One of the debates out there is whether the governments should keep ‘bailing out’ institutions to prevent a cascade of defaults. Or, just let them go bust, let the ‘haircuts’ fall where they fall, get it over with and then allow firms to restructure and start again. Avoid the Japanese mistake of prolonging the misery.
It is sometimes suggested that the former idea is somehow ‘Keynesian’. And, the latter is often described as ‘Austrian’.
Now, it is true that some Keynesians argue in favor of ‘bailouts’. And, Governments generally seem to be following both a bailout strategy and the more traditional Keynesian idea of fiscal stimulus during a slump. It is also true that some famous Austrians have been known to favor the default strategy. Yet, this discussion misses the point. None of this is actually what the various theories suggest. There’s a profound difference between policy prescriptions associated with a theoretical perspective, and the underlying theories themselves.
And, looking back at the simple principles of Austrian and Keynesian theories provides some clarity of what we are currently living through, how the policy debates fit in, and what is evolving in financial markets. It also helps us assess the increasingly popular ‘bond bubble’ concept that has been circulating this year.
The Austrian theory was perhaps best elaborated by a guy named Knut Wicksell. His analysis of business cycles was premised on the relationship between the cost of money, the real rate of interest, and the rate of return on physical capital, the real rate of return. A ‘Wicksellian equilibrium’ occurs when the real rate of interest equals the real return on capital. When the two are the same, the economy will likely be on a steady growth path. This is often referred more generally as a ‘steady state’.
The steady state is, of course, merely a benchmark. An ever-changing world fluctuates around this relationship. From this, a rough theory of business cycles emerges. And, a theory of slumps. In particular, when the real rate of interest is below the real return on capital, then according to Austrian theory you can get a boom. There is an incentive to borrow, take on debt and invest in new capital. That, in turn, spurs more spending and investment.
Two factors should serve to dampen the boom.
- First, the returns to capital should diminish as more and more physical capital is produced and put to work.
- And, second, increased borrowing should place upward pressure on the real rate of interest. Both factors should combine to produce a narrowing in the spread between the real rate of interest and the real rate of return on capital, serving to dampen and eventually break the spending boom.
This simple idea is exceptionally powerful. It allows us to understand, for example, how a period of innovation raises the rate of return on capital and can produce a longer period of growth.
Or, how the process of inflation, which pulls down the real rate of interest (but not necessarily the productivity of capital), can also serve to prolong an upcycle. Of course, the inflation-based upcycle is inherently less healthy than a boom based on enhanced innovation. Innovation helps sustain a higher rate of profit; inflation doesn’t.
The theory also helps us see why the low real rate of interest that existed over the past 10-15yrs likely distorted the business cycle. And, why, we ran into excess debt and excess leverage.
But, let’s not go through the history of this sorry mess. Especially since most of the great Austrian theorists understood that, in the real world, the process would often be associated with excesses and nasty adjustments. It was a theory of business cycles, of booms and busts. Not one necessarily of smooth adjustment.
So, a cyclical downturn occurs when the real return on capital falls below the real rate of interest. In such a situation, there is little incentive to invest in productive capital. The economy slows, the demand for labor drops, and unemployment rises. Now, in principle, this process should also be self-correcting. A drop in capital spending, combined with an aging and decaying of existing capital equipment, should raise the rate of return to new investment over time. And, reduced spending also means less borrowing, thus placing downward pressure on the real rate of interest.
Now, this is where things can get very interesting. And, dangerous. It’s where Keynes comes into the discussion. What happens if goods price deflation emerges, thus limiting how far the real interest rate can fall? That’s when you can fall into Keynes’ liquidity trap. The authorities can’t get nominal interest rates down enough to spur more spending.
That’s a situation that calls for fiscal stimulus. Arguably, that’s what happened in 2001-03, when aggressive rate cuts seemed to fail to stimulate activity after the stock market crash. It was only after the 2nd and biggest of the Bush stimulus packages was passed, in Q2 2003, that the economy and financial markets turned around.
But, what’s worse is when a broader debt/default cycle emerges and generalized asset price deflation takes hold. This is when the ‘perceived’ rate of return on capital can plummet. One of the many innovations in Keynes’ General Theory was to talk about the return on physical capital as based on expectations of future demand, and hence the importance of confidence and ‘animal spirits’. Expectations of the future.
In this type of extreme environment both sides of the Austrian equation cause problems. You get a liquidity trap when the demand for cash becomes extreme and so monetary provision is simply soaked up by the private sector. The velocity of circulation of money collapses. Narrow money grows rapidly, but broad money growth stagnates.
And, at almost the same time you get a drop in animal spirits. There is a tendency to want to pay back debt rather than borrow to invest. The perceived rate of return of new investments collapses as the view of future demand deteriorates. In this case, even if there isn’t a liquidity trap, the real interest rate can’t fall far enough or fast enough to keep up with the drop in the expected rate of return on capital.
In such circumstances, monetary policy again becomes impotent. They can’t get rates low enough. But, its also one where fiscal stimulus alone may also not be successful, unless the financial system is also somehow re-lubricated. It’s a very tricky situation to remedy. It is arguably what happened during the Great Depression, and what may also be happening now.
Now all of these things – the policy prescriptions, the underlying analysis, and of course the characterization and description of Austrian theory presented here – are highly controversial. You know the old story of getting two economists together and producing three or four opinions!
But, what shouldn’t be so controversial is the implication for real interest rates in all this. They need to come down!
If the expected real return on capital is collapsing; if, as the pessimists argue, China is headed for real trouble due to excess capacity; or if as many of us fear, a cascade of defaults loom ahead, then the real rate of interest will be under downward pressure, not upward pressure. Almost regardless of supply conditions.
