Bruce Caldwell is the Research Professor of Economics and Director of the Center for the History of Political Economy at Duke University.
He is one of the world’s pre-eminent Hayek scholars, and editor of The Collected Works of F.A. Hayek. Regular readers will know that it was Hayek who gave me the inspiration to set up the Cobden Centre.
In this contemporary article, Caldwell provides ten lessons from the past, which he brings to life and relates to the circumstances we find ourselves in today.
As it is a lengthy article, I’ve summarized it below with interpretation and comments of my own.
1. The business cycle is a necessary and unavoidable concomitant of a money-using market economy
Hayek in Monetary Theory and the Trade Cycle said
So long as we make use of bank credit as a means of furthering economic development we shall have to put up with the resulting trade cycles.
Caldwell points out that
It was in The Constitution of Liberty that Hayek described money as “a kind of loose joint in the otherwise self-steering mechanism of the market”
It should be noted that Hayek did advocate 100% reserves during parts of his academic life. This would, of course, stop stone cold any credit-created business cycle. I draw these references to the reader’s attention:
- Money, Capital, and Fluctuations: Early Essays, R. McCloughry, ed.
(Chicago, Ill.: University of Chicago Press, 1984). Chapter 1 in particular.
- Prices and Production and Other Works: F. A .Hayek on Money, The Business Cycle, and The Gold Standard (Mises 2008). Page 411 in particular.
Like most economists, Hayek could not define money, so he said that 100% reserves were the right direction to go, but noted that further thought was required.
Readers will know I favour Free Banking within the normal commercial and contract law, which would apply as it does with all commercial companies, leading to the full preservation of the creditors’ position. This will go a long way to making sure money or credit is not the problem in any future business cycle. I explain this position here.
In describing the Austrian Theory of the Business Cycle, Caldwell gives two fantastic contemporary examples of how attempts to stimulate the economy will in fact perpetuate boom and bust.
In late December 2008 GMAC, the lending arm of General Motors, was given a 6 billion dollar bailout by the Bush administration. What did they do with it? Within a day the radio and television were filled with ads saying that GMAC was now providing zero interest loans and lowering its minimum required credit scores from 700 to 621. For perspective, note that the “sub-prime” designation applies to loan applicants with credit scores of 660 and below.
The other example is the tax credit carrying a maximum value of $8000 offered by the federal government in 2009 for first time homebuyers. The idea, I suppose, was that this would help reduce the inventory of existing homes. Unfortunately it led to a mini-boom (which began showing up in the June housing statistics) in the construction of new single family homes. In other words, this policy further increased the supply of housing at a time when the evident problem was an excess supply of housing.
Caldwell also mentions that several eminent Austrian economists have made proposals along the lines of Hayek in their efforts to promote policies aimed at “tightening up the loose joint of money”. To these I would add De Soto’s proposal, which I summarize here.
2. The 1970s and why Keynesian economics was rejected
We are reminded in this section how the monetization of the debt of the state is “a precisely calibrated income tax surcharge.”
We are also reminded that in recent history, as near as the 1970’s and 80’s, we learned why we did not want to continue down the Keynesian path.
In short, the worst recession since the great depression 1) was consciously policy-induced, and 2) was made necessary by the failed attempts at activist discretionary counter-cyclical policy during the previous decade and a half. This history needs to be recounted! It is hard to imagine a more vivid cautionary tale, and explains why Keynesian demand management policy went so rapidly into eclipse three decades ago.
3. Some regulation is necessary, but….
Caldwell addresses the common assertion that increased regulation is the key to avoiding recessions.
Hayek faced an analogous dilemma in 1930s. Free market capitalism had apparently collapsed, and the favored solution to the problems of the depression was again more regulation, which then went under the rubric of “planning.” Indeed, his friend Lionel Robbins (1937, p. 3) described planning as “the grand panacea of our age.” The problem was, then as now, that the word “planning,” like the word “regulation,” can mean just about anything.”
It sounds to me like history is repeating itself and we have learned nothing! Despite grandiose claims from politicians, regulation over the last 80 years has not protected us from boom and bust!
