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Austerity’s Prophets

“Austerity” has become the watchword of the year. Governors, prime ministers, and presidents around the world are talking about cutting welfare benefits, curtailing public union power, and reducing deficits. We’ve over-promised at the public trough, and now we must pay the price. Whoever is elected president in November is going to face the need to retrench.

Yet only one school of economic thought, that of Friedrich Hayek and Ludwig von Mises, predicted and prescribed austerity before the Great Recession. More prominent branches of free-market economics, no less than spendthrift progressives, have been slow to realize that neither fiscal nor monetary stimulus can cure what ails the West. As the psalmist says, “The rejected stone has become the chief cornerstone.”

Nobody in power was talking austerity in 2008, when the financial crisis hit. Big government and its patron saint, John Maynard Keynes, were in the saddle, with Republicans and Democrats falling over each other to run up deficits and pass the Troubled Asset Relief Program. Keynes’s biographer, Robert Skidelsky, came out with a bestseller, The Return of the Master.

The monetarists, meanwhile, students of Milton Friedman and the Chicago school of economics, were extravagant in their own way. The Federal Reserve’s Ben Bernanke had told Friedman on his 90th birthday, in 2002, “You’re right, we did it”—causing the Great Depression by allowing the money supply to collapse—“We’re very sorry. But thanks to you, we won’t do it again.” Yet what was the monetarist response to the crisis?


Central bankers and professors of money and banking answered as one: Inject liquidity! Cut interest rates! Over the next two years, Bernanke instituted two rounds of “quantitative easing” (QE1 and QE2), a duplicitous name for printing money, and adopted a zero interest rate policy (ZIRP). He was convinced that Friedman would be smiling down from the Pearly Gates.

Maybe he’s right about that—or half-right. Last month on the London Underground I ran into Paul Krugman, last of the old “crude” Keynesian breed. He was in the city to promote his book, End This Depression Now! For the next half hour, we debated the causes and cures of the Great Recession. Krugman insisted that we need to double or triple the deficit—but only in the short run. “We must eventually adopt austerity.” He paraphrased St. Augustine: “Give me austerity, but not yet.”

I asked him if there was anyone equal to him in debate. He couldn’t think of anyone, so I suggested Milton Friedman—a safe bet because Friedman died in late 2006. Krugman nodded reverently, but insisted, “If Milton Friedman were alive today, he would be anathema to the Tea Party Republicans because he would have favored easy money to end this crisis.”

“But not TARP and the deficits,” I replied. Krugman sheepishly nodded. Friedman was convinced by the empirical data that fiscal activism—deficit spending—was unnecessary and even counterproductive. Monetary policy could do all the heavy lifting. British monetarist Tim Congdon confirms this. In his excellent and underappreciated work Money in the Free Economy, Congdon cites Friedman’s denigration of fiscal policy: “A deficit is not stimulating because it has to be financed, and the negative effects of financing it counterbalance the positive effects, if there are any, of spending.”


Massive government expenditures and deficits during World War II appeared to get us out of the Great Depression. But wait—Friedman was quick to point out that monetary policy was also activist: M2 grew at a 20 percent annualized clip from 1940-45. In another famous example, the Kennedy-Johnson tax cut of 1964 engineered by the Keynesians appeared to be stimulative. But wait—monetary policy was also expansionary during this time.

Congdon, following Friedman’s lead, looks at natural experiments where fiscal and monetary policy moved in opposite directions to see which one dominated. Monetary policy won out in almost every case. He observes that in 1981 the Thatcher government in Great Britain raised taxes by £4 billion in a recession, while adopting expansionary monetary policy. Three-hundred and sixty-four Keynesian economists signed a statement in The Times decrying the move and predicting economic collapse. Yet the economy roared. Why? Because monetary policy was liberal at the time, offsetting fiscal austerity. Congdon concludes: “Contrary to a large number of textbooks, the size of the government’s budget deficit is by itself not necessarily of any importance to aggregate demand.”

