The Skyscraper Curse: And How Austrian Economists Predicted Every Major Economic Crisis of the Last Century

To reiterate, the Austrian business cycle theory (ABCT) shows that artificially low interest rates produce systematic distortions in the economy. The most important of these distortions is the inducement to build longer structures of production and more roundabout production processes involving advanced or premature technologies. It is during the resulting boom when all the mistakes or malinvestments occur in a temporal cluster. The bust or economic crisis is when these errors are later revealed. While ABCT has been under critical internal review,1 more recent works2 have found that ABCT has a “general validity.”

Although it is very difficult to model ABCT empirically, several empirical investigations have taken place with supportive results.3 ABCT has also been proven useful in analyzing historical business cycles.4

The Austrian answer for the economic crisis is similar to the RBCT’s (real business cycle theory) rejection of the effectiveness of stimulative fiscal policy and monetary policy. However, ABCT does have a “positive” side to it. In general, government should follow a philosophy of laissez-faire. First, stop the inflation, raise interest rates, and achieve market-determined interest rates. Second, do not enact any policy that attempts to reduce bankruptcy or unemployment. Third, do not attempt to interfere with prices, wages, consumption, and saving.

This would allow the market’s corrective process to proceed at a fast pace to end the economic crisis quickly. On the active positive side, government should cut its budget, its taxes, and all types of regulations and prohibitions in order for more resources to be used productively and efficiently in the private sector. Following these policy recommendations would result in an economic crisis that is painful, but short.

The opposite policy approach to laissez-faire, which employs bailouts and monetary and fiscal stimulus, results in economic crises that are much more painful and prolonged. Examples of this include the Great Depression, the stagflation of the 1970s, Japan’s lost decade(s), and the current financial crisis. The Austrian policy approach tends to hurt the wealthy relatively more than the middle and lower income classes, while mainstream policy approaches tend to hurt the middle- and lower-income classes and to help the rich.

When interest in ABCT by the general public increased significantly after the housing bubble burst, it was largely ignored by mainstream economists. Eventually some economists started to make criticisms that were more like witticisms, such as when Nobel Prize–winning economist Paul Krugman labeled ABCT the “hangover theory.” More recently ABCT has experienced multiple attacks by notable mainstream economists. This could be a good sign if you believe in an idea often attributed to Mahatma Gandhi: “First they ignore you, then they ridicule you, then they fight you, and then you win.”

Criticisms of the Hydraulic Version of ABCT

The hydraulic version of ABCT is the one described by Gottfried Haberler.5 It could be described as a mainstream translation of ABCT as developed by Mises, Hayek, and Rothbard, with several critical divergences. Nevertheless, this version was surprisingly seized upon by economists in order to criticize ABCT.6

Their basic point is that if investment goes up in the boom, consumption should go down; and during the bust when investment goes down, consumption will ipso facto go up. They conclude consumption did not go up in the bust — it went down significantly — and therefore ABCT has been disproven by the facts.

Instead of ABCT, what the critics are arguing against is a simple mainstream two-sector overinvestment theory of the business cycle. However, Austrian economists do not embrace an overinvestment theory, but rather a malinvestment theory. During the boom consumption does not go down but goes up for two reasons. First, the lower interest rate discourages savings and encourages consumption, and second, and more importantly, the wealth effect or net-worth effect of higher wages, asset prices, stock prices, and real estate prices encourages people to consume more. Consumers draw down their illusionary wealth because on paper they can afford it.

With people drawing down their true wealth they will actually be consuming their savings and wealth, and this implies that there will likely be less overall investment, not more, during the boom. During the bust phase, consumption will be relatively strong compared to capital investment, but because of unemployment, lower wages, a negative wealth effect and a general malaise among entrepreneurs, there will hardly be a boom in consumption. The fact that some mainstream economists would base their criticisms on an obscure and flawed presentation of ABCT could be an indication of malicious intentions. Salerno gave an in-depth analysis of this criticism of ABCT.7

The Rational-Expectations Critique — Why Can’t Entrepreneurs Learn?

