falling prices. While deflation is more commonly understood as falling prices it’s important to understand that two distinct economic causes can have the same effect. Economist Nouriel Roubini, one of the few economists to have accurately forecast the economic crisis elaborates why in a video here.

Deflation more than just falling prices

I don’t have a transcript but the point Roubini was making was that if falling prices are a consequence of technological advancement and increased productivity (as was the case during the 2nd Industrial Revolution), they are a good thing, but if they are due to the fact that consumers are holding off purchases because of declining wage levels or lost jobs (eg. Great Depression, Japan’s lost decade, America 2008-?), we have a negative situation. Why is this distinction important despite the fact that in both cases, falling prices are the consequence?

To understand this in introductory economics under the assumption of perfect competition, falling prices due to technological advancement and productivity corresponds to a right-ward shift of the supply curve of the goods market, whereas if deflation is the result of withheld consumer spending, this means that the demand curve shifts to the left, which also results in lower prices. Why should the former be beneficial to the economy while the latter be disastrous? I would argue the difference that matters is because in the former case, though prices are lower the cost of producing goods are lower as well. Unlike in the latter case where decreased consumer spending is depressing prices, there’s still an increase in output. By comparison, in the latter destructive case of falling prices, output falls unreservedly.

To take the widely cited example of the computer industry, even though computer prices have fallen drastically since thirty years ago, the total annual number of computers manufactured and sold have not fallen. Similarly, though I have not actually searched for data on this, it is likely that despite the fall in average unit prices of steel, industrial engines and other industrial produce have all increased in output. Contrast this with the great contraction in output as tracked by GDP during the Great Depression, and much of the Western world today and you’ll see that falling prices are typically not accompanied by huge increase in output whether measured in real or nominal terms. Instead, falling prices are seen together with rising unemployment, cuts in wages and declining GDP.

Hence we see from the above explanation that the Austrian rebuttal fails to take into account the broader economic picture. Falling prices are harmful if they also imply falling wages, which leads to decreased consumer spending, causing prices to fall again in a destructive spiral. See here also for a much better written article on the difference between the two and why deflation is bad.

Does this mean that the Austrians do not understand the difference between the two? I was about to conclude that way, but happen to chance upon an article by a popular Austrian website where the difference is clearly explained:

What needs to be realized is that there are two distinct causes of generally falling prices. One is the increase in production and supply, which should never, never be confused with deflation, depression, or poverty. The other is a decrease in the quantity of money and or volume of spending in the economic systemFalling prices is the only effect that they have in common. They differ profoundly with respect to their other effects.[1]

For example, if falling prices result from the fact that while the quantity of money and volume of spending in the economic system are rising at a two percent annual rate, production and supply are rising at a three percent annual rate, the average seller in the economic system is in the position of having three percent more goods to sell at prices that are only one percent lower. His sales revenues will be two percent higher, and that is what counts for his nominal profits and his ability to repay debts. His profits will be higher and his ability to repay debt will be greater. There are lower prices here, but absolutely no deflation.

What wipes out profits and makes debt repayment more difficult is not falling prices but monetary contraction, i.e., the reduction in the quantity of money and or volume of spending in the economic system. This is what serves to reduce sales revenues, and, in the face of costs determined on the basis of prior outlays of money, causes a corresponding reduction in profits. It is also what makes debt payment more difficult, in that there is simply less money available to be earned and thus available to be used for the repayment of debts. It is monetary contraction, and monetary contraction alone, which should be called deflation.

The case is different when the need for the fall in prices is caused by monetary contraction. In this case, the failure of prices to fall, in the face of the anticipation that they will fall, to the extent necessary to clear the market of unsold supplies of goods and labor, leads to a speculative postponement of purchases, which increases the pressure on prices to fall.

Deflation, which, it cannot be repeated too often, means monetary contraction, not falling prices, is at best in the category of a pain to be endured only in order to avoid greater pain later on. It should never be, and virtually never is, regarded as any kind of positive in its own right.

