Bayesian Investor Blog

Book review: Meltdown: A Free-Market Look at Why the Stock Market Collapsed, the Economy Tanked, and Government Bailouts Will Make Things Worse by Thomas E. Woods Jr.

This book describes the Austrian business cycle theory (ABCT) in a more readable form than it’s usually presented. Its basic idea that malinvestment creates business cycles, and that central bank manipulation of interest rates can cause malinvestment, is correct. But when Woods tries to argue that only errors by a government can cause business cycles, his ideological blinders become obvious. He’s mostly right when he complains about government mistakes, and mostly wrong when he denies the existence of other problems.

He asks why businesses made a “cluster of errors” that added up to a big problem rather than independent errors which mostly canceled each other out. The only answer he can find is misleading signals sent by the Fed’s manipulation of interest rates. He doesn’t explain why businessmen fail to learn from the frequent and widely publicized patterns of those Fed actions. It’s unclear why groupthink needs a strong cause, but one obvious possibility that Woods ignores is that most people saw a persistent trend of rising housing prices, and didn’t remember large drops in housing prices over a region as large as the U.S.

He shows no understanding of the problems associated with sticky wages which are a key part of the better arguments for Keynesian approaches.

He wants to credit ABCT with having predicted this downturn. If you try to figure out when was the last time it didn’t predict a downturn (the early 1920s?), this seems less impressive than, say, Robert Shiller’s track record for predicting when bubbles burst.

His somewhat selective use of historical evidence carefully avoids anything that might present a picture more complex than government being the sole villain. He describes enough U.S. economic expansions to present a clear case that credit expansion contributed to the ensuing bust, and usually points to a government activity which one can imagine caused excessive credit expansion. But he’s unusually vague about the causes of the expansion that led to the panic of 1857. Could that be because he wants to overlook the role that new gold mining in California played in that inflationary cycle?

He mostly denies that free market approaches have been tested for long enough to see whether we would avoid business cycles under a true free market. He points to a few downturns when he says the government followed a wise laissez faire policy, and compares the shortness of those downturns with a few longer downturns where the government made some attempts to solve the downturns. When doing this, he avoids mention of the downturns where massive government actions were followed by mild recessions. Any complete survey comparing the extent of government action with the ensuing economic conditions would provide a much murkier picture of the relative contributions of government and market error than Woods is willing to allow.

The most interesting claim that I hadn’t previously heard is that a large decrease in the money supply in 1839-1843 coincided with healthy GNP growth, which, if true, is hard to explain without assuming Keynesian and monetarist theories explain a relatively small fraction of business cycle problems. My attempts to check this yielded a report at http://www.measuringworth.org/usgdp/ saying GDP in 2005 dollars rose from $31.37 in 1839 to $34.84 in 1843, but GDP per capita in 2005 dollars dropped from $1884 in 1839 to $1869 in 1843. Declining GDP per capita doesn’t sound very prosperous to me (although it’s a mild enough decline to provide little support for Keynesians/monetarists).

He tries to blame the “mistakes” of credit rating agencies on an SEC-created cartel of rating agencies. That “cartel” does have some special privileges, but he doesn’t say what stops bloggers from expressing opinions on bond risks and developing reputations that lead to investors using those opinions in addition to the “cartel”‘s ratings (Freerisk is a project which is planning a sophisticated alternative). I say that anyone who understands markets would expect the yield on the bonds to provide as good an estimate of risk as any alternative. Credit rating agencies must be performing some other function in order to thrive. An obvious function is to mislead bosses and/or regulators who don’t understand markets into thinking that the people making investment decisions are making choices that are safer than they actually are. It appears that the agencies performed that function well, and helped many people avoid being fired for poor choices.

His discussion of whether WWII spending cured the Great Depression points out that mainstream theories falsely predicted a return to depression in 1946. But it’s unclear whether all versions of Keynesianism make that mistake, and it’s unclear how ABCT could predict the U.S. would be much more prosperous in 1946 than at the start of the war.
Here’s an alternative explanation that lies in between those theories: wages were being kept too high for supply and demand to balance through 1941. Inflation and changes in government policy toward wage levels during WW2 eliminated the causes of that imbalance.

Arnold Kling has a good quasi-Austrian alternative here and here.