TCS Daily

Heed the Austrians

By Hans H.J. Labohm - October 6, 2002 12:00 AM

THE HAGUE - Economists still do not agree about the causes of the great depression of the thirties. That is regrettable, because this period contains undoubtedly lessons which could be used to face the current crisis-like situation. But if economists do not agree about the causes of the disease, how then should they agree on the remedy?

The current slump manifests itself in falling stock prices, with all kinds of harmful fall-out for the real economy. The chairman of the FED, Alan Greenspan, who is reputed to be the incarnation of monetary prudence, warned already in December 1996, for what he called 'irrational exuberance'. At that time the Dow Jones was at 6,400. But the markets were not deterred by his alert. The Dow Jones continued to rise to a peak of 11,700 in January 2000. When it dawned on the markets that the goodies of the new economy had been overrated, they slumped. Recently Wall Street reached a low of 7,422.

But from a historical perspective the present level is still high. This is all the more true if one looks at the price earnings ratio. Since 1872 the price earnings ratio of the funds which are included in the Standard & Poor's 500-index (S&P 500, which is broader than the Dow Jones) have been fluctuating within broad margins around an average of 16. In earlier times they reached a peak of 28, just before the crash of 1929. In 2000 they reached a peak of 45. Subsequently, the ratio declined. Last July, the level of S&P 500 corresponded with a price earnings ratio of 20. That is still a way ahead of the historical average of 16.

Is it conceivable that Alan Greenspan and his FED colleagues are co-responsible for this bubble? In the light of Greenspan's reputation many will consider the mere fact of asking the question as a kind of blasphemy. But it is nevertheless useful to think the unthinkable, because so often following the well-trodden path of conventional wisdom will not lead to the desired destination: in this case economic recovery.

Many economist believe that if the economy slumps, the central bank has to lower interest rates and has to pump money into the economy, which will lead to recovery. The followers of the so-called Austrian School, in the tradition of Ludwig von Mises and Friedrich von Hayek, beg to differ. 'Austrians' are particularly well represented in the United States where they operate a couple of excellent websites, on which they disseminate their ideas. In doing so, they have become the guardians of a legacy which originated in Europe, but which has been scandalously neglected in the old continent. When I lectured for more than 400 economists at the University of Groningen (The Netherlands) I asked my audience whether they had ever heard of one of the greatest economists of the 19th century, Ludwig von Mises. I was shocked that only 10
hands were raised, mostly of elderly people.

The 'Austrians' recognize that the overoptimism (which it proved to be with the benefit of hindsight) about the new economy had played a major role in the present slump. But in addition they believe that loose monetary policy of the preceding period, which was characterized by a low rate of interest and excessive credit creation, were responsible for the bubble and the subsequent fall of stock values. In their view, the cause of the bursting of the recent bubble was in essence the same as that of the crash of 1929, notably a monetary policy that was not sufficiently restrictive. The same applies to the Japanese crisis of the nineties, which was also preceded by loose monetary policies at the end of the eighties.

According to the Austrians a low rate of interest and credit expansion will spur a temporary economic recovery. But this policy cannot be continued indefinitely. At a certain moment, the interest rate will have to be brought back to a more 'normal' level and credit expansion has to be finished. When this happens prices of stock and property will decline and reveal their 'true' value. Furthermore, many investments will prove to be unprofitable (malinvestments). Their profitability was inextricably linked with the expansionary policy. The moment this policy is abandoned, they are not profitable any more and have to be liquidated. Subsequently economic decline will set in. Then central banks will be tempted to loosen the monetary reigns, whereupon the vicious cycle starts again. Conclusion: loose monetary policies retard the process of inevitable liquidation of malinvestments. One should bear the loss rather sooner than later.

'Once bitten, twice shy?' Not according to the Austrians. They fear that central banks will be tempted to commit the same mistakes again. In other words, they fear that what has happened in Japan is just sort of a dress rehearsal for what will happen in the US and - to a lesser extent - in Europe in the years to come.

Let's hope that they will be wrong. And that is possible if monetary authorities pay heed to their warnings.

Hans H.J. Labohm is senior visiting fellow at the Netherlands Institute of International Relations, 'Clingendael', The Hague.

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