ABCT has been criticized on the basis of rational-expectations theory. The critics argue that rational entrepreneurs could not be continuously fooled by artificially low interest rates. Based on entrepreneurs’ past experience and analysis of current market conditions, the critics ask, why would they be systematically fooled by the central bank?8

As I have emphasized throughout this book, the distortions in credit markets from artificially low interest rates are not something that is obvious to the casual observer, and the amount of distortion between the market rate and the natural rate is not known definitively by anyone. What we do know is that when you leave your ivory tower and investigate the economy, you will find that some entrepreneurs, bankers, and market analysts have the experience to detect the possibilities of such market distortions.

These people could act more cautiously, withdraw from certain markets, or require greater risk premia in their dealings. The problem for these people is that their competitors are acting in a boom market where everyone is seemingly making large profits and capital gains. Either you join the party or you get replaced. I have seen this displacement effect in the construction industry, banking, and even on CNBC.

ABCT shows that as the amount of loanable funds expands, less creditworthy borrowers will enter the market. Several economists have explored this adverse-selection argument at length.9 Austrians see entrepreneurs as rational, but they also realize that the success or failure of a venture is dependent on many factors that cannot be known in advance. Easy-credit policies let more entrepreneurs into the process, the results of which are known not instantaneously, but only as or shortly after these long-term capital projects near or reach completion.

What about Nineteenth-Century Panics?

ABCT has also been criticized for blaming the business cycle on the Federal Reserve when in fact there were business cycles in the nineteenth century before the Fed existed. I have already addressed this criticism in chapter 2 on the history of the skyscraper curse. ABCT actually blames the central bank and the fractional-reserve banking system. Even mainstream economists agree that the panics from the time of the Civil War to the time of World War I were caused by the National Banking Acts. The acts’ requirements ensured that bank deposits were structured in an unstable manner. Many also agree that business cycles prior to the Civil War were caused by the First and Second Banks of the United States, which were pseudo central banks.

What about Robert Murphy’s Prediction of Double-Digit Inflation?

Critics of the Austrian school of economics have been throwing barbs at Austrians such as Robert Murphy because there is very little inflation in the economy. Of course, these critics are speaking about the mainstream concept of the price level as measured by the Consumer Price Index (CPI).

Let us ignore the problems with the concept of the price level and all the technical problems with the CPI. Let us further ignore the fact that this has little to do with Austrian business cycle theory, despite what the critics would like to suggest. The basic notion that more money (i.e., inflation) causes higher prices (i.e., price inflation) is not a uniquely Austrian view. It is a very old and commonly held view by professional economists and is presented in nearly every textbook that I have examined.

This common view is often labeled the quantity theory of money. Only economists with a mercantilist or Keynesian ideology even challenge this view. However, only Austrians can explain the current puzzle: why hasn’t the massive money printing by the central banks of the world resulted in higher prices?

Austrian economists such as Ludwig von Mises, Benjamin Anderson, and F. A. Hayek saw that commodity prices were stable in the 1920s but that other prices in the structure of production indicated problems related to the monetary policy of the Federal Reserve. Mises, in particular, warned that Fisher’s “stable dollar” policy, employed at the Fed, was going to have severe ramifications. Absent the Fed’s easy-money policies of the Roaring Twenties, prices would have likely fallen throughout that decade.

So let’s look at the prices that most economists ignore and see what we find. There are some obvious prices to look at, such as the price of oil. Mainstream economists really do not like looking at oil prices: they want them taken out of the CPI along with food prices, and Ben Bernanke says that oil prices have nothing to do with monetary policy and that oil prices are governed by other factors.

As an Austrian economist, I speculate that in a free market economy, with no central bank, the price of oil would be stable. I further speculate that in the actual economy with a central bank, the price of oil would be unstable and oil prices would reflect monetary policy in a manner informed by ABCT.

