Friday, 13 September 2013

An Interview with Mark Thornton: Only Austrian Theory Can Explain and Expose Booms and Bubbles

By Mark Thornton

Mises Institute: While elected officials and various pundits are clear that they believe the Keynesians can solve the current crisis, do the Keynesians have a theory that explains what caused the crisis in the first place?

Mark Thornton: Keynesian business cycle theories are based on the idea that cycles are caused by changes in aggregate demand. This theory, however, provides no purely economic cause for business cycles. The instigator or cause in Keynesian theory is a psychological factor that is driven by so-called “animal spirits.” Small changes in entrepreneurs’ optimism and pessimism affect their investment decisions and can spread and snowball out of control causing sharp increases and decreases in aggregate demand, profits, and employment.

The general solution for these problems within the Keynesian framework is for aggregate demand to be decreased or increased by the public sector as a substitute for the private sector. The primary means to increase public sector aggregate demand is to increase government spending financed by borrowing rather than taxes.

The problem with Keynesian business cycle theory is that cycles just happen or are brought about by random exogenous factors. With the Housing Bubble, people just went out and built too many houses and then realized they made a mistake. At that point, the animal spirits of depression took over the economy and in particular the housing and banking sectors went into a tailspin. The Keynesian explanation for the Housing Bubble crisis is correct in that expectations were psychologically impacted in a positive way during the bubble and in a negative manner after the crash and therefore do play a part in the narrative describing the cycle.

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