A few things to note. Unlike the quick and misleading rebuttal, the author acknowledges some key points about deflation in general. Namely, that falling price levels due to decreased spending will make debt much more difficult to repay (resulting in bankruptcies), that a deflationary spiral may result from it, that it’s traditionally accompanied by massive unemployment or cuts in working hours and pay. In other words, deflation should never be seen as a good thing but at best a necessary pain to be endured sooner so as to avoid even worse future economic suffering. In the end however, while there is much to commend the Austrian economics professor for acknowledging these crucial facts the economist also seems to think there should be some magical level prices would have to fall to before the economy can pick up again. As pointed out in a reply to Christopher, this is wishful thinking:

You are arguing from the perspective of an economy which is already at potential output. This is not the case for the US or much of Europe now. In the US, there are five unemployed persons to every job vacancy, which means that if every job vacancy is somehow miraculously filled 80% of the unemployment problem would still be there. The entire argument about crowding out works only when you have limited resources and when there is demand for it but right now there’s only slack. I hope you recognise that deflation is self-reinforcing, falling prices only make consumers hold back purchases in anticipation of further price declines; there isn’t any magical level prices would have to fall back to before firms and businesses suddenly decide to invest and hire. Inflation on the other hand, is what makes it unprofitable to sit on cash. Expectations of future inflation would make businesses and consumers do something with idle cash instead of just sitting on them. This is something Greg Mankiw pointed out in an op-ed last year. Raising inflation expectations sharply might be a way of jolting the moribund economy.

In other words, while Austrians assert that while prices have to fall, they have not told us explicitly how much prices have to decline before the economy picks up again. For example, prices in Japan today are actually lower than they are in 1989 (a somewhat amazing fact once you consider that every other part of the world has only seen higher prices), and in return Austrians have claimed that the reason why Japan hasn’t boomed is because prices haven’t fallen enough yet. At the moment, Christopher has yet to address most of the rebuttals made to his replies. It’s somewhat regrettable to see that New Asia Republic host articles such as Christopher Pang’s economic myths which themselves are really nothing more than unsubstantiated and debunked economic fallacies. At the same time they’re a good thing because it forces laypersons such as us to clarify and nail down exactly what is meant and implied when we use certain terms such as inflation/deflation.

Update: To be fair to Christopher, I realise that it’s more accurate to say that he hasn’t addressed the arguments yet rather than because he doesn’t bother to. My apologies to Christopher for sounding extremely rude and discourteous.

Do the Austrians offer any lessons?

Now despite what I’ve written above many will continue to point to the fact that the Austrians have a good explanation of recession busts and economic booms, the Austrian business cycle theory. These same folks are fond of pointing out that the monetarists and (Neo/Post/New)-Keynesians on the other hand can’t explain why booms and busts occur. While I agree that contemporary economics (though be warned that as a layperson I might be completely mistaken) can’t explain why both booms and busts occur, the idea behind a credit surge and bust coupled with speculation and market irrationality isn’t unique to Austrian economics.  As Professor Krugman explains in a new Voxeu.org paper, non-Austrian economist Hyman Minsky spent much of his professional life developing theories of speculative bubbles, credit models linked with financial instability; which sounds much like what we’ve seen the past few years:

The current preoccupation with debt harks back to a long tradition in economic analysis, from Fisher’s (1933) theory of debt deflation to Minsky’s (1986) back-in-vogue work on financial instability to Koo’s (2008) concept of balance-sheet recessions. Yet despite the prominence of debt in popular discussion of our current economic difficulties and the long tradition of invoking debt as a key factor in major economic contractions, there is a surprising lack of models – especially models of monetary and fiscal policy – of economic policy that correspond at all closely to the concerns about debt that dominate practical discourse.