That is, artificially low interest rates generated by the Fed would encourage entrepreneurs to start new investment projects. This in turn would stimulate the demand for oil (where supply is relatively inelastic in the short run), leading to higher oil prices. As these entrepreneurs would have to pay higher prices for oil, gasoline, and energy (and many other inputs) and as their customers would cut back on demand for the entrepreneurs’ goods (in order to pay higher gasoline prices), some of the entrepreneurs’ new investment projects would turn from profitable to unprofitable. Therefore, you should see oil prices rise in a boom and fall during a bust. That is pretty much how things work.

As you can see, the price of oil was very stable when we were on the pseudo gold standard. The data also show dramatic instability during the fiat paper-dollar standard (post-1971). Furthermore, in general, the price of oil moves roughly as Austrians would suggest, although monetary policy is not the sole determinant of oil prices and obviously there is no stable numerical relationship between the two variables.

Another commodity that is noteworthy for its high price is gold. The price of gold also rises in the boom, and falls during the bust. However, since the last recession officially ended in 2009, the price of gold actually doubled. The Fed’s zero interest rate policy has made the opportunity cost of gold extraordinarily low. The Fed’s massive monetary pumping created an enormous spike in the price of gold. No surprise here.

Actually, commodity prices increased across the board. The Producer Price Index for commodities shows a similar pattern to oil and gold. The PPI (Producer Price Index) commodity index was more stable during the pseudo gold standard, with more volatility during the post-1971 fiat-paper standard. The index tends to spike before a recession and then recede during and after the recession.

High prices seem to be the norm. The US stock and bond markets are at, or near, all-time highs. Agricultural land in the United States reached an all-time high. The contemporary-art market in New York is booming, with record sales and high prices. The real estate markets in Manhattan and Washington, DC, are both at all-time highs as the Austrians would predict. That is, after all, where the money is being created, and the place where much of it is injected into the economy.

This doesn’t even consider what prices would be like if the Fed and world central banks had not acted as they did. Housing prices would be lower, commodity prices would be lower, and the CPI and PPI would be running negative. Low-income families would have seen a surge in their standard of living. Savers would get a decent return on their savings.

Of course, the stock market and the bond market would have seen significantly lower prices. Bank stocks would have collapsed, and the bad banks would have closed. Finance, hedge funds, and investment banks would have collapsed. Manhattan real estate would be in the tank. The market for fund managers, hedge fund operators, and bankers would have evaporated.

In other words, what the Fed chose to do ended up making the rich richer and the poor poorer. If it had not embarked on the most extreme and unorthodox monetary policy in memory, the poor would have experienced a relative rise in their standard of living and the rich would have experienced a collective relative decrease in their standard of living.

There are other major reasons why consumer prices have not risen in tandem with the money supply in the dramatic fashion of oil, gold, stocks, and bonds. It would seem that the inflationary and Keynesian policies followed by the United States, Europe, China, and Japan resulted in an economic and financial environment where bankers were afraid to lend, entrepreneurs were afraid to invest, and everyone is afraid of the currencies they are forced to endure.

In other words, the reason why consumer price-inflation predictions failed to materialize is that Keynesian policy prescriptions such as bailouts, stimulus packages, and massive monetary inflation have failed to work and have indeed helped wreck the economy.

