Savings and Investment (5) - Austrian Solution

Austrian economists propose a different solution. They suggest that the government should do nothing and let the dislocation work its way out of the economy. Unfortunately, if the dislocation has been really severe, businesses in category A and B will have to make massive cuts in production. This will lead to high levels of unemployment that reduces demands for the output of business in category C. Category A businesses will shrink more than is necessary.

Category C businesses, which should be the majority, will have to reduce production, when we really need them to increase production.

The Austrian solution is better in the longer term, as it allows the economy to move towards an optimal use of capital. This is the correct solution, but it may be very painful in the short. Very few people will choose short term pain for long term gain, so few governments will choose the Austrian solution.

I am not sure about which is the best policy. The short term pain of the correct solution may be so awful, that we might be best not to go there yet. Living in comfort has made he people of the west so soft, that we are so grossly unprepared for dealing with a tough economic adjustment. We might be better to live a while longer with suboptimal economic performance until we are ready to deal with real and costly change.

Of course, the Austrians are right. The best that governments can do is postpone the adjustment. We will have to face the day of reckoning eventually.

The real moral of the story is that getting into a situation where the only choice is between painful medicine and medicine that does not work well is foolish. Allowing central banks to distort an economy by manipulating interest rates is a journey down a “no exit” road.