23 January 2011

The Missing Piece

Imagine that you saunter to the faculty cafeteria one day and sit down at a table already occupied by two theoretical physicists. You discover them deep in a debate. One says he has developed the wind-driven theory of leaf fall that portrays the path of a leaf, once it has left its parent tree, to be determined almost entirely by the wind. The other fellow has a gravity-driven model of leaf fall, which has it that it is gravity controlling the show. You are somewhat amazed by the fierceness of their debate, and by the fact that they just keep going on at the level of theory. Finally, exasperated, you ask, “Has it ever occurred to either of you that you are both right? That both things are at play in the fall of leaves? And that rather than having this bitter argument, you’d both be better off working together, to see which of your theories works best at which times? For instance, it seems to me that, on a very still day, the gravity theory is going to be highly accurate. However, during a hurricane, it will apply hardly at all, while the wind theory will be almost the whole story?”
That little tale is a metaphor for how I have come to view the debate between the followers of Keynes and the followers of Hayek over how to describe the business cycle. Both of them have logically coherent models that plausibly describe some things that might result in an economic downturn. The real dispute between them ought to be, “To what extent do (or did) each of our models apply to this (or some past) economic downturn?” Instead, the dispute too often proceeds as if the goal is to crush the rival model, rather than to find out what models work where and when.

Though my background in economics is heavily dominated by the Austrian school, I am, at best, a quasi-Austrian.  I say this for a couple of reasons.  First, the Classical school of economics is still a small influence on my thinking (Smith, Bastiat, et al.).  Second, I subscribe the philosophy of consequentialism, which simply means that I don’t make one-variable prognostications, at least in the realm of economics.  Also, I’m rather pragmatic when it comes to application of principles.  Yes, theory is wonderful and all, but the one question I always have at the end of the day is:  what can we do with what we have?

The other reason I don’t completely subscribe to the Austrian school is seen, somewhat, in Mr. Callahan’s comments.  There are, by my own humble estimation, two significant flaws in Austrian philosophy.  One flaw is in regards to “free trade,” an issue I’ll address later.  The other flaw is in regards to the boom-bust cycle.

Robert Murphy has done a wonderful job addressing the general uncertainty of this issue, but, unfortunately, most Austrian economists don’t seem to take the time to do the same.  While I agree with Austrians that a central is pretty much only downside and greatly exacerbates the boom-bust cycle, I’m not particularly inclined to argue that the central bank is the primary cause of booms or busts.  A lot of the more severe boom-bust cycles, at least in America, seem to be the result of politicians subsidizing inherently inefficient products/businesses/industries.  Of course, like I said, the central bank will encourage these to “boom,” but they do not specifically direct people to invest in these things.

Furthermore, as any direct investor will tell you, some booms are brought about by “exuberance.”  Contrarians seem especially on point about this, as they understand that humans will behave as a herd from time to time.  Thus, some booms seem to be brought on by normal human behavior.

A drop in aggregate demand can also cause busts, though I don’t think this is a common primary cause. It shouldn’t be neglected from consideration, though. Along with that, a drop in aggregate demand doesn’t require the existence of a central bank; the market should correct itself naturally, albeit rather painfully.

Other than this issue, as well as the issue of free trade, the Austrian school is the most correct method of economic analysis currently in use.  This school, alongside the emerging discipline of behavioral economics, should help to make better sense of the world.  It’s not perfect, to be sure, but it is the best.

(By the way, the title is derived from this song, to which I had been listening while writing this piece.)

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