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Friday, August 30, 2019

Bringing Austrian and Keynesian Theory Together

Is it possible to fit Austrian and Keynesian economic theory under one roof? This article answers that question, with reference to the threat of America becoming a sub-zero interest rate economy.


In two articles I have used, respectively, Keynesian and Austrian economic theory to explain  the emerging sub-zero economy. These are two theories that rarely meet in a solid analytical environment, and a blog article is too small a format to explore the full potential of merging these two theories. However, focusing again on the major issue of negative interest rates across the economy, we can draw a couple of interesting conclusions from these two theories. 

Austrian theory is an excellent tool for analyzing distortions in the allocation of economic resources. In a nice, basic application of Austrian economic theory, Austin Hein, formerly with Wyoming Liberty Group, explained how one kind of government spending - economics development - distorts resource allocation by upfronting spending and eroding long-term investments.  

The misallocation of economic resources

When central banks engage in sub-zero interest rate policies they affect the economy principally in the same way. Their distortion of the free market has two channels. 

The first is the negative interest rate itself. This rate destroys the market for risk assessment: with interest rates negative, ignoring risk is no longer distinguished from responsible risk assessment. Since risk by definition is an intertemporal term, government manipulation of the price on risk-taking will over-allocate resources to the present time and under-allocate it for the future. 

Austrian economists define this as the beginning of a recession. In our context, with interest rates parked permanently in the negative, the effect would be an increasingly short-term outlook on the commitment of economic resources. Speculation in equity markets will become increasingly prominent in investor portfolios, while productive, long-term investments will lose out. 

The second channel through which the sub-zero rate affects the economy is by means of government spending. We must not forget that these sub-zero rates have become reality on the treasury bond market because governments keep spending more than taxpayers can afford. Therefore, a full picture of the damage done by sub-zero rates must include the distortionary effects of government spending. These effects include the consequences of taxation. 

No tax leaves the economy unaffected, but there is a bracket of taxation within which the private sector can accommodate and work around the cost of government and still be relatively productive. That does not mean the distortions from government are negligible - all it means is that the weight of government is bearable.

When taxes reach a certain point, though, it is no longer economically reasonable for the private sector to invest money in tax-accommodating measures. The profits and other benefits from adjusting business operations and workforce participation to taxes, simply fall short of the cost of making those adjustments. At this stage, the private sector begins stagnating; commitment of capital and labor for the future gradually fades away. 

At this point, there is a permanent slowdown in economic growth. This directly affects the government budget, as the tax base erodes relative spending. However, economic stagnation is also driven by high, sustained levels of government spending: government is almost by definition less efficient than the private sector.

In theory, when the tax burden begins to take this long-term toll on private-sector economic activity, the political system would respond by reining in taxation - and spending. This has happened in the United States on a couple of occasions, but only when it comes to taxes. There has never been a concerted effort to actually bring government spending down to where it is sustainably affordable to taxpayers. 

As a result of a lopsided focus on tax reform, Congress has slowly aggravated the distortionary effect from government spending. This effect, which has been much more pronounced in Europe, means that government - the inefficient and market-distorting component of the economy - continues to grow relative the private sector, allocating economic resources to the present and less to the future. By means of this disallocation from investments in favor of government consumption, productive investments suffer, and so does economic growth. 

Fundamental uncertainty, investments and consumer spending

Keynesian economic theory reaches a similar conclusion, albeit from a different perspective. Its core theoretical concept is "fundamental uncertainty", which differs from "risk" in that it cannot be quantified. In times plagued by high uncertainty, investors pull back from long-term commitments so as not to risk their capital. As one of my favorite economists, Paul Davidson, once put it: "In times of uncertainty, he who hesitates is saved to make a decision another day."

To deal with uncertainty, we create price contracts. Their purpose is to become conveyors of confidence into the future: the more prices we contract, the more confident we are that we can manage our personal finances in the future. Likewise, price contracts help businesses and investors become more confident in the future and commit more resources to investments in that future. 

The interest rate is one of the prices that, when predictable, helps foster confidence among economic decision makers. However, in order to do so it needs to be mutually beneficial for both parties; a negative interest rate punishes the lender while benefitting the borrower. With this crucial intertemporal price going negative, and its sub-zero values spreading across the economy from treasury bonds to corporate bonds, it exacerbates uncertainty rather than mitigating it. 

When uncertainty spreads through the economy, two things happen. The first is a pullback by investors from investment in the sovereign and corporate debt markets. This increases holdings of highly liquid assets, but since speculation is now the only way to make money on financial markets, there will be more money going toward the stock market. 

The second effect is a decline in consumer spending. I established the connection between uncertainty and consumer spending in my doctoral thesis a long time ago, but the topic has remained under-researched since then. This is unfortunate (and obviously in part my fault) since a more detailed understanding of uncertainty and consumer spending would help us gauge the longer-term effects of the rise and fall of uncertainty in our economy. Nevertheless, the basic mechanism here is that which Keynes captured so well in his "sundry observations" chapter in General Theory: when a consumer decides to not spend money today, he does not automatically make a decision to spend that same money at some future point in time. He, again, prefers to make a decision another day.

Negative interest rates affect consumers directly by distorting their long-term savings plans. Indirectly, households feel the growth of business uncertainty through the labor market. When businesses become more short-termed in their planning, they prefer to have a more flexible relationship with their workforce. In plain English, this means keeping more people on temporary contracts, using more temporary surges in work time, shifting to consultants rather than employees, and so on. 

When workers experience growing uncertainty as to the long-term stability of their earnings, they reduce their spending commitments relative their income. This was, in fact, one of the most solid findings I reported from the empirical part of my dissertation. It stands to reason, too: if your income becomes more flexible, you simply try to avoid having recurring bills that add up to more than what you expect to be your minimally tolerable standard of living. 

In other words, just as with Austrian theory, Keynesian theory tells us that sub-zero interest rates will erode the commitment we all make to the future. Economic activity, in the aggregate, will become more short-sighted and overall weaker than it otherwise would have been. 

The overall conclusion from this combined theoretical analysis is rather serious. If our governments, both in America and in Europe, continue their erosion of the private sector by over-spending and recklessly using money supply to fund it (of which the negative interest rate is a necessary consequence) they will push us to a point where we will experience a structural implosion of our economies. It is almost impossible to recover from such an implosion; it may take generations. This situation is aggravated by the fact that the United States and Europe together represent close to half the global economy. Long-term stagnation in that big a part of the world is going to have crippling effects on the rest of the world. 

That stagnation has already begun. We are exacerbating it by means of reckless government deficits, and now we are going to perpetuate it by printing gobs of money, pushing interest rates negative, just to fund excessive government spending. 

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