We envision an economy very much along the lines of standard New Keynesian models – but instead of thinking in terms of a representative agent, we imagine that there are two kinds of people, “patient” and “impatient”; the impatient borrow from the patient. There is, however, a limit on any individual’s debt, implicitly set by views about how much leverage is safe.

We can then model a crisis like the one we now face as the result of a “deleveraging shock.” For whatever reason, there is a sudden downward revision of acceptable debt levels – a “Minsky moment.” This forces debtors to sharply reduce their spending. If the economy is to avoid a slump, other agents must be induced to spend more, say by a fall in interest rates. But if the deleveraging shock is severe enough, even a zero interest rate may not be low enough. So a large deleveraging shock can easily push the economy into a liquidity trap.

Krugman wasn’t alone in noticing that Minsky’s work of the 1960s and 1970s offered a promising non-Austrian theoretical framework from which more rigorous and prescriptive economic theories and policies may be formulated. Both Tyler Cowen and Rajiv Sethi have acknowledged this as well. In addition Krugman has an additional post on that here.

In addition I argue that although it is admissible that current prevailing economic orthodoxy does not offer good theoretical and model explanations of the causes of the economic crisis as well as recommendations, Austrian economics does not appear to be the way forward. At the heart of Austrian theory lies the assumption that the free markets must be allowed to work their magic, outside of any form of government interference whether it be the open market operations of the central bank or any fiscal policy apart from cutting taxes. Minsky’s theories on the other hand, centre around an explicit distrust of the efficiency of the free markets which he characterises as the “financial instability hypothesis”, arguing that left unchecked, financial institutions are no more rational than gambling dens driven by Keynesian “animal spirits”, in stark contrast with the efficient market hypothesis:

Minsky’s model of the credit system, which he dubbed the “financial instability hypothesis” (FIH),[5] incorporated many ideas already circulated by John Stuart MillAlfred MarshallKnut Wicksell andIrving Fisher.[6] “A fundamental characteristic of our economy,” Minsky wrote in 1974, “is that the financial system swings between robustness and fragility and these swings are an integral part of the process that generates business cycles.”[7]

Disagreeing with many mainstream economists of the day, he argued that these swings, and the booms and busts that can accompany them, are inevitable in a so-called free market economy – unless government steps in to control them, through regulationcentral bank action and other tools. Such mechanisms did in fact come into existence in response to crises such as the Panic of 1907and the Great Depression. Minsky opposed the deregulation that characterized the 1980s.

Personally I would say ignore the Austrians. Once upon a time it could be said the Austrians were ahead of everyone else in economics when they came up with their business cycle theories in the 1920s, but that was then. They have not progressed in any way since then. On this point John Quiggin has an excellent post on an overview of Austrian theory and why it shouldn’t be taken seriously here.

P.S. Here’s a constantly updated page which contain links to articles critiquing  Austrian theory.


Written by defennder

January 6, 2011 at 1:48 AM

Posted in Economics and business

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19 Responses

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  1. Hi, you do realise that people have life outside blogging too, right?

    Donaldson Tan

    January 6, 2011 at 2:08 AM

  2. Hi There,

    Happy new year to you and glad that you have taken to writing again.

    am a big fan of your articles here…so keep on doing what you are good at.


    Gilbert Goh

    January 6, 2011 at 4:38 AM

  3. Donaldson
    Hi Donaldson, upon re-reading my post I realised I was too harsh and discourteous in describing my debate with Christopher. I have since edited the article to tone down the language. And yeah personally I’ve not had the time to sit down and write stuff like this post for some time. Which is why I’m somewhat grateful to Gilbert Goh for welcoming me back.

    I should also thank Christopher for the correspondence we had. Prior to this I admit that I did not have a good understanding of the issues and it was that exchange which prompted me to dig out all this material so I could rebutt some of those points.