If he were alive, Friedman would not be surprised that trillion-dollar deficits have had little impact in stimulating the U.S. economy. What government gives, private business takes away. Despite record profits and historically low interest rates, corporations are holding back on spending and hiring because of the uncertainty caused by wasteful government spending.

The deficits have run their course without success, leaving us with mounds of debt and interest payments. Monetary easing, Friedman would agree, is the only game in town. But even easy money is not having the effect it once did. Mises said it best: “We have outlived the short run, and are now suffering from the long-run consequences of [Keynesian-monetarist] economics.”

The Great Recession is in its fourth year, and the legacy of big-government macroeconomics is long indeed—unsustainable and chronic deficit spending; permanent easy money; excessive dependence on the welfare state (with 46 million on food stamps); overregulation (including Sarbanes-Oxley and Dodd-Frank); an anti-saving, debt-ridden consumer society; deteriorating public infrastructure; economic stagnation; and a stop-start market on Wall Street. Political leaders around the world are looking for a new model with which to restore prosperity and economic stability.

What about the supply-siders? Tax cuts play a role in encouraging economic growth, but in an age of rising deficits legislators are reluctant to slash rates aggressively. Supply-siders blundered in the past decade by repeatedly contending that “deficits don’t matter” and assuming that we could grow our way out. Unfortunately, without constitutional restrictions on government spending, increased revenues from more efficient tax policies simply lead to more spending without solving the deficit problem.


There is only one school that consistently defends the classical model of fiscal and monetary responsibility as established by Adam Smith in The Wealth of Nations. And that is the school of austerity, led by the Austrian economists Ludwig von Mises and Friedrich Hayek—whom Krugman laughingly calls the “Austerians.” But nobody is laughing anymore.

Who is the anointed economist of austerity? The leading theoretician appears to be Friedrich Hayek. Who would have thought that the austere Hayek would make a comeback after the financial crisis of 2008? He is the only Austrian to have won the Nobel Prize in economics, but until now his reputation has languished in the shade of Milton Friedman’s sun.

Perhaps the best example of Hayek’s resurrection is a bestselling book by British economist Nicholas Wapshott, Keynes-Hayek: The Clash That Defined Modern Economics. Even a popular rap song, “Fear the Boom and Bust,” has come out of the debate between Keynes and Hayek. (Google “Keynes Hayek” and it’s the first result to pop up.) The rap song is the brainchild of musician John Papola and George Mason University economics professor Russ Roberts. It’s a favorite way on campuses to explain the ideological divide in macroeconomics.

Why isn’t Milton Friedman the nemesis of Keynesian economics? Because during a crisis, he is not a classical economist. While he opposed fiscal stimulus, he advocated easy money to keep the economy from collapsing. Hayek and his mentor Mises are the real enemies of big government. Hard-core Austrians are true believers in the classical model of fiscal and monetary restraint, even during a Great Recession.

The first debate between Keynes and Hayek took place in the 1930s and is recounted in Wapshott’s book and in chapter 12 of my own Making of Modern Economics. Hayek, then teaching at the London School of Economics, opposed Keynes’s prescription of deficit spending and easy money to get out of the Great Depression. Hayek defended the classical “Treasury” view that governments, like the private sector, should cut costs and prudently live within their means even during downturns. He excoriated easy money as well, which he said would only make matters worse. If the central bank had any legitimate role, it was as a lender of last resort—but along the lines described by Walter Bagehot, who advocated in Lombard Street (1873) that the central bank lend money to troubled banks at higher, not lower, interest rates.

The Great Depression was so deep and long that eventually Keynes won the debate, at least in the minds of policy-makers. Hayek fell into obscurity and turned to political writing, producing his bestselling Road to Serfdom (1944) and The Constitution of Liberty (1960). After Hayek shared the 1974 Nobel Prize in economics with socialist Gunnar Myrdal amid the inflationary stagnation of that decade, interest in his economic thinking rose, but he still played a smaller role on stage than Milton Friedman—who won the Nobel in 1976—and the supply-siders.

Hayek, building on the original work of Ludwig von Mises, developed a macro model of the economy and the Austrian theory of the business cycle. Austrian macroeconomics is a sophisticated improvement in the classical model, while Keynesian macroeconomics seeks to demolish the House that Adam Smith built.

