My apologies for a long article, but this is a very important topic.

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When someone titles his article “The Bankruptcy of Governments” it attracts interest from every friend of economic freedom. If the piece is well-written, it makes a valuable contribution to the intellectual battle over the future of Western Civilization. We need more of intellectually sharp contributions and less of ill-founded demagoguery. Our followers on the political side of the arena are inspired by us, bring our arguments and our analysis to the legislative hallways and try to get laws and budgets passed that will change economic policy and the role of government in the better direction.

If we get it right, all the way from good analysis to good policy decisions, we win – and more importantly: everyone else wins when we all benefit from more economic freedom. The wealthy can invest and improve businesses under more liberty; the poor and needy get more opportunities to improve their lives; creative, entrepreneurial people get more opportunities to build new businesses.

However, if we get our analysis wrong our cause is badly hurt. In theory, it does not matter where the mistake is made in the chain from analysis to legislation, but the closer the error is to the analytical starting point, the more serious the mistake is. Policies that are built on flawed legislative work will have repercussions that are limited to the legislative process; analysts and policy advocates can still do their work without having put their future credibility in jeopardy.

When the error is in the analytical foundation, the entire chain unravels. Bad analysis contaminates analysts, policy advocates, grassroots and activists, as well as elected officials. We who create the analytical foundation therefore have to hold ourselves to the standard that we can’t miss once.

In fact, as I explain in my book Ending the Welfare State, with the big welfare state we have today we will in reality only get one chance to restore economic freedom. If we stumble on the reforms or execute them in such a way that it causes a lot of hardship for many people, we will lose the battle for at least a generation. By that time there won’t be much of a prosperous, industrialized world to save.

For precisely this reason it is crucial that we freedom scholars and analysts do not waste our time – and other people’s time – on analytical constructs that lead to pain, suffering and a certain death for the cause of freedom. This is also why I engage other scholars and analysis whose ambition it is to promote economic freedom, but whose analysis I disagree with.

In the field of economics there is one school that meets all the criteria of purportedly supporting freedom but in reality doing a lot of harm to the cause. That school is, hardly surprisingly, Carl Menger’s Austrian tradition of economics. I have already on a few occasions written about the flaws in Austrian economics and I will continue to do so until its role in the freedom movement has been marginalized to the point of no influence.

This side of Marxism, Austrian economics is the most ill-conceived theory currently at use in the public policy arena. When it was put to work in Russia after the collapse of the Soviet Union, the result was a decade of economic waste, deprivation, abject poverty and collapse of almost every social institution except the Orthodox Church. The demise of a bankrupt government did not automatically, through some spontaneous order, give rise to a well-ordered society with a minimal government. When big government disappeared chaos, anarchy and mob rule took over.

With this experience in mind we have to know exactly what we are doing when we lay out a path to limited government. The article mentioned earlier, ”The Bankruptcy of Governments”, has a promising title but unfortunately turns out to be yet another example of flawed Austrian thinking. It is an important example to discuss, though, precisely because it so well illustrates the fine line between good and bad analysis.

The author, Alasdair Macleod with the British think tank The Cobden Centre, starts off well:

For a long time governments have been redistributing peoples’ income and wealth in the name of fairness. They provide for the unemployed, the sick, and the elderly. The state provides. You can depend on the state. The result is nearly everyone in all advanced countries now depends on the state. Unfortunately citizens are running out of accessible wealth. Having run out of our money, Governments are now themselves insolvent. They started printing money in a misguided attempt to manage our affairs for us and now have to print it just to survive.

That is not entirely true. The excessive money printing did not start until the Great Recession broke out in 2009. Up until that point EU governments in particular were very good at maxing out taxes on their citizens. But Mr. Macleod’s point about governments printing money just to survive financially is a good one, and falls well in line with my analysis.

However, this statement…

The final and inevitable outcome will be all major paper currencies will become worthless.

…is a bit on the excessive side, to say the least. Austrians have been crying about American monetary inflation for years, yet it has not happened. The reason is that their analysis does not recognize the existence of transmission mechanisms between the monetary and the real sectors of the economy. In order for newly printed money to drive up prices in the real sector there has to be some movement of activity in the real sector to motivate price setters to mark up their prices at hyper-inflation rates. In a recession like the current one those transmission mechanisms are weak – consumer credit demand is weak and it is tough for small businesses to get bank loans for investments. As a result, the newly printed money stays in the monetary sector of the economy, where it has no contact with prices.