    Hi Gilbert thanks again for your strong interest in this blog. I see that your extremely insightful blog is far more active than mine which is a good thing because otherwise your readers might be sad that you haven’t updated yours. I sure must have disappointed quite a number of people who check this site regularly. I think I should tell them all to read your blog instead since mine is only updated on my whims.


    January 6, 2011 at 9:04 AM

  4. Considerable theoretical work has been done on credit cycles by Kitoyaki and Moore (see their 1997 classic). Kiyotaki is incidentally at Princeton. Classically, debt is no big deal because one man’s debt is another’s illiquid store of wealth.


    January 6, 2011 at 10:10 AM

  5. Fox
    Hi Fox, thanks for pointing that out. Searching through Krugman’s blog I found this post which really attempts to debunk the classical picture of debt as being no big deal since for every debtor there is always a creditor. As mentioned above, I am no economist nor even a student of economics so I’m not able to go into the details of those theories.


    January 6, 2011 at 10:58 AM

  6. BTW, Austrian economics doesn’t conflate monetary inflation and price inflation. It just defines inflation differently. So, it is just a question of semantics. Kinda like calling a chicken a duck and saying Donald Duck cannot swim.

    If you read whatever C. Pang writes, it is quite obvious that he does not understand how things like fiat money and central banks work. Sometimes, I wonder if he even realizes that the balance sheets of central banks are zero or if he actually knows what kind of monetary policy MAS has (which is quite different from the US Feds).


    January 6, 2011 at 11:18 AM

  7. Btw I would like to repost this at NAR. This is the kind of the detailed debate which i feel is lacking in the policy debates among lawmakers.

    Donaldson Tan

    January 6, 2011 at 3:49 PM

  8. Fox, Chris never wrote about MAS.

    Donaldson Tan

    January 6, 2011 at 3:50 PM

  9. […] It’s the economy, stupid – Furry Brown Dog: Austrian economics and the fallacy of deflation […]

  10. Yes, he did in his comments in one of his earlier essays, “What is inflation”.


    January 7, 2011 at 1:27 AM

  11. Fox
    I have to admit that I myself am not exactly clear on what exactly the Austrians believe in! That’s because many of the economic terms which we take for granted are defined and understood differently by the Austrians. This makes conversations and debate difficult until the definitions are sorted out. My personal belief is that the Austrians claim that inflation refers to both higher prices and the increases supply because they believe that the latter necessarily and sufficiently implies the former. After all, how persuasive is Austrian theory to laypersons if they didn’t and couldn’t run around screaming “Inflation! Higher prices all because of the central bank!” but instead “Inflation! Money supply expands!” A little melodramatic I confess, but you get the point.

    I managed to locate Chris Pang’s earlier piece on inflation here. Didn’t notice it earlier, certainly not the exchanges by Fox and a few other commentators including C. Pang. Although he didn’t mention MAS at all in the main article he did appear to have implicitly blamed MAS in one of the comments for not keeping the money supply constant:

    Unfortunately Singapore money supply is determined by MAS and it has not done us any favours in terms of maintaining the value of our dollar. There is a tool which we can play with on MAS website.
    This allows you to see the money supply expansion over any period of time you wish to. I ran the numbers and noticed we had double digits percentages increase in the money supply from 2006 and 2010 for M1, M2 and M3. M1 consists of checking accounts and currency in circulation. That rose by 181% over 10 years, 10.9% year on year. The most notable increase started from 2006 to 2010, 2006 – 13%, 2007 – 22%, 2008 – 18%, 2009 – 23%. It seemed to coincide with the speculative bubbles we created in both housing and stock market.

    It may be easily verified, however that MAS doesn’t target the money supply for a few reasons. Firstly because of Mundell-Fleming open economy hypothesis which states that central banks cannot hope to achieve a fixed exchange rate, zero capital controls, interest rate determination.