Hayek and the Austrians contend that easy-money policies—expanding the fiat money supply and artificially lowering interest rates below the natural rate—lead to structural imbalances in the economy that are not sustainable. Austrians predict that the Fed’s policies of QE and ZIRP will inevitably lead to further asset bubbles in the stock market, manufacturing, exports, and real estate, depending on who gets the money first. As Mises taught, “Money is never neutral.”

The Austrians conclude that the boom-bust cycle is not a natural phenomenon under free-enterprise capitalism but is caused by government intervention in the monetary sphere. A legitimate international gold standard and “freely competitive banking” would minimize the risks of a boom-bust cycle. (Incidentally, the Austrians are the only school of economics today that defends the classical model of the gold standard.)

Until the 2008 crisis, the Keynesians and monetarists were unconcerned about asset bubbles. A bear market in housing prices or high-tech stocks would, they thought, only have a marginal impact on the global economy and could easily be countered by deft monetary stimulus. The market recovered from the 1988-90 real estate bust and from the 2001-2002 dot-com stock-market collapse without a global meltdown, for example.

The real-estate/mortgage bust of 2008 changed all that, and suddenly the focus shifted to the only school that argued all along that “asset bubbles” had macroeconomic effects: the Austrians. Since then, the Austrians and their primary advocate, Friedrich Hayek, have been in the limelight, popularized by financial gurus like Peter Schiff and political figures like Ron Paul. Management theorist Peter Drucker once predicted that the “next economics” would have to come from the “supply side, productive sector,” by which he meant the Austrians. He had in mind Joseph Schumpeter of “creative destruction” fame, but Hayek will do.


In May, I visited Poland for the first time to give a series of lectures on Austrian economics. Most of my books have been translated into Polish, thanks to energetic publisher Jan Fijor. My lectures were packed with business leaders, academics, and students who had an insatiable interest in Austrian economics and finance.

[1]Eastern Europe, in particular, is taking a Viennese waltz down the economy. Leaders there are focused on adopting sound monetary and fiscal policies along the classical/Austrian lines. The supply-side flat tax movement is also popular.

Right now Estonia is in the limelight because it’s the fastest-growing economy in the region, expanding at a 7.6 percent rate. It is the only eurozone country with a budget surplus. National debt is just 6 percent of GDP. How did they bounce back from the devastating 2008-09 crisis?

“I can answer in [three] words,” states Peeter Koppel, investment strategist at the SEB Bank: “Austerity, austerity, austerity.” Estonia went through three years of belt-tightening. Public sector wages were cut, the pension age was raised, benefits were reduced. “It was very difficult, but we managed it,” explains Juhan Parts, Estonia’s minister of economy and communication. This “little country that could” is now leading the way to recovery and prosperity. The Austrian way.

26 Comments (Open | Close)

26 Comments To "Austerity’s Prophets"

#1 Comment By libertarian jerry On July 9, 2012 @ 8:19 am

Great Article. Unfortunately, for Americans,the largest entity for “too big to fail” is the American Government. The politicians,who buy votes with Welfare State spending,will not dismantle the Federal gravy train. Instead they will blame the “rich” and whats left of the Free Market. All the finger pointing at further economic hardships and the coming inflation will be scapegoated on “speculators”,”greedy businessmen” and the “System.” The politicians,in America, will do the opposite of what will get America out of the current economic Depression. Austerity? They will grow the government,raise taxes,increase spending,print more money and add more regulations. Along with bailing out their cronies on Wall Street plus continuing useless wars abroad,most of the American politicians will do what is wrong economically for our Nation. We are doomed.

#2 Comment By Geoff Guth On July 9, 2012 @ 10:27 am

I’m not an economist, so I have a few questions about this article that I hope someone will answer.

First, what is the difference between the Austrian model advocated here and Andrew Mellon’s advice to “liquidate labor, liquidate stocks, liquidate farmers, liquidate real estate” early on in the Great Depression? The history of the period suggests that austerity failed and only when the government adopted Keynesian policies did the economy begin to recover. Indeed, the 1937 recession its often attributed to a too-early return to austerity.