This does not mean that a modern economy in a recession cannot succumb to high inflation pressure. We know numerous examples from Latin America where government has used its own spending to push newly printed money out in the economy. This is in part how Venezuela under Hugo Chavez got stuck with 30 percent inflation. So far this has not happened in the United States, but that is no guarantee it won’t happen. While the simplistic Austrian prediction is wrong, the facts on the ground are not sufficient to completely dismiss their argument. More evidence is needed, especially on the nature of the transmission mechanisms.

Alasdair Macleod disagrees. True to the Austrian school he dismisses the use of empirical evidence and quantitative reasoning in economics:

Modern economists retreat into two comfort zones: empirical evidence and mathematics. They claim that because something has happened before, it will happen again. The weakness in this approach is to substitute precedence for the vagaries of human nature. We can never be sure of cause and effect. Human action is after all subjective and therefore inherently unpredictable.

Does this mean that Macleod never drives? After all, he apparently cannot be sure that his fellow Brits will drive on the left side of the street tomorrow just as they did today.

Macleod’s statement about the “inherently unpredictable” nature of human action is of course rather silly. It is, however, typical for the Austrian school. One of its key tenets is the denial of empirical analysis, which of course begs the question why they even bother with economics. But by taking the attitude that human action is inherently unpredictable they also suggest that we as humans are not rational. Rationality means, among other things, repeating successful behavior in order to assure your own survival. In terms of economics this means repeating successful trade and other exchange relations with other rational individuals.

I should not have to explain this to someone who is in the game to change public policy. But Alasdair Macleod appears to be one of those activists/analysts who have been seduced by the supposedly refined nature of Austrian theory without seeing its public-policy consequences. If he did he would realize that a theory that starts out with suggesting that human action is inherently unpredictable will have a hard time convincing legislators that they can trust people to make the right decisions on their own. Quite the contrary, in fact: if we all behave unpredictably there is no chance for a society with a minimal government to survive, let alone thrive; the only way to create a stable, predictable society would be to have government organize and regulate it.

Macleod is of course wrong on the fundamental nature of human action. So is the Austrian theory. May I recommend some reading on the role of uncertainty in economic analysis. Austrian theorists might also want to disseminate Armen Alchian’s classic but very dense essay on uncertainty, evolution and economic theory.

Because of their disdain for empirical evidence and quantitative reasoning, Austrians have a hard time constructing workable analytical arguments on their own. Instead they often spend their time producing pure rhetoric, often directed at competing theories. Mcleod is no exception, going after the man Austrian theorists dislike almost as much as Karl Marx:

Keynes was strongly socialistic. In the concluding remarks to his General Theory, Keynes looks forward to the euthanasia of the rentier (or saver) and that the State will eventually supply the resources for capital investment.

This statement is not only false, but also very telling of the difference between Austrian theory and Keynesianism. Austrians prefer the armchair as the foundation of their analysis, while Keynesians work inductively to constantly evolve and enhance the proficiency of their theory and their ability to interact with the public policy arena. The statements by Keynes that Macleod has cherry-picked are from chapter 24 of the General Theory, where Keynes has left his theoretical work and is speculating about what role economic policy could play, and how government would fit in to that role.

It is important to note that in the preceding 23 chapters of his General Theory Keynes barely even touches upon government, even as a subject of conversation. Already for this reason, Macleod’s statement about Keynes being a socialist is false. But there is also a deeper and from a policy viewpoint more important reason. When Keynes got to the end of his book he had examined the “mechanics” of a modern industrialized economy – he had in effect laid the groundwork for what we now know as macroeconomics. With this pioneer work Keynes challenged a great many prejudices held by Classical economists, but he also opened for the potential of an entirely new era of economic policy.

First and foremost, Keynes’s work allowed for a new understanding of what brings about recessions – and, even more importantly, depressions. Never before had anyone systematically proven that when you try to starve an economy out of a recession, you make matters worse. But to produce and explain this proof, Keynes had to spend almost the entire volume we know as his General Theory; as he was finishing it, he only had time for brief, speculative thoughts about what role government could play in defending or restoring full employment.

This is what Austrians do not get. Keynes’s analysis was systematic. He built a macroeconomic theory, induced from evidence, that allowed him and anyone else who takes it seriously to do an open-ended analysis of what role government might play. Unlike closed systems like Marxism or Austrian theory, the Keynesian analysis is open in that its conclusions are not deductively produced – or, to be blunt, dictated – by the theory.

