austrian school of economics; paulson

8/7/2019 Austrian School of Economics; Paulson

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The current financial crisis represents an important

victory for an oft-overlooked school of thought: The

Austrian school of economics

By George Bragues So much for all those predictions that the

markets would begin to recover once members of the U.S. House of

Representatives summoned the courage to resist the populist outcry

and vote for Hank Paulsons $700-billion rescue plan. Whatever the

excitement it generated, and the disappointment its original rejection

by Congress caused, the market appears to have arrived at a more

considered view of the U.S. Treasury Secretarys scheme. Sadly, the

markets negative verdict is on the mark. To understand this, we have

to unravel the contradiction infecting much of the commentary andanalysis regarding the current financial crisis. While there isnt

perfect unanimity on this, it is widely acknowledged that a significant

part, if not the root, of our difficulties originated with the low-

interest-rate policy implemented by the Alan Greenspan-led Fed in

2001-2005. This generated a housing boom, which was further stoked

by the financial engineering of Wall Street in securitizing mortgages,

by obliging bond rating agencies in evaluating these securities and by

portfolio managers eagerly willing to buy them, hungry for extrareturns in a low interest rate environment.To the extent that this

assessment has been made, it represents an important victory for a

school of thought that has long hung on the margins of the economics

discipline: the Austrian school of economics, whose most illustrious

figures include the Nobel prize winning Friedrich von Hayek and

Ludwig von Mises. Austrian economists hold that downturns are the

inevitable aftermath of loose monetary policy, thus opposing

explanations typically heard prior to the current crisis that attributed

recessions to price shocks, underconsumption or central bank

tightening of monetary policy.But if, to rephrase a well-known Nixon

quote, we are all Austrians now, it illogically only extends to the

diagnosis of the crisis and not to the schools market-based cure. For

it is just not consistent to simultaneously assign blame to Greenspans

easy money and then support government intervention to fix the


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damage, as so many of the business op-ed writers and talking heads

on CNBC have. As the Austrian tradition points out, the dilemma with

easy money is that the central bank sets rates below that which the

market would naturally set. The natural rate reflects peoples

willingness to trade present for future satisfactions. When the actualrate is established under this, entrepreneurs and firms are issued a

false signal that people are willing to defer more consumption into

the future than they really are. As a result, excess investments in

capital goods industries, such as housing, are made on the

expectation that these will pay off in the long-run. The boom ends

when monetary conditions are tightened back to natural levels or the

passage of time makes clear that the demand was never really there to

sustain the investments made. At this point, a crisis takes place inwhich capital investments get liquidated and resources are shifted

such that the economys productive capacity more appropriately

reflects peoples time preferences. As we are witnessing now, this

stage is not pretty, since the banks and creditors who financed the

boom activities see the value of their loan assets impaired, forcing

them to restrict credit to even credit-worthy customers. Financial

institutions that became heavily exposed to the boom activities either

go bust, like Lehman Brothers, or they become prey, as Merrill Lynch

did to Bank of America, and to those who wisely minimized theirparticipation in the bad investments. Depositors start to doubt the

security of their funds and bank runs become a threat. This is, to be

sure, less of a problem now thanks to government deposit insurance,

though this security blanket comes at the price of giving banks

incentives to take undue risk with the customers deposits. In todays

globally integrated financial system, this dynamic plays itself

worldwide. American mortgage securities were marketed around the

world and the exposure of institutions became linked throughcomplex derivative transactions. Still, the Austrians argue that the

liquidation process must be allowed to proceed, since any

government intervention to mitigate the necessary adjustments will

end up sustaining the very pattern of production that caused the crisis

in the first place. This was the error that Greenspan committed in

dramatically lowering interest rates in 2001, which allowed excess


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investment in future goods to persist, as resources merely shifted

from one capital goods industry to another, from the technology and

Internet sectors to housing. No such switch is in the offing now, so

any further government intervention is apt to prolong the economic

slowdown. How exactly Paulsons plan is supposed to work remainsmurky, but the basic idea is that the government will buy distressed

mortgages from financial institutions, hold on to them until the

markets and housing stabilize and then sell those that havent yet

matured. With less risky balance sheets, the hope is that banks will be

better able to attract capital, and thereby gain the confidence to

provide credit to worthy customers at more normal interest rate

spreads to government debt. This stratagem would represent an

authentic liquidation if the banks were to sell their mortgage debt atits real present value and the government, in turn, had no

compunction in pursuing foreclosures on non-performing loans, no

matter what the impact on house prices. But, as hinted by CIBCs

recent deal with Cerberus to reduce its exposure on US$1.05-billion

in problem mortgages, there is a sea of cash sitting in private equity,

hedge and vulture funds waiting to buy distressed securities if the

price is right. That they havent bought much yet suggests the banks

are resisting lowering their price. There being pressure to expedite

the transfer of securities and assist the banks, the government is verylikely to acquiesce to this resistance, pay above market and effectively

institute a price support mechanism for mortgage assets. Besides the

public relations mess of having a throng of failed borrowers

compelled to give up their homes by a government agency, the fear of

contributing further to the decline in the real estate market means

foreclosures will probably be kept to a minimum. In this way, the

Paulson scheme will also turn into a price support regime for housing.

Most commentators resist following the Austrian logic through to theend out of the fear of repeating the policy mistakes that led to the

Great Depression. This reflects the orthodox interpretation of that

period, according to which the economy fell apart in the early 1930s

while U.S. president Herbert Hoover took a laissez-faire approach to

the downturn and the Fed ran an overly tight monetary policy. The

truth is that the Fed at the time did try to add liquidity, lowering its


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rediscount rate until late 1931 and continuously increasing reserves

under its control. Money supply nevertheless fell, but that was

because people lost faith in the financial system and hoarded

currency. Meanwhile, Hoover met the downturn with interventionist

gusto. He passed the Smoot-Hawley tariff to help domestic industriesand obtained the co-operation of business leaders to support wages

and investment. We havent gone down this protectionist and

corporatist road yet but Hoovers attacks on short selling and his

creation of the Reconstruction Finance Corporation, which among

other things loaned money to banks, bear an eerie resemblance to the

current policy response. We might have done nothing, Hoover said,

[but] we determined that we would not follow the advice of the

bitter-end liquidationists. Thus has the Bush administration decidedas well, having successfully cajoled a recalcitrant Congress to follow

Hoovers example.

Financial PostGeorge Bragues is Program Head of Businessat the University of Guelph-Humber in Toronto.Photo:Friedrich Van Hayek.

austrian school of economics; paulson

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