    MAS itself makes this point here:

    Monetary policy in Singapore centres on the management of the exchange rate. There is no independent policy targets for either interest rates or money supply. This choice of monetary regime is based on the following assumptions:

    (a) Money supply is essentially endogenous, or adjusts passively, to economic activity. Changes in money supply thus have a limited impact on economic activity, both in real and nominal terms;

    (b) Exchange-rate changes have a major influence on inflation, and not insignificant effects on the international competitiveness of the real sector;

    (c) An exchange rate-centred monetary regime in Singapore cannot co-exist with an independent policy on domestic money supply or interest rates; i.e., the active management of the exchange rate implies a loss of domestic monetary autonomy in the context of an open economy.

    2 The present paper examines the first of these precepts, item (a). There is good economic reasoning stemming from the extreme openness of the economy, for the view that money supply has little independent influence on economy activity. The dominance of external demand in the economy implies a minimal role for changes in the domestic money supply as an independent stimulus of demand. The heavy reliance on foreign investments also reduces the role of domestically funded capital expenditures. Finally, the high exposure of the monetary sector to capital flow from abroad implies that any excesses in the demand or supply of money would be eliminated with only small changes in interest rates.

    Also see here and here. I’m not clear on what you mean when you say the balance sheet of central banks are “zero”. What exactly does that mean?

    By the way that point that money is created by the fractional banking system which in turn is managed by the central bank through setting reserve requirements. This point is best explained by none other than economist Anna Schwartz who authored a seminal work on the monetary history of the US together with Milton Friedman here. However, there is also a heterodox school of thought in the Post-Keynesian tradition where money is created and destroyed by the commercial banks in the economy rather than by the Fed. According to these folks that’s why the Fed was unable to jump start the economy, ultimately if banks don’t want to lend out all the money pushed to them by the Fed you don’t get inflation or a growing economy. Of course the Fed has other less conventional tools at its disposal, most notably the means to depreciate the US dollar or create high inflation expectations so as to force banks to stop sitting on cash.

    Donaldson Tan
    Hi Donaldson as stated here you’re welcome to reproduce this post or any other in whole or in part so long as a link in provided back to originating post. Thanks for helping to bring this to greater attention.


    January 7, 2011 at 2:25 AM

  12. “I’m not clear on what you mean when you say the balance sheet of central banks are “zero”. What exactly does that mean?”

    Sorry if I was unclear but I was talking about base money supply. When MAS issues 1.0 SGD, its liability goes up by one dollar. However, under the Currency Act, it can only create the dollar by taking in one extra SGD-equivalent of foreign asset, which in turn increases its asset by 1.0 SGD. So, in total, its balance sheet is still zero. When the MAS tries to destroy 1.0 SGD, it sells 1.0 SGD worth of Singapore government securities that it owns. You can see the problem here: because our exchange rate is managed (or semi-fixed), every dollar of USD flowing into Singapore gets converted into an equivalent amount of SGD. Unless MAS changes the exchange rate band, there is no way to control the inflow or outflow of capital through currency appreciation, and hence the base money supply. For the same reason, it has a limited control of inflation. This does not mean that all inflation in Singapore is caused by the inflow of USD but rather, MAS cannot fight inflation by adjusting interest rates.

    The US Fed is different. It modulates the base money supply in the US by buying and selling Treasury bills, not foreign assets. The balance sheet of the US Fed is always zero, by definition. Ultimately, everyone’s USD bill is backed by T-bills and of course, the power of the US government to demand tax payment in USD (not gold, euro or chickens).

    Ultimately, central banks merely exchange liquid assets (money) for illiquid ones (foreign currency, securities, etc).

    Sorry, if this sounds trivial to you.


    January 7, 2011 at 8:30 AM

  13. Strictly speaking, the MAS does own a minuscule amount of assets: the MAS building, its furniture, the small amount of money to pay the staff, etc. It also earns revenue through the issuance of Chinese New Year gold coins, the interest it earns from the securities in its portfolio, etc. Of course, this is all chump change with respect to its liabilities (SGD) and assets (OFR).

