Is Keynesian Economics Flawed? Austrian Economics Examined

Posted On: Monday, April 9, 2012

Modern economic theory is rooted in what is commonly referred to as Keynesian economics.  A major distinguishing factor of Keynesian economics is rooted in the idea that economic systems can be modeled and analyzed.  Another branch of economics, The Austrian School of Economics, views the idea of modeling the economy as suspect, arguing that the basis of all economics is the individual whose decisions ultimately can’t be modeled.  The idea that current economic theory and practice is fundamentally flawed, and leading to an inevitable calamity is worth exploring.  With this in mind, the following is a brief examination of how Keynesians and Austrian adherents would analyze the current global economic situation.   

A central distinction between the Austrian School of Economic thought and Keynesian Economics is the purpose of monetary policy.  Monetary policy under the Austrian School would seek to minimize changes to the value of money, thereby reducing the level of uncertainty that exists when two economic parties make an exchange.  Since the basis of all economic analysis under the Austrian school is the individual and his choices, an active monetary policy by a central bank is akin to socialism, or central planning.  The attempt to centrally plan the money supply distorts the market pricing mechanism for interest rates, and impacts individual views of the stability of money’s value. 

For example, the current orthodox response of central banks to counter an economic slump and rising unemployment is to follow Keynesian policies and ease monetary policy.  According to the Austrian School, while this may indeed provide a brief lift to economic activity and reduce unemployment, the long-run impact will inevitably be a more severe economic downturn.  The reasoning behind this assertion is that a central bank induced increase in the money supply leads to “malinvestment” because interest rates or the cost of money is artificially lowered.  Capital decisions that would not have taken place otherwise are now deemed to be economically sound.  Eventually, this accumulation of malinvestment would lead to a bigger bust.      

1.  What is the goal of government stimulus intervention?

The current goal of government stimulus intervention is to prevent a deflationary economic environment following the bursting of the housing bubble in 2008.  By “priming the pump” the government is seeking to create a virtuous cycle of strong economic growth, falling unemployment, and higher tax revenues leading to federal budget sustainability.    

2.  What is the downside?

The downside of government stimulus is that the necessary adjustment that is required following years of malinvestment is merely forestalled.  In other words, the fiscal stimulus by government is pouring funds into unproductive areas (malinvestment), while artificially low interest rates is promoting capital investment that would not otherwise have taken place (malinvestment).  It can be easily argued that house prices in the U.S. remain artificially elevated given the easy money policy of the Federal Reserve, and the deficit spending of the Federal Government.     

Other downsides include

a.        substantial increases in federal debt. 

b.       a financial system that has become increasingly reliant on central bank monetary easing. 

c.        elevated levels of inflation. 

3.  Who pays for it in the long run?

People pay for it in the long run through higher tax burdens or a debased currency. 

4.  What will likely happen to the economy if they can’t pay for it?

If financial markets begin to believe that debt levels are too large to finance, fixed income investors will seek to protect themselves by refusing to fund the offending country’s debt and deficits.  Individuals and business will look to protect their local currency purchasing power and wealth by shifting their savings into other stores of value.  Collectively, these actions will cause interest rates to rise while the value of the local currency relative to other currencies will fall. 

The likely end result would be a massive devaluation of the local currency, and a severe contraction in economic activity.

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