Herein lies the problem with Austrian theory. Because it refuses to recognize the role of evidence, it refuses to open itself to the probable – as opposed to uncertain – nature of human action. Because there is no room for probability, there is no open end to the analysis an Austrian produces. His conclusions are dictated beforehand.

This leads to major problems when theory is brought in to the public policy arena. More on that in a moment. First, let me wrap up Macleod’s point about Keynes being a “socialist”. In chapter 24 of the General Theory Keynes suggests a death tax as one possible policy measure to help build economic policy in favor of full employment. The tax would be used to fund investment activity when private-sector activity is unable to reach full employment. Keynes speculates on the possibility of having government be a permanent agent in this way, which he suggests would mean that the economy would be operating at or very close to the point of full employment.

Keynes’s theory of investment equates full employment to a point where the so called marginal efficiency of capital is virtually zero. The practical meaning of this is that there is no more profit opportunity left in expanding the economy’s capital stock – it is operating at its economically viable maximum. This is accomplished, Keynes suggests (but does not firmly conclude), when private-sector investment is supplemented by government investment, funded by a death tax

Obviously, a death tax, even at 100 percent, would never lead to government replacing private investment funding. Yet Macleod makes the critical mistake of thinking that the point where the marginal efficiency of capital is zero is also the point where private credit is eliminated. He misreads Keynes’s idea about “euthanising the rentier” as the elimination of privately funded investment. In reality, this statement means that funding for investment is so abundantly available that it ceases to be scarce. Thereby no one can make money on credit in response to systemic uncertainty. Individual risk factors still remain, though, as Keynes makes clear in his elaboration of his theory of investment and the concept of the marginal efficiency of capital.

In short: government eliminates systemic uncertainty while the private sector handles uncertainty and risk at the market level.

I disagree with Keynes’s speculation about the death tax. But I do agree with him that the free market is unable to incorporate and manage systemic uncertainty. How that is best done is a matter for further scholarly work; my own doctoral dissertation was devoted entirely to finding the demarcation line between the roles of government and the private sector in managing uncertainty. What I learned from Keynes is that there is indeed a role for government to play there; the exact nature of that role is still an open question, especially because the attempts made thus far at organizing government to eliminate systemic uncertainty have had a lot of side effects.

I apologize for the wordiness of this article, but it is important to understand the depth of the problem with Austrian theory. One good way to do that is to contrast it toward its arch enemy, Keynesianism.

Speaking of which, it is almost amusing to witness the obsession that many Austrian theorists have with Keynes. As Alasdair Macleod demonstrates, this obsession sometimes gets so bad that they throw out the only analytical tool they themselves cherish, namely logic, just to get another chance to go after Keynes:

The misconceptions of Keynesianism are so many that the great Austrian economist von Mises said that the only true statement to come out of the neo-British Cambridge school was “in the long run we are all dead”.

Let’s put this in its proper Austrian context. In December last year one of the Cobden Centre’s academic advisors, Phillip Bagus, applauded the shrinking GDP that some European countries were experiencing. Bagus was jumping up and down with joy over the fact that Greece had lost a quarter of its GDP and suggested merrily that this elimination of economic activity would free up resources that would create new investments and new jobs. He suggested that it was a home run for the economy that people were laid off from jobs right and left and forced to scavenge for food because an austere government was not providing the poverty relief people had been promised.

Bagus is a prime example of what Austrians do when they enter the public policy arena. They are completely locked in to their theory, without a single open window to the outside world and its empirical evidence that when they are confronted with the worst economic crisis since the Great Depression they suggest that the world needs more of the same. To them there is no such thing as hesitation and caution among private entrepreneurs and consumers. Their static and rigid theory says that consumers and entrepreneurs fail to produce full employment for the economy because government takes away resources from them. There is a great deal of truth in this part, but what the Austrians forget is that there is a second leg to this analysis: they conclude that all you need to do is fire government bureaucrats and  they will all get jobs in the private sector. All you need to do is shut down a government agency and someone else will take over their office.

The problem is, as we witnessed in Russia during the 1990s, the private sector may hesitate to step in and absorb idle resources formerly employed by government. The one tiny detail that Austrians forget is that an entrepreneur will not make an investment unless he has reasons to believe that he will be able to pay off the loan he funded the investment with. Furthermore, the banks won’t lend him money toward the investment unless he can make a good case for the profitability of that investment.