Second, as far as I am aware, Greece has been following this prescription (at German insistence) and yet shows no sign of recovery at all. It could even be argued that the euro in the Greek case plays the role of a quasi-gold standard, as it is beyond the control of the Greek government and the ECB has been focused on keeping inflation low.

Third, would you care to comment on the experience of Iceland since its massive crisis a few years back. My impression there is that recovery there is well under way thanks to monetary expansion and targeted defaults on bad debts.

Thanks for any light than can be shed!

#3 Comment By Clint On July 9, 2012 @ 12:02 pm

The uninformed repeat the customary false-attribution when they suggests that Andrew Mellon utilized Austrian theory when urging Herbert Hoover to liquidate during the Great Depression. In an article for the Journal of Money, Credit and Banking Larry White refutes this myth – it was the real bills doctrine that governed their thinking, and Mellon in fact called for monetary and fiscal expansion.

#4 Comment By Geoff Guth On July 9, 2012 @ 1:06 pm

I freely admit to being uninformed. That’s why I was asking the question 🙂

Do you have a link to the article you cited? I’d like to read it. Or if it’s only behind a paywall as an academic article or something, a recommendation for further information online on the topic? Thanks.

#5 Comment By David Peterson On July 9, 2012 @ 1:35 pm

The Hayek-Mises devotees are the Marxists of the right. They are always 100% accurate– living in a Disneyland World– an economy never touched by human hands. Hayek did make some interesting contributions, but his legacy includes advocating the De-Christianizing of the public square. Like Bertrand Russell, who he admired, Hayek wrote that all religion is an anachronism, and he agreed that religious believers should have no role in public life.

#6 Comment By Barry On July 9, 2012 @ 1:51 pm

Read Krugman on the topic.

As for the Great Depression, read actual historians.

#7 Comment By John Heavner On July 9, 2012 @ 3:55 pm

What does Marxist of the right mean? It’s oxymoronic. Quoting Krugman on the free market is also oxymoronic. How many times must John Keynes be proven wrong before people quit mentioning him and economics in the same breath? What value is gained by bringing religion into an economic discussion? Could it be that socialism is a religious belief system?

#8 Comment By Tom On July 9, 2012 @ 4:46 pm

During Hoover’s 4 years in office Federal
government spending increased 40% in nominal
terms and over 50% in real terms due to deflation. That is not austerity. He also raised taxes.
The more important thing is we went into the
great depression with a long string of balanced budgets except for the civil war and WWI with virtually no debt. We went into the great recession with 12 balanced budgets since 1930 and 4 since 1960 and 3 generations in which living off the government is an accepted way of life. It’s
taken us since 1936 (enactment of social security) to get into this mess, It will take at least 50 years, if ever to get out. Why social security? It says you are not responsible for your own retirement.
Your employer contributes half, the other half comes from people currently working not what you contributed.

#9 Comment By K. W. Jeter On July 9, 2012 @ 5:40 pm

How come whenever we talk about the need for austerity, we never mention the Pentagon going on a budget? If we had the trillions back that we’ve squandered in the Middle East, would all those nasty “entitlements” really look so unaffordable?

#10 Comment By George Leef On July 9, 2012 @ 5:46 pm

Sorry, Mr. Peterson, but your comment is both obtuse and irrelevant. Whatever Hayek said about religion is completely beside the point of the argument between the Austrians and the Keynesians. Your notion that Austrian theory is about “an economy never touched by human hands” is absurd. An essential point of Austrian analysis is that all decisions involve human hands, but if those hands belong to politicians who don’t stand to lose if they’re wrong (just think of the many crony capitalist flops of the Obama regime for starters) we will get lots of wasted resources and the undermining of incentives for real entrepreneurship.

#11 Comment By Anonymous On July 9, 2012 @ 5:49 pm

“…and he agreed that religious believers should have no role in public life.”
Should religious believers (Christians) have a role in public (state) life? It is something to consider. Believers in a religion generally characterized by its adherence to peace may need to tread carefully when considering interacting with an organization generally characterized by it monopoly on violence.