    The same goes for the US Feds except that they don’t issue Chinese New Year gold coins. By law, any additional revenue that is not used to cover the cost of printing paper, paying the staff, etc must be returned to the Treasury.


    January 7, 2011 at 8:40 AM

  14. Here are a couple of links which you may find edifying:

    1. Fed Pays Record $78.4 Billion to Treasury on Income

    2.Understanding The Modern Monetary System

    The first link demonstrates the point that the Fed swaps USD for government bonds to allow the Treasury inject liquidity into the private sector through government spending. Fundamentally, there is no limit to how much the US government can spend so long as inflation is under control since the Fed can buy T-bills to finance the spending. The Treasury pays the Fed interests on the T-bills held in the latter’s portfolio. The Fed in turn remits the interests back to the Treasury. This is a pure accounting procedure and has no meaning at all.

    The second link ultimately explains why the US government spending is constrained by inflation and not revenue, as opposed to governments in the Euro-zone whose spending is constrained by revenue since they do not issue their own currency. It also explains why government spending is unlike household spending.



    January 17, 2011 at 2:12 AM

  15. Fox
    Hi Fox for the links and comments. I haven’t had the time to read through them and respond to them at length, because I’m getting more comments and feedback for my other posts on this blog and elsewhere. I will revert to you and Tan Kuan Han in due time. Thanks again.


    January 17, 2011 at 9:21 AM

  16. Did you really call John Quiggin’s post “excellent”??!!
    Come on, this guy doesn’t even seem to know what links the fractional reserve system within the gold standard and the central banking under fiat ‘legal tender’ as money. He seems to find incoherent Austrian stance criticising both. :/
    The discussion how to ensure the monetary expansion doesn’t occur is a secondary one and purely technical. As he pointed out, some Austrians would like to solve this problem by free banking, others by competing currencies etc., but this lack of common voice on technicalities really doesn’t change the major point, that we should avoid the expansion!! Do we say the idea ‘Down with the theft!!’ is wrong because some people would like to see more CCTV, while the others – more officers patrolling??


    February 15, 2011 at 10:02 PM

  17. liberalismuss

    Hi thanks for commenting. I’d like to say that if you have issues with what Quiggin’s beliefs on Austrian theory are you should leave your comments there on his blog. What I found “excellent” about his post was that he gave a good overview of the history of Austrian theory and how it has evolved. He has pointed out and I fully agree with him that the early Austrians could have taken their own framework to its logical conclusion and precociously pre-date Minsky’s theories of the financial system being inherently unstable without regulation.

    But they didn’t of course, because to a large extent they were ideologically blinded to the idea that free markets are always ideal, ignoring that economists such as Stiglitz have shown how information asymmetry can lead to large distortions and economic inefficiency in the markets.

    And secondly, Quiggins’ point about the Austrians being confused is actually a very valid one, despite your theft analogy. One hardly knows what they believe in coherently enough to formulate a criticism of it.

    For example, take Hayek, whom almost no one would dispute was a founding father of Austrian economics. You might think that like most Austrians today he was dead set against any form of monetary expansion to maintain the money supply to prevent deflationary contraction. With a bit of research I can show that even Hayek himself, the original Austrian economic maestro repudiated this view in the 1970s:

    I am the last to deny – or rather, I am today the last to deny – that, in these circumstances, monetary counteractions, deliberate attempts to maintain the money stream, are appropriate. I probably ought to add a word of explanation: I have to admit that I took a different attitude forty years ago, at the beginning of the Great Depression.

    At that time I believed that a process of deflation of some short duration might break the rigidity of wages which I thought was incompatible with a functioning economy. Perhaps I should have even then understood that this possibility no longer existed. … I would no longer maintain, as I did in the early ‘30s, that for this reason, and for this reason only, a short period of deflation might be desirable.