Keynes knew of this problem very well. That is why he speculated that government should supplement private investment in times of uncertainty, in order to eliminate systemic risk factors. While I disagree with Keynes’s particular suggestion, I am wholeheartedly with him on the nature of the problem. Individuals can be held back by uncertainty and thereby, in the aggregate, hold back the entire economy.

Austrians do not believe in uncertainty. They recognize its existence but they do not incorporate it into their analysis. Instead, they assume that all that needs to happen for the economy to be perpetually in full employment is that the so called “natural” rate of interest can prevail. They assume the existence of this “natural” interest rate without ever providing proof of its existence. This assumption, again entirely theoretical, allows them to create a perfect intertemporal allocation of resources – in other words, to eliminate uncertainty.

When you ask an Austrian theorist when this natural interest rate will come about, he will give you an answer that resembles something like “in the long run”. In other words, in the long run the economy will always be in a perfect state of equilibrium and full employment.

Keynes always criticized Classical economists for relying on the long run to fix all sorts of problems. When Austrian theorists take the same view on the long run as Keynes did, they jeopardize the very foundation – flawed as it is – of their own theory. Either they have to resort to illogical reasoning or they have to make up their mind: do they agree or disagree with Keynes on the role of uncertainty in the economy?

Alasdair Macleod, needless to say, does not see this lack of logic in Austrian theory. He marches on like nothing happened. The rest of his analysis is unfortunately as simplistic as the Austrian theory he relies on. He echoes a commonly held belief among Austrians that there have never been economic crises before big government:

The misallocation of economic resources which is the result of decades of increasing government intervention cannot go on indefinitely. Businesses have stopped investing, which is why big business’s cash reserves are so high. Money is no longer being invested in production; it is going into asset bubbles. Dot-coms, residential property, and now on the back of zero interest rates government bonds and equities. These booms have hidden the underlying malaise.

Although I disagree with John Kenneth Galbraith on virtually everything under the sun, I have to give Galbraith credit for his book A Short History of Financial Euphoria. There, Galbraith takes the reader on a journey through speculative bubbles that have occurred throughout history – the ones we know of – and done so at times when there was no big government.

I have discussed the nature of today’s crisis at length in other articles. Very briefly, I do agree with Macleod that government has played a bad role in exacerbating this crisis – my conclusion is that our banking system would have absorbed the shock from the real estate crisis were it not for the fact that those same banks had also invested heavily in government bonds. During 2011 and 2012 more and more of those bonds turned into bad assets, effectively destroying an otherwise sound balance on banks’ balance sheets.

The implication of a sound analysis of today’s crisis is that we need to get government out of the economy, but that we need to do it in a structurally sound way and by showing great respect for two groups of citizens:

• Those who already live on the dole because they have lost their jobs and been let down by government;
• Those who still work but have become dependent on government to make ends meet.

The true challenge for freedom-minded public policy scholars is to design a path for our economy out of the welfare state without causing undue hardship for either of these two groups. It can be done. The problem is that we are not getting much help from Austrian theorists here: all they suggest is the destruction of the welfare state so that Phoenix may rise from the ruins.

Macleod is no exception. He makes a good observation about the role of government…

Take France. Government is 57% of GDP. The population is 66m, of which the employed working population is about 25m, 17m in the productive private sector. The taxes collected on 17m pay for the welfare of 66m. The taxes on 17m pay all government’s finances. The private sector is simply over-burdened and is being strangled.

But then, instead of helping pull the economy out of this entitlement quagmire, Macleod resorts to the favorite Austrian pastime, namely to bash the printing of money:

The progressive replacement of sound money by fiat currency has destroyed economic calculation, and has destroyed private sector wealth. These policies were deliberate. We have now run out of accessible wealth to transfer from private individuals to governments. That is our true condition. Governments will still seek to save themselves at the continuing expense of their citizens, and in the process destroy what wealth is left.

He never gets to the usual advocacy for a gold standard, but he comes pretty darn close. However, as a brief look at Galbraith’s book will show, we have had crises even during the heydays of the gold standard.

The problem is not big money. The problem is big entitlement. It would be nice if Austrians could put down their Scriptures and help us get rid of the welfare state in a sound, stable way that encourages people to be optimistic about the future. If they are not interested in that, may I suggest they withdraw to their academic chat rooms and stop pretending to be concerned.