#12 Comment By Clint On July 9, 2012 @ 5:57 pm


Do your own homework,next time,Sport.


#13 Comment By Clint On July 9, 2012 @ 7:21 pm

Peterson may want to read Christian Reconstructionist, Gary North and his contributions to The Austrian School of Economics.

#14 Comment By Jann On July 9, 2012 @ 7:53 pm

The world clearly needs some fresh minds to create theories for a different age. None of these learned economic scholars got it all right. Rather than argue these various veiws on how the Capitalist system works best perhaps it is time to admit that the system is flawed and needs to be rethought. There has to be a better system beyond today’s unsustainable, unmanagible Capitolism.

#15 Comment By George Leef On July 10, 2012 @ 8:07 am

Thinking about it further, Peterson gets it precisely backwards. It is the Keynesians who think of the economy as something “untouched by human hands” with their mathematical models and equations that purport to demonstrate how “the economy” works. The Austrians put that aside and argue that only by understanding the logical of human action can you understand economic phenomena.

#16 Comment By Webe On July 10, 2012 @ 8:59 am

If Eastonia is our shining example we’re in deep trouble. Eastonia is a country where real GDP is far lower than in 2008. Eastonia has suffered huge losses of (educated) young people emigrating because there is no hope. Taxes on labour are punishingly high, while the asset side of the economy is unfettered: mortages underwritten by Swedish banks (bidding up prices or pre-existing assets with borrowed money) are cosigned generationally by family members. Eastonia is not a model.

As for religion, surely you are not advocating keeping Christians or Muslims out of public office? It seems that few people can master the distinction between the separation of church and state (institutional influence of the state in church matters or vice versa) on the one hand and religious inspiration and public/political life on the other. Different aspects of life will always overlap each other in unpredictable ways.

As for how the crisis has played out, it is not just Austerians who have insight into the underlying dynamics. Marx spoke very presciently about the roving cavaliers of credit and how the exchange value uncouples from underlying value, or stated differently, how the ballooning of financial assets and credit not marked to market leads to crisis and dislocation in the underlying production economy. If people read Marx as the first political econnomist who tried to base economic theory on historical and empirical evidence instead of as the first “socialist”, they would be surprised how much insight he had. I am not advocating Marx(ism), but I do advocate basing economics on empirical evidence instead of the standard “thought models”. And that includes the Austrian theory of how money and credit came into existence in human society: it is a fable without historical evidence.

#17 Comment By Uncle Vanya On July 10, 2012 @ 11:34 am

Hayek feared big government, because something that big would, inevitably, crush innovation, entrepreneurship, creativity and freedom.

One must wonder, then, what he might say about today’s mega-corporations, which, effectively, own governments that can set policies to favor them over their smaller competitors and over private citizens and which crush innovation, entrepreneurship, creativity and freedom.

#18 Comment By D. Saul Weiner On July 10, 2012 @ 1:36 pm

Jann states: “The world clearly needs some fresh minds to create theories for a different age. None of these learned economic scholars got it all right.”

Not so. The Austrians DID predict the collapse and have been warning for years about the dangers of central banking and fiat currency. The problem was that nobody in power listened to them. They only listened to economists who argued that the solutions to all of our economic problems all involve BIG Government.

#19 Comment By Clint On July 10, 2012 @ 5:05 pm

“Ludwig von Mises outlined how Karl Marx confused a strictly hereditary CASTE system, as practiced in India or feudal Europe, with a modern CLASS system where any citizen can be in the class of Chairmen of the Board of Directors or the class of a janitor of that corporation.”

#20 Comment By Edmund On July 11, 2012 @ 8:19 pm

The level of misunderstanding and misinformation in this article makes me weep for American conservatism. Don’t endorse a “school” of economics that scorns rigor and dismisses empiricism. It’s a difficult and technical subject that shouldn’t be approached armed with with a tool kit of shibboleths and totems.

