Slabbed takes the regulatory challenge part 2: Which school do you belong to?

Ok folks, we had some fun in part 1 where the good people at econstories.tv contrasted classical economist Friedrich Hayek (Austrian School of Economics) with the father of Keynesian economics John Maynard Keynes via a well done rap song. Our friends over at Greenbackd are unabashed adherents to the Austrian model (Toby has written several excellent posts on the topic) while Team Obama thus far has favored the Keynesian school in their economic policy with programs like stimulus and cash for clunkers. These distinctions are important as they fundamentally shape how their adherents view the regulation of our financial system which is a vital subject given the implosion of our financial system in late 2008. Before I give my thoughts let’s visit with Wiki and get some background, first on the Austrian School:

According to Austrian School economist Joseph Salerno, what most distinctly sets the Austrian school apart from neoclassical economics is the Austrian Business Cycle Theory:

The Austrian theory embodies all the distinctive Austrian traits: the theory of heterogeneous capital, the structure of production, the passage of time, sequential analysis of monetary interventionism, the market origins and function of the interest rate, and more. And it tells a compelling story about an area of history neoclassicals think of as their turf. The model of applying this theory remains Rothbard’s America’s Great Depression.

Austrian School economists focus on the amplifying, “wave-like” effects of the credit cycle as the primary cause of most business cycles. Austrian economists assert that inherently damaging and ineffective central bank policies are the predominant cause of most business cycles, as they tend to set “artificial” interest rates too low for too long, resulting in excessive credit creation, speculative “bubbles” and “artificially” low savings.

According to the Austrian School business cycle theory, the business cycle unfolds in the following way. Low interest rates tend to stimulate borrowing from the banking system. This expansion of credit causes an expansion of the supply of money, through the money creation process in a fractional reserve banking system. This in turn leads to an unsustainable “monetary boom” during which the “artificially stimulated” borrowing seeks out diminishing investment opportunities. This boom results in widespread malinvestments, causing capital resources to be misallocated into areas which would not attract investment if the money supply remained stable. Economist Steve H. Hanke identifies the financial crisis of 2007–2010 as the direct outcome of the Federal Reserve Bank’s interest rate policies as is predicted by Austrian school economic theory.

Austrian School economists argue that a correction or “credit crunch” – commonly called a “recession” or “bust” – occurs when credit creation cannot be sustained. They claim that the money supply suddenly and sharply contracts when markets finally “clear”, causing resources to be reallocated back toward more efficient uses.

Sounds good. I’ll also note Friedrich Hayek predicted the great depression in advance using the concepts thus the Hayek lyrics in the rap song:

The place you should study isn’t the bust
It’s the boom that should make you feel leery, that’s the thrust
Of my theory, the capital structure is key.
Malinvestments wreck the economy

Next up is Keynesian economics courtesy of wiki:

Keynesian economics advocates a mixed economy—predominantly private sector, but with a large role of government and public sector—and served as the economic model during the latter part of the Great Depression, World War II, and the post-war economic expansion (1945–1973), though it lost some influence following the stagflation of the 1970s. The advent of the global financial crisis in 2007 has caused a resurgence in Keynesian thought. The British Prime Minister Gordon Brown and other global leaders have used the theory of Keynesian economics to justify intervening in the world economy.

In Keynes’s theory, there are some micro-level actions of individuals and firms that can lead to aggregate macroeconomic outcomes in which the economy operates below its potential output and growth. Some classical economists had believed in Say’s Law, that supply creates its own demand, so that a “general glut” would therefore be impossible. Keynes contended that aggregate demand for goods might be insufficient during economic downturns, leading to unnecessarily high unemployment and losses of potential output. Keynes argued that government policies could be used to increase aggregate demand, thus increasing economic activity and reducing unemployment and deflation.

Keynes argued that the solution to depression was to stimulate the economy (“inducement to invest”) through some combination of two approaches: a reduction in interest rates and government investment in infrastructure. Investment by government injects income, which results in more spending in the general economy, which in turn stimulates more production and investment involving still more income and spending and so forth. The initial stimulation starts a cascade of events, whose total increase in economic activity is a multiple of the original investment.

A central conclusion of Keynesian economics is that, in some situations, no strong automatic mechanism moves output and employment towards full employment levels. This conclusion conflicts with economic approaches that assume a general tendency towards an equilibrium. In the ‘neoclassical synthesis’, which combines Keynesian macro concepts with a micro foundation, the conditions of general equilibrium allow for price adjustment to achieve this goal.

More broadly, Keynes saw this as a general theory, in which utilization of resources could be high or low, whereas previous economics focused on the particular case of full utilization.

The new classical macroeconomics movement, which began in the late 1960s and early 1970s, criticized Keynesian theories, while New Keynesian economics have sought to base Keynes’s idea on more rigorous theoretical foundations.

Some interpretations of Keynes have emphasized his stress on the international coordination of Keynesian policies, the need for international economic institutions, and the ways in which economic forces could lead to war or could promote peace.

At its heart Keynesian theory is demand based while Austrian theory is supply based thus the Keynes lyrics in the rap song:

You see it’s all about spending, hear the register cha-ching
Circular flow, the dough is everything
So if that flow is getting low, doesn’t matter the reason
We need more government spending, now it’s stimulus season

Other schools of economics, which in my mind are really subsets of the Austrian and Keynesian economic models are Keynesian based Monetary Economics as most notably espoused by the late Milton Friedman and Austrian based New Classical Macroeconomics. I will not further explore those two subsets beyond the links though I will say a solid understanding of monetary economics as applied to the pieces of paper otherwise known as stock certificates will take one far in investing while New Classical Macroeconomics is crap as it is completely underpinned on the notion that humans being are rational creatures that make rational decisions.

Not presented in the econo-rap is the modern-day successor to the Austrian school in Behavioral Economics which we’ll explore courtesy of wiki:

There are three main themes in behavioral finance and economics:

Heuristics: People often make decisions based on approximate rules of thumb, not strictly rational analysis. See also cognitive biases and bounded rationality.

Framing: The way a problem or decision is presented to the decision maker will affect their action.

Market inefficiencies: There are explanations for observed market outcomes that are contrary to rational expectations and market efficiency. These include mis-pricings, non-rational decision making, and return anomalies. Richard Thaler, in particular, has described specific market anomalies from a behavioral perspective.

Barberis, Shleifer, and Vishny (1998) and Daniel, Hirshleifer, and Subrahmanyam (1998) have built models based on extrapolation (seeing patterns in random sequences) and overconfidence to explain security market over- and underreactions, though the source of misreactions continues to be debated. These models assume that errors or biases are correlated across agents so that they do not cancel out in aggregate. This would be the case if a large fraction of agents look at the same signal (such as the advice of an analyst) or have a common bias.

More generally, cognitive biases may also have strong anomalous effects in the aggregate if there is a social contagion of emotions (causing collective euphoria or fear) and ideas, leading to phenomena such as herding and groupthink. Behavioral finance and economics rests as much on social psychology within large groups as on individual psychology. In some behavioral models, a small deviant group can have substantial market-wide effects (e.g. Fehr and Schmidt, 1999).

Devoted Slabbed readers will immediately recognize how the concepts in behavioral economics have profoundly influenced my blogging on insurance related concepts including the failure of certain politicians to extract their heads from their anuses long enough to see what is going on in the dysfunctional coastal wind insurance market. It also accounts for the rationale I used in a recent Yallpolitics post which somewhat explains what is coming in part 3 as we explore public choice theory and its implications for a regulatory framework.

To that special reader for whom this series is dedicated how are we doing so far?

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