4. … a lot of regulation, what Hayek called ‘legislation,’ is fraught with problems, and can make matters worse
Regulation also inserts uncertainty, or as Hayek put it, “…the more the state ‘plans,’ the more difficult planning becomes for the individual” (Hayek  2007, p. 114). There was plentiful evidence of the adverse effects of regime uncertainty in the recent downturn. In the fall of 2008, each announcement by the Fed and Treasury, meant to reassure the markets, produced more and more panic. It also froze people into inaction. One could imagine the decision-making process that took place in many people’s minds. Should I hold onto my house that is underwater, in the hopes of a government bailout? Should I buy a car now that the prices are low, or wait for some government program that will cause them to fall even lower? A stimulus plan is coming, and I don’t know what it will look like; probably best to delay all decision-making for now, to wait and see. Over and over again we encounter examples of people basing their decisions on trying to guess what the government is going to do. Contrast this with what happens in well-functioning markets, where people make their decisions principally by looking at changes in market prices, prices that reflect underlying scarcities.
I could not add anything to that!
Also, a great point that we should never forget:
“Who is to watch the regulators? The most notorious example here is probably still the inglorious episode of the Keating Five. The Austrians would note that the market provides its own very effective regulators: they go by the names of profit and loss.
5. The economy is an example of an essentially complex phenomenon, for which precise forecasting (on which the construction of rational policy depends) is ruled out.
It is important to be clear: this does not mean that policy-makers cannot get things right when it comes to managing the economy as a whole. It is just that sometimes stabilization policy stabilizes the economy, and sometimes it destabilizes it, and we usually can’t tell in advance, and sometimes not even in retrospect, which scenario is unfolding or has unfolded.
6. The two sides of unintended consequences when dealing with complex orders.
Following Menger, the founder of the Austrian School, [Hayek] pointed out that many beneficial social institutions have emerged gradually and spontaneously throughout human history. No one, for example, invented language, perhaps the most useful and universal of human institutions … The bad side of unintended consequences is that many attempts to impose our will on the complex adaptive system that is the economy cause things to happen that were no part of our original intention.
7. Basic economic reasoning captures what we can know and say about the essentially complex phenomenon that we call the economy
Learn how to reason in a logical fashion and a lot of mistakes can be avoided. There is a great story of an encounter that Caldwell had as a student with Milton Friedman.
8. But what about social justice?
Beware of trying to engineer outcomes, as Hayek says in The Constitution of Liberty
From the fact that people are very different it follows that, if we treat them equally, the result must be inequality in their actual position, and that the only way to place them in an equal position would be to treat them differently. Equality before the law and material equality are therefore not only different but are in conflict with each other; and we can achieve either the one or the other, but not both at the same time.
Caldwell concludes this great section by saying
From this perspective, the extension of free markets, while leading to income inequality, simultaneously increases the total size of the pie to be shared, and thereby benefits mankind as a whole. There are many ways to think about “social justice.” Advocates of markets would do well to emphasize benefits that extend to the world as a whole.
9. The basic Hayekian insight – how freely adjusting market prices help solve the knowledge problem and allow social coordination.
The flip side of Hayek’s insights provides a warning to those who seek to improve on markets. Two sorts of errors are possible. The first is not to recognize that for the vast coordination mechanism to work, agents must be allowed to act on their knowledge, and prices must be allowed freely to adjust. Many “reforms,” of course, do just the opposite, seeking to restrict entry into markets, or keep prices from adjusting, on the grounds of protecting the consumer, or assuring the quality of a product or service, or supporting diversity or equity or balance or fairness, and so on. The second is assuming that decision-makers have more knowledge than they do. Hayek admitted that if we had more knowledge we could do a lot more to improve the world. But we don’t. And in the world we live in – a world of dispersed knowledge – much of the knowledge we actually do possess is due to the workings of the market mechanism.
10. The basic public choice insight – why government cures so often are not only worse than the disease, but lead to further disease.
Caldwell reminds us here that in the 1970’s and 80’s we learned from the Public Choice School exactly why officials will budget maximize as opposed to profit maximize. He offers wise counsel to all of the legislators who read this site that
The list of ills that public choice theorists have identified lead one to a general three step principle that if followed can help to minimize the impact of government intervention. In capsule form: Negotiation (as occurs in market exchange) is always preferable to adjudication. If negotiation fails, adjudication that clarifies rights is always preferable to legislation. Only if both negotiation and adjudication fail should one turn to legislation. Unfortunately, too often legislation is the first and only step.
A great article.
I hope you learn at least as much from it as I did.