#21 Comment By Ben, Okla. City On July 11, 2012 @ 8:37 pm

Austrian economics is not a theoretical system that lends itself to producing refutable hypotheses and testing said hypotheses. It is an a set of revealed preferences for minimalist government based on a priori arguments.

Get empirical, then I’ll take it seriously. Right now, you’re right below the Randian Objectivists and anti-vaxxers on my Silly List.

#22 Comment By Clint On July 12, 2012 @ 2:50 pm

“Austrians consider their methodology to be superior to mainstream economists’ attempts to mimic the “hard’ sciences through what Austrians consider to be a “naive” empiricism. This “naive” attempt by the mainstream academic community to mimic the hard sciences through econometrics has had questionable results.”

#23 Comment By Jack Tracey On July 12, 2012 @ 11:54 pm

I tried my best to get through Human Action. It was on my desk, in my living room and in my bathroom for a year. Every statement is so thoroughly reasoned that a working stiff like me has to read a section or a concept and let it sink in.

As for the rejection of reason in favor of empiricism, the Mises Institute folks give plenty of solid responses, but one need only notice that current circumstances and the path that led to them– though arrived at through reason before they were observed– are now clearly visible, and the theories arrived at through inductive reasoning by Keynes, et al have yet to produce any result beyond a call to double down when we have clearly busted on face cards. The hypothesis has been tested and has been rejected, “Sport”.

Economics is not physics. The human hand is precisely what the classical economists and their progeny have been trying to explain. Give Human Action a try. You’ll find no tired and meaningless slogans.

#24 Comment By Jack Tracey On July 13, 2012 @ 12:00 am

Also, whatever Hayek thought of religion, in economic terms, it is only a factor that affects preference and the perception of value. Individuals may have made normative statements, but ultimately the theoretical work of the “Austrians” is only describing principles and consequences. It is explaining what happens when you put your hand on a hot stove or borrow from the future to spend today. It’s up to us to decide what consequences we desire.

#25 Comment By Justin Jubilee On July 13, 2012 @ 11:28 am

The key to solving our current economic mess lies in dealing with debt, specifically systematic debt cancellation. The call for a new economic model is right on, and has been answered by Steve Keen, who built a new model taking the effects of debt into consideration. Actually, Keen traces his own intellectual heritage back to the economists Hyman Minsky and Irving Fisher.

The key problem is DEBT, and the solution is DEBT CANCELLATION. See the above theorists if you want to understand why the Austrians, the Keynesians, the Monetarists, they are all INCOMPLETE.

#26 Comment By TheProtectionist On July 22, 2012 @ 11:58 am

Mark, My first book on economics was your great intro to the history of economic thought which I still highly recommend. But twenty years and 100s of economics books later I’ve come to a very troubling conclusion. America’s rapid decline is the result of the fact that there has never been a sound school of economics. Consider that Karl Marx suggested free trade as the fastest means to destroying capitalism, while Daniel Webster claimed the primary reason we have our US Constitution was to stop the economic chaos unleashed by free trade with Britain under the Articles of Confederation. Yet, astonishingly we have three political parties which have adopted unwittingly Karl Marx’s advice, while the Chinese have adopted Webster’s advice. The Tea Party seems to be oblivious to Webster’s claim, and the average Republican has no idea that Lincoln was a protectionist, and that his party remained protectionist until the 1960s when it became an economic mirror image of the Democrats who have historically been free traders. The dangerous error therefore the modern free trader makes is the failure to make a critical distinction between free international markets and free domestic markets. The new website rescuingeconomics.wordpress.com attempts to fill this intellectual gap, by building a new school of economics to make sense of the success of American protectionism. Explaining the intricacies of this failed dynamic is the goal of the sites’ associated book, The Un-Republican, by Geldstone. The Austrian’s and Keynes (to some degree) both operate on the flawed foundation of neoclassical supply of labor with its dangerous model of flexible wages and reduced labor under falling real wages (I’ll just quit my job and eat pizza at the pool all day –more leisure time–if wages are not high enough). This in turn is the result of an incomplete economic definition of money. It’s time to shake the tree of economics for a healthier fruit, before it is tool late.