Re: ECON: The Hangover Theory?

From: Technotranscendence (
Date: Wed Mar 21 2001 - 08:50:23 MST

On Wednesday, March 21, 2001 12:57 AM wrote:
> In a message dated 3/20/01 9:08:34 PM, writes:

I did NOT write that article. I forwarded it.:)

> >Many media pundits compare the business cycle to a party in which the
> >(the central bank) takes away the punch bowl (raises interest rates) just
> >the party (the boom) is really getting underway. The idea is that tight
> >money and credit policies trigger recessions. Ergo, loose or easy credit
> >policy is the way to prevent a recession.
> Not entirely fair to that recession model; the assumption is that the
> bank does so to stop or end inflation.

I think John Cochran's point is that if you avoid the initial inflation, you
don't get the need to stop or end it.

(For the record, I don't entirely agree with Cochran, especially in his
assumption that zero growth in the money supply is necessary to end
inflation. I think he's hinting at a 100% reserve regime being the only
solution. I disagree with this. I think free market banking is the
ultimate solution and this type of banking will almost definitely be
fractional reserve. The difference between free market banking and today's
system? Each bank would set it's own reserve requirements and pay for its
mistakes. Inflating (having less reserves than necessary to deal with
day-to-day needs and a buffer for some deviations) risks the bank going
under. Deflating (having more reserves than necessary to deal with
day-to-day needs and a buffer for some deviations) means lower profits and
less business than other banks. The feedback would be immediate and banks
would act just like other businesses, having an incentive to manage their
assets comptently or going under if they don't. This would be radically
different than central banks or even 100% reserve systems. See George A.
Selgin's _The Theory of Free Banking: Money Supply Under Competitive Note
Issue_ for more on the subject. See also Kevin Dowd's short list of works
on free banking at )

> >In contrast, the Austrian business cycle theory traces the cause of
> >recession (bust) back to the beginning of the party (the boom). The host
> >guilty, not of taking away the punch bowl and spoiling the party, but of
> >spiking the punch and thus causing many of the partygoers to suffer from
> >unanticipated hangover.
> Both the "stop inflation" (party pooper) and the "malinvestment"
> models of recession are quite old.

Cochran cites von Mises who had elaborated that model in his 1949 book
_Human Action_. I'm not sure of the history of it, BUT Cochran makes no
claim that he just thought of it yesterday. At the same time, a theory's
being not new does not make it wrong. Nor does it being new make it right
(or more right than older theories).

> The economist just had an article
> (March 10, 2001, p 67-70) speculating that the US has generally had
> "party pooper" recessions since WWII but now is due for a "hangover".
> In your metaphor,

Whoa! It's not MY metaphor. It's Cochran's.:)

> the punch *has been* spiked, but the host (the
> Fed) pulls the punch when the guest start getting rowdy, and they never
> get drunk enough for a hangover. Now that the Fed has gotten quite good
> at managing inflation,

I dispute this claim. By what measure has the Fed managed inflation?
Stephen Horwitz points out in his recent book _Microfoundations and
Macroeconomics: An Austrian Perspective_, the total costs of inflation are
much than higher than the conventional measures. If this is so, then even
so called "low inflation" regimes might be causing much more damage to the
capital structure -- making it less sustainable -- than is commonly thought.
This would, to some extent, explain why even periods of low inflation lead
to all kinds of financial maladies. (More information on this book is
available at See also his "The
Costs of Inflation Revisited," which is to appear in _The Review of Austrian
Economics_ and a draft is now available online at Some of the arguments he uses
in the book also appear in this article.)

> we've had a boom run on long enough for serious
> malinvestment (e.g. internet mania) and now we're due for a hangover.

It's not, as you might be suggesting, that a little inflation is okay.
There are unrecoverable costs of inflating period, mainly because of how any
change in monetary equilibrium does not evenly flow through the economy.
Certain people benefit from inflation immediately, while others get burned.
Even deflating afterward -- assuming one does not overdeflate, which causes
other irreversible damage as well -- does not undo this. Horwitz goes over
this in detail in his book. He has a chapter dedicated to inflation and
another dedicated to deflation. I highly recommend it. (I'm working on a

> The economist observes that Japan's malaise of the 90's (which still
> continues) is a hangover type recession, which indicates how bad they
> can be. IMO Japan's trouble qualifies as a depression, albeit mild and
> drawn-out.

I don't know enough about the Japanese example, though I think there several
problems with government intervention there, including a long period of
inflation, price rigidities (set by law), and massive subsidies. All of
these make it very hard for that economy to readjust itself. Recall just a
decade ago, Japan was the marvel of the world and many in the US feared they
would soon be working for Japanese companies...


Daniel Ust

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