1. NS3040 The Austrian School of Macroeconomics Fall Term, 2014

2. Austrian School I Austrian Economics mainly a theory of business cycles Centered around patterns of interest rates and investment Two types of interest rates The natural rate of interest – reflecting return on investment The market rate which reflects the borrowing costs of funds charged by the banks When the market rate is below the natural rate companies borrow to invest and the economy expands In opposite case investment is reduced and the economy contracts Drawing on this mechanism the Austrian School emphasizes bank credit’s role in the business cycle 2

3. Austrian School II Austrian Mechanisms: Low interest rates stimulate borrowing from banking system. The expansion of credit induces an expansion of money through the banking system This in turn leads to an unsustainable credit-fueled investment boom in which “artificially stimulated” borrowing seeks out diminishing investment opportunities Boom results in widespread overinvestment causing capital resources to be misallocated into areas which would not attract investment if the credit supply remained stable Expansion turns into a bust when credit creation cannot be sustained – either increase in market rate or a fall in natural rate A “credit crunch” sets in – money supply suddenly and sharply contracts when markets finally clear Causes resources to be reallocated back to more efficient uses 3

4. Austrian School III Austrian Business Cycle 4

5. Austrian School IV Austrians often referred to as “Liquidationists” Best way back to recovery is to liquidate the bad investments out of the system and start fresh with capital better allocated In 1930s Austrian mechanism did not work because extreme risk aversion kept the market rate above the natural rate even after liquidation Roosevelt, by putting banking system on sound footing through guaranteeing bank deposits – liquidity situation improved and credit began expanding Economy began expanding in 1934 due to credit expansion, not fiscal stimulus Recovery in 1934 more Austrian than Keynesian. Economy tanked in 1934 when monetary and later fiscal support was withdrawn. Austrians right about role of credit and recovery in 1930s, but wrong in not recognizing need for confidence-building economic measures 5

6. Austrian School V 1930s Credit Impulse 6

7. Austrian School VI Austrian critique of current crisis: Major Factor: The belief that even in a world of uncertainty economic and financial outcomes could be planned Assumptions of rational expectations and efficient financial markets Led to overconfidence in ability of policy makers, firms and individuals to successfully plan for the future despite uncertainty -- “unknown unknowns” At macro level rational expectations and efficient market theory became the rationale for inflation targeting by major banks Replaced monetary targeting of the early 1980s Economy expected to grow in a steady state if only central bank ensured stable and low rates of inflation Policy mainly implemented by Alan Greenspan at the U.S. Federal Reserve 7

8. Austrian School VII The new approach to Federal Reserve policy had several ramifications: Under-regulation of financial markets – assumed that when individuals had rational expectations and markets were efficient – no need to worry about asset markets or regulate financial markets Development of highly leveraged financial products and risk management Financial participants saw only “known unknowns” that could be quantified with probability theory – felt there was little need for contingencies for the truly unforeseen – the “unknown unknowns” Seemed appropriate to raise leverage to the extreme Feeling of being in control with good foresight laid the ground for the extremely high leverage built into financial products and balance sheets of firms. 8

9. Austrian School VIII Lessons the Austrians drawn from the crisis Clear markets are not highly rational with perfect foresight There are elements of irrationality and inefficiencies in the behavior of people and markets As a result outcomes can not be planned with a high degree of certainty This reality leads to conclude: Idea that more regulation of markets will provide stability is incorrect – in a world of uncertainty can only best tentatively plan for the future – use trial and error or a flexible approach In a world of unknown unknowns firms and investors need larger buffers to cope with the unforeseen – more equity and less leverage In a world where markets are not always liquid but can freeze up – need greater reserves of liquidity Need to accept the reality that we can not fine tune the business cycle. 9