• 1See Jeffrey Rogers Hummel, “Problems with Austrian Business Cycle Theory,” Reason Papers 5 (Winter 1979): 41–53, and Jörg Guido Hülsmann, “Towards a General Theory of Error Cycles,” Quarterly Journal of Austrian Economics 1, no. 4 (1997): 1–23.
• 2Joseph T. Salerno, “Comment on Gordon Tullock, ‘Why Austrians are Wrong About Depressions,’” Review of Austrian Economics 3 (1988): 141–45. Reprinted in Joseph T. Salerno, Money Sound and Unsound (Auburn, AL: Mises Institute, 2010), pp. 325–31; William Barnett and Walter Block, “On Hummel on Austrian Business Cycle Theory,” Reason Papers 30 (Fall 2008): 59–90; Mihai Macovei, “The Austrian Business Cycle Theory: A Defense of Its General Validity,” Quarterly Journal of Austrian Economics 18, no. 4 (2015): 409–35.
• 3C. Wainhouse, “Empirical Evidence for Hayek’s Theory of Economic Fluctuations,” in Money in Crisis, edited by B. Siegel, (San Francisco: Pacific Institute for Public Policy Research, 1984), pp. 37–71; P. le Roux, and M. Levin, “The Capital Structure and the Business Cycle: Some Tests of the Validity of the Austrian Business Cycle in South Africa,” Journal for Studies in Economics and Econometrics 22, no. 3 (1998): 91–109; James P. Keeler, “Empirical Evidence on the Austrian Business Cycle Theory,” Review of Austrian Economics 14, no. 4 (2001): 331–51; Robert F. Mulligan, “A Hayekian Analysis of the Term Structure of Production,” Quarterly Journal of Austrian Economics 5, no. 2 (2002): 17–33, and “An Empirical Investigation of the Austrian Business Cycle Theory,” Quarterly Journal of Austrian Economics 9, no. 2 (2006): 69–93.
• 4A.M. Hughes, “The Recession of 1990: An Austrian Explanation,” Review of Austrian Economics 10, no. 1 (1997): 107–23; Jeffrey M. Herbener, Herbener, “The Rise and Fall of the Japanese Miracle,” Mises Daily, September 20, 1999; Benjamin Powell, “Explaining Japan’s Recession,” Quarterly Journal of Austrian Economics 5, no. 2 (2002): 35–50; Gene Callahan, and Roger W. Garrison, “Does Austrian Business Cycle Theory Help Explain the Dot-Com Boom and Bust?” Quarterly Journal of Austrian Economics 6, no. 2 (Summer 2003): 67–98; Patrick Newman, “The Depression of 1873–1879: An Austrian Perspective,” Quarterly Journal of Austrian Economics 17, no. 4 (Winter 2014): 474–509, and “The Depression of 1920–1921: A Credit Induced Boom and a Market Based Recovery?” Review of Austrian Economics (January 2016): 1–28.
• 5Gottfried Haberler, Prosperity and Depression: A Theoretical Analysis of Cyclical Movements (Lake Success, NY: United Nations, 1937).
• 6Tyler Cowen, “Paul Krugman on Austrian Trade Cycle Theory,” Marginal Revolution, October 14, 2008; Bradford DeLong, “I Accept Larry White’s Correction.…” Cato Unbound, December 11, 2008; John Quiggin, “Austrian Business Cycle Theory,” Commentary on Australian & World Events from a Social Democratic Perspective, May 3, 2009; Bryan Caplan, “What’s Wrong with Austrian Business Cycle Theory?” EconLog, January 2, 2008.
• 7Joseph T. Salerno, “A Reformulation of Austrian Business Cycle Theory in Light of the Financial Crisis,” Quarterly Journal of Austrian Economics 15, no. 1 (Spring 2012): 3–44.
• 8This criticism has already been addressed by several economists, such as Lucas Engelhardt, “Expansionary Monetary Policy and Decreasing Entrepreneurial Quality,” Quarterly Journal of Austrian Economics 15 no. 2 (Summer 2012): 172–94; Anthony J. Evans and Toby Baxendale, “Austrian Business Cycle Theory in Light of Rational Expectations: The Role of Heterogeneity, the Monetary Footprint, and Adverse Selection in Monetary Expansion,” Quarterly Journal of Austrian Economics 11, no. 2: 81–93 (2008); William Barnett II, and Walter Block, “Professor Tullock on Austrian Business Cycle Theory,” Advances in Austrian Economics 8 (2005): 431–43; and Anthony M. Carilli, and Gregory M. Dempster, “Expectations in Austrian Business Cycle Theory: An Application of the Prisoner’s Dilemma,” Review of Austrian Economics 14, no. 4 (2001): 319–30. For a review of these arguments, see Nicolás Cachanosky, “Expectation in Austrian Business Cycle Theory: Market Share Matters,” Review of Austrian Economics 28, no. 2 (2015): 151–65.
• 9Evans and Baxendale, “Austrian Business Cycle Theory in Light of Rational Expectations”; and Engelhardt, “Expansionary Monetary Policy and Decreasing Entrepreneurial Quality.”