Much fuss has been made about Rick Perry’s careless remark about Ben Bernanke.  While most of the media has honed in on the obvious ridiculousness of basically calling for the lynching of a public official for doing his job, I think it’s more telling from a policy perspective to try to understand why Rick Perry would be so against monetary easing.

Ezra Klein and Matt Yglesias weigh in on this very topic.  Klein bemoans an “a much broader, and unfortunate, shift among Republicans on monetary policy.”  While Yglesias somewhat disagrees by pointing out that “Perry’s concern is that monetary easing would work well, and he was putting Bernanke on notice to avoid it because he wants to win the election.”

The thing is that they are both right.

I think one of the most startling discoveries I’ve made in the last few years is that the GOP is dominated by Austrian School disciples.  I wasn’t even aware of this non-mainstream school of economics until I had a chance encounter with a believer at work, who had manage to convert one of my friends.  One of the major theories of the Austrian School is the Austrian Business Cycle Theory, in which they basically blame the Fed for every recession ever:

Proponents believe that a sustained period of low interest rates and excessive credit creation results in a volatile and unstable imbalance between saving and investment.^[2] According to the theory, the business cycle unfolds in the following way: Low interest rates tend to stimulate borrowing from the banking system. This expansion of credit causes an expansion of the supply of money, through the money creation process in a fractional reserve banking system. It is asserted that this leads to an unsustainable credit-sourced boom during which the artificially stimulated borrowing seeks out diminishing investment opportunities. Though disputed, proponents hold that a credit-sourced boom results in widespread malinvestments. In the theory, a correction or “credit crunch“ – commonly called a “recession” or “bust” – occurs when exponential credit creation cannot be sustained. Then the money supply suddenly and sharply contracts when markets finally “clear”, causing resources to be reallocated back towards more efficient uses.

So it’s not as if the GOP doesn’t think that monetary easing wouldn’t work in the short term.  I think they mostly agree that it would.  It’s that they believe that in the long-term we will suffer for it.

So the real problem here isn’t a lack of understanding or a disingenuous ruse to win an election.  It’s much worse than that.  The entire GOP has been captivated by a non-mainstream school of economics, which proposes long refuted theories, and they are fighting for something they think is right.

The problem is that they are really, really wrong.

I’ve been absent for a little while, which is partly due to work, World Without End, and house guests, but one other thing that I’ve been doing lately is studying the Austrian School.  The Austrian School of economics is the libertarian’s school of choice because it advocates a complete laissez-faire approach to economics, idolatry of the market, and a rabid hatred of the Federal Reserve.  This is pure Ron Paul and Ayn Rand.

The reason I’ve been spending so much time on this subject is that I had sort of an email battle with a friend-of-a-friend at work whom I’ve never met.  We were fighting over the root cause of the financial crisis, and as you might suspect, me (Keynesian) and him (Austrian School) didn’t really agree.  I plan on posting our full exchange as soon as I get permission from the other party, but for now I wanted to touch on one of the many principles cited by Austrian School disciples, and supply-siders in general: Say’s Law.

In economics, Say’s Law or Say’s Law of Markets is a principle attributed to French businessman and economist Jean-Baptiste Say (1767-1832) stating that production, or supply, inherently creates demand for what is produced. An important implication of Say’s Law is that recessions do not occur because of inadequate demand or lack of money. According to Say’s Law, the production of goods provides the means to the producers to purchase what is produced, and hence, demand will grow as supply grows. For this reason, prosperity should be increased by stimulating production, not consumption. Another implication of Say’s Law is that the creation of more money simply results in inflation; more money demanding the same quantity of goods does not create an increase in real demand.

This has been brought up countless times in the past couple months by non-Keynesians against the stimulus.  They say something along the lines of this:

[B]ailouts and stimulus plans are funded by issuing more government debt. (The money must come from somewhere!) The added debt absorbs savings that would otherwise go to private investment. In the end, despite the existence of idle resources, bailouts and stimulus plans do not add to current resources in use. They just move resources from one use to another…

First of all, there are issues with this type of theory when it comes hoarding and dishoarding.  Under Say’s law, an assumption must be made that the amount of people hoarding money in an economy balances out with the amount of people dishoarding (i.e. spending) money.  The mechanism for this is that any hoarding will result in an increase in loanable funds, which in turn causes an interest rate adjustment (making loans cheaper), and spurring investment.

Unfortunately, during a worldwide banking crisis, interest rate adjustments don’t exactly work the way they’re supposed to.  A corollary to all of this is that the velocity of money is not constant, or in other words, the amount of money being spent per year is not fixed, and typically drops substantially during a recession.  Therefore, since we have a bunch of resources sitting idle, why doesn’t the government increase spending to utilize the increase in idle resources?  There’s your stimulus.

This is not to say that we shouldn’t be concerned about any “crowding out” of private investment, but during a severe recession, the risk of that is very low.  Brad DeLong:

Could it happen that as the government starts its spending that the spending is, in Fama’s words, “funded by issuing more government debt…. The added debt absorbs savings that would otherwise go to private investment… [and] just move[s] resources from one use [private investment] to another [government purchases]…”? Yes, it can happen, When government deficit spending triggers a sharp rise in interest rates, that rise in interest rates will discourage and crowd-out private investment spending. But you have to have that rise in interest rates, and we don’t: the ten-year Treasury rate last Friday was 3.02% per year, down from 4.01% back before Obama’s election victory.

This is why the government should spend like crazy during a recession, and then eliminate budget deficits during boom periods.  Unfortunately, in the past 8 years we piled up a huge deficit fighting a disastrous war that had nothing to do with strategic American interests.

Heckuva job, Bush.