“There’s something wrong with everything. In macro; not, you know, in life.” That may not be a verbatim quotation, but I remember Tyler explaining this in PhD macro I, and it has stuck with me. You don’t really understand a school of macroeconomic thought until you can dispassionately evaluate both its strengths and weaknesses. If your answer is that it has no strengths, then you don’t understand it; lots of very smart people developed the theory for a reason. If your answer is that it has no weaknesses, then you don’t understand it; lots of very smart people disbelieve the theory for a reason.
I’m writing this post on Austrian macro because the Austrian school seems to be both en vogue with and poorly understood by Tea Party types. For that matter, it is poorly understood by critics of the Tea Party. I’ll be the first to admit that I am not the most qualified person in the world to write this post. I am not an Austrian or a macroeconomist. Lots of people, including some GMU first-years who are taking the macro prelim this weekend, could do a better job than I will do. Maybe they can comment and refine the post that way. Let’s get started:
What’s right with Austrian macro?
The starting point for modern macroeconomics is what is known as dynamic stochastic general equilibrium (DSGE) models. These models vary depending on the point that the theorist is trying to make, but in the broadest class of them, there is in fact very little economics even going on. Say we start with Long and Plosser’s classic RBC model. How many goods are there in Long and Plosser? One (plus leisure). How many people are there in Long and Plosser? One! How much trade is there in Long and Plosser? Zero. Now, if what you mean by economics is intertemporal optimization in the face of random shocks, then Long and Plosser is an economic model. But as Hayek argues, “This, however, is emphatically not the economic problem which society faces.” DSGE models are poorly suited to evaluating changes in an economy with arbitrarily diverse agents with arbitrarily diverse preferences and arbitrarily diverse information sets. This critique of DSGE-style macro is part of the core of Austrian theory.
Furthermore, in the Austrian view, capital is heterogeneous and multi-specific. If you invest in a pet store, and then decide you want to convert it to a massage parlor, that is costly and time-consuming. This opens the door to malinvestment. In many RBC and New Keynesian models, capital is homogeneous, meaning that it is costless to switch from one investment into another. Kydland and Prescott explicitly assume time-to-build, but this is not the only friction in real-world investment.
According to the Austrians, production functions for the multi-specific capital are discovered over time. In virtually all RBC and New Keynesian models, production functions, the way of transforming the single type of capital into the good or (rarely) goods are specified in advance and do not change. Austrians emphasize competition as a discovery procedure. Entrepreneurs are constantly trying to find new ways to turn existing capital stocks into goods that consumers may want. This discovery procedure is obviously sensitive to policy shocks.
What is wrong with Austrian macro?
The biggest problem with the Austrian school is a legacy of the fact that much (not all!) of the theory was developed before the rational expectations revolution. Even if you think rational expectations is bogus, the fact is that many Austrian models do not explicitly state what is driving expectations. If the monetary authority inflates, everyone is tricked. This is clearly problematic. A better Austrian theory in my opinion would evolve along the lines of the Lucas islands model. I have written before that I think our current situation is one of severe model uncertainty. Some people think money is tight and others think money is loose. If that is the case, then even if people have, say, Bayesian expectations, many of them will be tricked, resulting in monetary distortions.
The other major weakness in Austrian business cycle theory is that it focuses way too much on one particular distortion, monetary policy. Now, the Austrians have an answer to this; they argue that money is one half of every single transaction in the economy, so if money is distorted, then that is a big problem. I don’t think this is true. First, monetary distortions will cause primarily intertemporal distortions. This may be problematic, but as I wrote above, one of the biggest strengths of the Austrian model is that it takes seriously the heterogeneity of goods, capital, and preferences. Focusing primarily on intertemporal investment gives away that huge gain. Austrians should be more open to examining other distortions, such as the subsidization of fixed-value financial claims (FDIC insurance, favoring debt versus equity) and industrial policy. I think Arnold Kling is onto something with his emphasis on Patterns of Sustainable Specialization and Trade.
What is misunderstood about Austrian macro?
The Austrian mantle has been claimed by the Tea Party, but very few Tea Partiers are familiar with modern Austrian scholarship. Michelle Bachmann famously takes Mises with her to the beach, but there is a great deal of Austrian theory that is post-Mises. In particular, most of the modern Austrians I have talked to are not goldbugs. They understand that the most important characteristic of money is not its store-of-value property. In general they favor rules versus discretion in monetary policy, but those rules are ones that non-Austrians can easily get behind. For instance, George Selgin writes, “Scott Sumner’s general views on macroeconomics are so much in harmony with my own that, in commenting on the present essay, I’m hard pressed to steer clear of the Scylla of fulsomeness without being drawn into a Charybdis of pettifoggery.” Furthermore, to the extent that Austrians like gold as currency, they like it because they believe it would “win” in a free-market competition against fiat currency, not because gold is special per se. A simple test would be to get rid of capital gains taxes on gold and other assets and see what wins.
Modern Austrians view policies like NGDP targeting as coming straight out of Hayek, who wrote about the importance of preventing a “secondary deflation.” Consequently, the mainstream accusation that Austrians favor no policy in the face of a financial crisis is misguided. The correct policy, according to many Austrians, is to adopt the most non-distortionary monetary policy there is, which is to keep nominal spending at the expected level. Letting spending collapse is itself a distortionary policy.
The Tea Party is populist, but it seems to be populist for the sake of populism. Austrian theory, on the other hand, is anti-elitist because it believes that neither elites nor anyone else can successfully “manage” the economy. There is consequently a certain populist interpretation of Austrianism; but the theory is not so much about giving the masses what they want as about letting a decentralized process take place. This is the main reason I am skeptical about the political adoption of Austrianism. It is being used as a rhetorical tool in a cultural dispute, not as a way of understanding the nature of the economic problems we face.