Aus­trian eco­nom­ics might ex­plain China's tur­moil

The Pak Banker - - OPINION - Noah Smith

There are still econ­o­mists who pub­lish pa­pers in the Re­view of Aus­trian Eco­nom­ics, and there are still a bunch of peo­ple on the In­ter­net who will tell you they sub­scribe to the "Aus­trian school." The Aus­trian school, for the unini­ti­ated, is a hodge­podge of be­liefs, usu­ally hold­ing that fiat cur­ren­cies are doomed to fail, that a re­turn to the gold stan­dard is in­evitable and that cen­tral banks are re­spon­si­ble for bub­bles, mar­ket crashes and re­ces­sions. But this group has grown rel­a­tively quiet of late, and it isn't hard to see why.

First, there was the dra­matic fail­ure of the Fed­eral Re­serve's pro­gram of quan­ti­ta­tive eas­ing to cause even a hint, even the slight­est whiff, of in­fla­tion. For a few years, the fears of in­fla­tion were kept on life sup­port by Aus­trian claims that in­fla­tion was be­ing hid­den from the public eye, that as­set price in­creases were ac­tu­ally a form of in­fla­tion, or -- my per­sonal fa­vorite -- that QE it­self is in­fla­tion. Even­tu­ally, even the most diehard sup­port­ers of these silly backup ar­gu­ments were forced to quiet down; re­al­ity can only be de­nied for so long.

Then there was the burst­ing of the gold bub­ble. Gold was the Aus­tri­ans' big as­set play - - the hedge against the end of the mod­ern econ­omy and the re­turn of the 1500s. That hasn't worked out too well. If you fol­lowed Aus­tri­ans' ad­vice and bought gold at the peak, you have now lost more than a third of your money. I hope, for your sake, that you didn't need to re­tire or make any big pur­chases dur­ing that time -- or that you only gam­bled on Aus­tri­an­ism with a small frac­tion of your life's sav­ings. At any rate, with the Fed pre­par­ing to hike in­ter­est rates, it seems doubt­ful that the Aus­trian gold bugs will be re­deemed any­time soon.

So it's un­der­stand­able why the Aus­tri­ans have been main­tain­ing ra­dio si­lence, more or less. That isn't to say that they've changed their minds, of course -- Aus­tri­an­ism, like many eco­nomic schools of thought, is a "brain worm" that doesn't easily re­lin­quish its host.

What's in­ter­est­ing to me, how­ever, is that events in China are ac­tu­ally bear­ing out some of the clas­sic pre­dic­tions of Aus­trian think­ing. Though most Aus­tri­ans on the In­ter­net spend their time flog­ging gold, hy­per­ven­ti­lat­ing about in­fla­tion and call­ing var­i­ous peo­ple com­mu­nists, the orig­i­nal "Aus­trian school" thinkers -- Lud­wig von Mises and Friedrich Hayek -- had some other ideas as well. And some of these might be use­ful for think­ing about China. One of these is "ma­l­in­vest­ment." Aus­trian thinkers such as Mises con­tend that re­ces­sions hap­pen be­cause too many re­sources are fun­neled into as­sets that won't ac­tu­ally be pro­duc­tive in the fu­ture. By the time busi­nesses re­al­ize that they have made a mis­take, they are locked into bad lines of busi­ness, or bad busi­ness lo­ca­tions.

It has never been very clear ex­actly why ma­l­in­vest­ment causes an eco­nomic hang­over. Why don't busi­nesses just cut their losses and im­me­di­ately start in­vest­ing in some­thing more use­ful, as soon as they re­al­ize that they're do­ing the wrong thing? Aus­trian the­ory has never been par­tic­u­larly clear on that (and its no­to­ri­ous re­fusal to use pre­cise math­e­mat­i­cal mod­els cer­tainly doesn't help).

But at least Aus­tri­an­ism em­braces the pos­si­bil­ity that busi­nesses might make big, sys­tem­atic mis­takes. That pos­si­bil­ity is es­sen­tially ruled out by most mod­ern main­stream mod­els, which use "ra­tio­nal ex­pec­ta­tions" as their jump­ing-off point. It also re­quires that pro­duc­tive cap­i­tal come in mul­ti­ple forms, while main­stream macro usu­ally as­sumes that all forms of cap­i­tal are in­ter­change­able. Over in China, it seems clear that there has been a lot wasted re­sources -- ghost cities and over­ca­pac­ity in var­i­ous man­u­fac­tur­ing in­dus­tries. That in turn seems to have led to a bub­ble in Chi­nese real es­tate prices, whose slow de­cline may in turn have caused the re­cent spec­tac­u­lar stock bub­ble and crash.

That brings us to another in­ter­est­ing Aus­trian no­tion -- the in­sta­bil­ity of fi­nan­cial mar­kets. Main­stream macroe­co­nomics is only just barely start­ing to deal with the idea that fi­nan­cial mar­kets may have a nat­u­ral ten­dency to boom and bust. Aus­tri­ans have been say­ing this for al­most a cen­tury.

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