On February 9th, Rep. Ron Paul of Texas chaired his first meeting of the House Monetary Policy Subcommittee that he now leads due to the Republican victories in last November’s congressional elections. Congressman Paul invited several expert witnesses to testify to the committee on their opinions about monetary policy. Among these were Austrian economist Tom Dilorenzo.
Much has been made of Rep. Lacy Clay’s attack on Dilorenzo’s credibility due to his alleged association with a “politically incorrect” group called the League of the South. However, Clay also attacked the Austrian school of economics itself, calling the “Austrian deductive method a non-rigorous scientific method.” Clay bases this allegation on the fact that Austrian theory is not based upon “an empirical method to study economics.” He refers to the fact that the Austrian school does not recognize the Keynesian theoretical models or the aggregate data that those models rely upon to “prove” their theories scientifically.
However, as Robert Wenzel has pointed out, Nobel Prize winner F.A. Hayek has already addressed this criticism and argued that economists should indeed use the deductive method, rather than an empirical one to understand economic principles. He even suggests that Robert Rubin would likely agree with Hayek’s argument, because of what Rubin called “the very nature of reality–its complexity and ambiguity.”
It is somewhat futile to try to win this argument with entrenched government policy makers. The Keynesian school advocates massive government intervention into the economy in order to protect us from the supposed shortcomings of the free market. When crises in the economy occur, the Keynesians recommend even greater intervention in the form of increased government spending, regulation, and monetary expansion.
The Austrian school advocates no government intervention into the economy at all. They argue that monumental crises are actually caused by intervention, so their cure is to cease whatever intervention has brought on the crisis, to relax regulations that impede adjustment in the labor market, and to allow the economy to rebalance itself through natural market forces.
Therefore, governments are not likely to reject Keynesianism, which grants them enormous power, and listen to the Austrians, who would strip it all away. One is reminded of the medieval governments that refused to acknowledge that the world was round and called upon appointed court scientists to legitimize their assertion that it was in fact flat.
However, it is important for investors to understand which theory within the “dismal science” truly does pass scientific muster. If you cannot dissuade the government from basing their policies on the wrong theory, you can at least choose the right one yourself to protect your own wealth and economic viability.
Anyone who has taken a basic chemistry class in high school remembers how you prove or disprove a theory. You conduct experiments to determine whether the predictions that your theory makes are correct. For example, your theory might predict that mixing two colorless chemicals in a test tube will result in the mixture turning blue. To prove it, you must not only conduct the experiment once, but over and over again, yielding the same result. If your test tube turns blue under the same conditions every time, you have proven your theory. If not, your theory is considered invalid and a new one must be formulated.
Austrian economists like F.A. Hayek predicted the Great Depression when the Keynesians said that the economy was fine. Once the crisis hit, the Austrians argued that the Keynesian policies prescribed to cure it would fail, as they were just an increase in the interventions that had caused the crisis in the first place. When massive government spending and devaluation of the currency failed to pull America out of the Depression, the Keynesians argued that more of the same to underwrite WWII would finally do the trick. Yet, the Depression lasted throughout the war and only subsided when it was over and there were massive cuts in government spending, consistent with the predictions of the Austrians.
The Keynesian answer to this anomaly? Ignore the results and just state that Keynesian policies did cure the Depression, regardless of indisputable facts to the contrary. This is science?
The Keynesians were also explicit that high unemployment and price inflation could never coexist together. The Austrians made no such claims, as they recognized that monetary expansion causes both price inflation and the malinvestment that leads to unemployment. In the 1970’s, Austrian theory was again proven correct and Keynesian theory proven wrong.
Most recently, the Keynesians argued that the technology and housing bubbles were not bubbles at all, but sustainable increases in wealth caused by their wise stewardship of the economy. If you listened to them, you were either wiped out by the NASDAQ crash or left owning a house with an underwater mortgage, or both. If you listened to the Austrians, you got rid of your technology stocks early during the formation of the bubble and avoided buying houses whose price had been bid to unsustainable levels by the combination of monetary expansion and government intervention.
Even after all of this proof is in, the Keynesians are still employing the only defense they have left that their theory is sound. Deny, deny, deny. With government and consumer debt threatening to cause cataclysmic economic collapse, the Keynesians are encouraging government and consumers to borrow and spend more. The Austrians advise consumers to pay down their debts and investors to avoid the next bubble. They urge investors to protect their wealth in gold and other commodities, as they have for the past decade. Those that have listened to them have turned huge profits during this historic economic calamity.
Imagine that you are back in your high school chemistry class lab, conducting experiments. In the row behind you, an Austrian economist is testing his theory. The test tube turns blue one time after another, just as he predicted it would. In the row ahead, a Keynesian economist is testing his theory. His test tube turns a different color every time and then finally explodes, lighting his beard on fire. Which one would you deem the better scientist? Which one would you bet your life savings upon in the next experiment? If you wish to take the scientific approach, listen to the Austrians.
© Thomas Mullen 2011