This analysis has several implications. First, it suggests that this ‘bond bubble’ idea; the bear case for Government bonds premised on the notion of excess supply seems to essentially rely on the idea that a recovery will emerge within some visible time period.
That the Obama fiscal boost will be successful. Or, that China will succeed in promoting domestic and global growth. Otherwise, the demand for cash and near cash will stay high. And, that means the demand for Government bonds.
For example, consider the argument for a bond bubble made by none other than the great guru, Warren Buffett, in his latest annual letter to shareholders. He argues that ‘holding government bonds … is almost certainly a terrible policy if continued for long‘ (emphasis mine). He goes on to suggest that the idea that those that ‘proclaim “cash is king” even though that wonderful cash is earning close to nothing will surely find its purchasing power eroded over time‘ (again, emphasis mine).
Oh wow. Of course the guru is right. Over time. And, under the assumption that price inflation will be positive. That is, he assumes a negative real interest rate!
And, as we are witnessing, in extreme conditions of debt default it can be real hard to real rates down. But, according to Austrian theory, down they must come, one way or another. Whether it takes direct Government intervention in bond markets or not.
… How does this theory fit in a more international context? What about countries like Iceland where real rates had to rise as the slump emerged? Doesn’t that contradict this story? How does the ‘Austrian’ theory apply in a more global context?
Well, it certainly makes things trickier, but here’s an imperfect stab at the issue. If the currency gives, then suddenly the Government interest rate becomes more of a credit, than a domestic cost of capital. That’s why vulnerable currency countries, debtors like Iceland earlier (but not now that it is in slump, has a cheap currency and a C/A surplus!), and perhaps Hungary or South Africa today, may have to raise interest rates into a slump.
Another way to think about this in Austrian terms is that currency depreciation means the (currency adjusted) real rate of interest has already fallen pretty sharply. The recent big shift in currencies has kept inflation relatively high in weak currency countries.
Take a look at the recent numbers out of Australia, South Africa or even Sweden. So, some downward adjustment in the real interest rate has already taken place via extreme currency depreciation (what economists like to call the ‘ex ante’ real rate, based on expected rather than actual inflation). As an smart guy recently pointed out, it is not at all clear how the S Africans are going to get rates down as much as priced into the forwards given ongoing currency weakness.
This stab at internationalizing this simple version of the Austrian story suggests that a bear story for US bonds is more likely to be relevant in an environment of chronic US dollar (USD) weakness, rather than during a period of strength in the USD. A drop in the USD and/or signs of a recovery in economic activity seem much more likely to prompt an unwindof the ‘bondbubble’ than the problem of increased Government bond issuance.
Finally, if this is wrong, and real bond yields go up significantly despite the slump and without signs of recovery, then this will simply add to the downside to economic activity. You don’t need to be an Austrian to see that the last thing the economy needs is tighter financial conditions due to increased supply of Government bonds. That would serve to undermine the stimulus programme, and add to deflationary pressures.
Reposted with permission. Copyright © 2009 DrobnyGlobalTrading, LP. No reproduction, transmission or distribution permitted without consent of the copyright holder.
About the author
Andres is DGA’s moderator, economist, strategist and all around smart guy. Andres is the thought leader of the DGA membership circle helping to keep the discussion intellectually honest, highly focused and profitable.
Before starting Drobny Global Advisors in 1999, Andres Drobny served as Chief Strategist and proprietary trader at Credit Suisse First Boston in London and NY from 1992-1998. While at CSFB, Andres was also on the Global FX Management Committee and a partner in the Leveraged Investment Fund. Prior to CSFB, Drobny was Chief Economist and Head of Research at Bankers Trust London. Before entering the financial markets, Andres was an academic economist at Cambridge and the University of London.
Andres Drobny holds a PhD in Economics from King’s College Cambridge, a Masters from London School of Economics and a Bachelors from Tufts University. When not in front of his Bloomberg, Andres can be found playing soccer or hanging out with friends at his compound in Venice Beach.
For another perspective on this
(2) “Wasting Away in Hooverville“, Jonathan Chait, The New Republic, 18 March 2009 — A powerful rebuttal to the historical revisionism of Amity Shalaes about the Great Depression, which has become so popular among conservatives.
(3) “From Central Bank to Central Planning?“, J. Bradford DeLong(Professor of Economics, Berkeley), September 2008 — I recommend reading it! Excerpt:
According to the followers of Knut Wicksell, the central bank must keep the market rate of interest near the natural rate of interest. No, said the followers of John Maynard Keynes, it must offset swings in business animal spirits in order to stabilize aggregate demand. On the contrary, said the followers of Milton Friedman, it must keep the velocity-adjusted rate of growth of the money stock stable. In fact, if you do any one of these things, you have done them all, for they are three ways of describing what is at bottom the same task and the same reality.
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To read other articles about these things, see the FM reference page on the right side menu bar. Of esp interest are:
Posts about the work of John Maynard Keynes:
- The greatness of John Maynard Keynes, our only guide in this crisis, 4 December 2008
- About the state of economic science, and advice from a famous economist, 8 December 2008
- Words of wisdom about the global recession, from the greatest economist of our era, 29 December 2008
- Some thoughts about the economy of mid-21st century America, 12 January 2009
- Economics is not a morality tale, 14 January 2009
Posts about Austrian economic theory:
- Geopolitical implications of the current economic downturn, 24 January 2008
- “A depression is for capitalism like a good, cold douche.”, 17 December 2008
Originally published at Fabius Maximus and reproduced here with the author’s permission.