The Current Economic Problems

I've not really commented on the current developments in the sub prime crisis, and there's a lot of interesting articles out there. However I do want to correct a fear I have about the mis-characterisation of what Austrian Economics has to say about these events, and use as evidence comments I've made before things started to turn bleak.

My motivation stems from this piece in the Guardian by Larry Elliot, their economics editor. He says:

The libertarian right comes to a similar conclusion but for a different reason. Using the analysis developed by the Austrian school of economists - Ludvig von Mises and Friedrich von Hayek - it argues that markets will cure themselves, with state intervention not only in vain but ultimately damaging. The analogy is of a forest fire, which if allowed to burn itself out allows healthy new growth to emerge.

Imagine if an alcoholic is admitted to hospital and the doctors have a conversation:

Dr A (representing the consensus of doctors in this area): He's been drinking heavily for the last few years, he's going to be really upset if we don't let him drink. Best thing is to get a few cans of Special Brew

Dr B (an obscure maverick people often mention but never take the time to understand): Erm, alcoholism is bad. He needs to stop drinking and those who've kept giving him a drink should be struck off

It would be pretty ridiculous to paint Dr B as a callous bastard for wanting to create hardship for the patient. He's the only one who seems to have actually diagnosed the underlying problem, and come up with a solution to cure it (rather than just prolong things and hope for the best). As a commentator to Elliot says:

Larry, the Austrians would let the banks burn in a virtual forest fire, and the directors would go into the fire and not escape with the loot. But, the Austrians measures would never have let the situation reach this stage. Without Central Bank distortion of the money supply and non-market setting of the interest rates, causing malinvestment from these bad economic signals, and without the credit created by overt fractional reserve banking and derivatives(another form of fractional reserves), there would never have been enough credit to ignite this unsustainable boom and now the proportionate bust. Prevention is the best cure, but nothing can remedy where we are now.

I think it's intellectually misleading to say that the Austrian's contribution is to simply blurt out "creative destruction". There is strong and robust evidence to show that Austrian's diagnosed this problem in the 1920s (and I''ve alluded to it on many occasions) and nothings changed. Governments still monetise their debt to create asset bubbles, and monetary policy isn't how government controls the economy, it's how (good) economists control government - i.e. dynamic inconsistency, Lucas critique etc.

The problem is that when the FRC accept responsibility for the current credit crunch, us consumers let them off the hook by retaining our support for the underlying regulatory system. In other words they say "ok we messed up, but we'll do better next time" and we respond "ok, have some more powers". We should be sacking these guys, not rewarding them!

My concern is that we're not learning the real reasons for what's happened, and are opting for the simplistic "sweep it under the rug" solution of opting for greater regulatory zeal. This is problematic for at least two reasons:

1. The people in the finance industry who invent complex financial instruments are probably more knowledgeable than regulators, and this poses a real difficulty for a "if we don't understand it, regulate it" mentality. High finance is complex, and will inevitably become more so
2. There will always be off balance sheet activity, and evasion. Since we cannot create a system of full transparency we have to accept that firms will engage in activity that is difficult to monitor. Indeed that's often the source of their competitive advantage! So the greater the regulatory burden on balance sheet activities, the greater the incentives to push normal, value-creating enterprise into off balance sheet activities.

As John Kay recently said:

The state cannot ensure the stability of the financial system and a serious attempt to do so would involve intervention on an unacceptable scale.

At the moment investors expect and demand for activity to be occurring off balance sheet because of the scale of ordinary regulation. Attempts to reach deeper and deeper into the complexities of the system will simply incentivise more complexity and this is untenable. Ideally the regulatory system would scale back, and reduce the burden on those institutions that wish to operate with transparency. That would give us all a reasonable choice as to how we wish to manage our investments, and the risks that they entail.