    Today I believe that deflation has no recognizable function whatever, and that there is no justification for supporting or permitting a process of deflation. The moment there is any sign that the total income stream may actually shrink, I should certainly not only try everything in my power to prevent it from dwindling, but I should announce beforehand that I would do so in the event the problem arose. …You ask whether I have changed my opinion about combating secondary deflation. I do not have to change my theoretical views.

    As I explained before, I have always thought that deflation had no economic function; but I did once believe, and no longer do, that it was desirable because it could break the growing rigidity of wage rates. Even at that time I regarded this view as a political consideration; I did not think that deflation improved the adjustment mechanism of the market.

    – Hayek, Friedrich A. A Discussion with Friedrich A. von Hayek. (1975). Washington, DC: American Enterprise Institute

    The quote may be found in this paper by Professor Lawrence H White here:

    Professor Scott Sumner’s blog alerted me to this, FYI.

    Yes, even Hayek himself regretted supporting or championing deflation as a means of returning to economic growth. Today’s Austrians shouldn’t be called Austrians at all. Rather they should be recognised as deflationists or as Krugman says deflationistas, extremists who perverted actual Austrian thought to support a poorly articulated and supported theory. Contemporary Austrians have resurrected a theory alien even to its founding father. It’s not surprising that most critics of the theory often say that they are confused and that’s not an invalid ad hominem argument.

    P.S. I’m no economics major, so if you or anyone else is interested in a protracted discussion, do give me extended time to read and decide how to respond to your arguments. Thank you.


    February 16, 2011 at 12:31 AM

  18. […] I borrowed this discussion entirely from  Furry Brown Dog […]

  19. I read your article, and I feel that you have some misconceptions about austrian economics and other economic theory:

    “As I and another commentator Fox have said, Austrian economics conflates between consumer price inflation and monetary inflation.”

    No, austrian economics merely defines inflation as an increase in the money supply, caused by money printing and/or fractional reserve banking. Austrian economics recognizes that prices can increase If anything, most economists conflate the two, as they use inflation to mean an increase in the CPI. However, ultimately, any price can change because of changes in supply in demand for both goods: money and the good money is used to purchase. The reason other economists may feel this is a conflation, is because the definitions don’t match.

    Additionally, Austrian Economics recognize that there is no such thing as an overall level of prices. As inflation doesn’t affect prices uniformally, any attempt to aggregate price changes into a statistic will be misleading (price changes can result from a change in supply or demand of the goods being priced or money). Especially misleading is an attempt to aggregate supply or demand, as they measure preferences for one good compared to another (remember opportunity cost). Decreased spending is not a fall in aggregate demand, but happens when people choose more goods that aren’t counted as spending,

    “A commentator pointed out that prior to 1913 there was no CPI data for the US, so the claim can’t quite be verified using official statistics.”

    Irrelevant. All you need to verify this is statistics of prices, and observations about changes in living standards. CPI data has bias (there is no objective measurement of it, as the definition of what the basket of consumer goods changes from year to year!), and is not needed for this= observation. Heres a conflation of falling prices with CPI.

    “But more importantly, the fatal flaw in the Austrian argument that deflation may be a positive thing lies in a failure to distinguish between different factors behind falling prices.”

    Nope. Austrian economists distinguish between whether deflation is good or bad based on the cause. The difference is in how the cause is evaluated (which is why Austrian and Mainstream economists disagree about whether falling prices are good/bad in a recession).

    “Contrast this with the great contraction in output as tracked by GDP during the Great Depression, and much of the Western world today and you’ll see that falling prices are typically not accompanied by huge increase in output whether measured in real or nominal terms. Instead, falling prices are seen together with rising unemployment, cuts in wages and declining GDP.”

    First of all, GDP, even real GDP, increases with rising prices (this is one reason why GDP is inaccurate). The reason why this happens is because these two things are two effects of a recession, not because one causes the other.

    I will evaluate more of this later.


    February 22, 2012 at 1:02 AM

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