Austrian vs Keynesian Economics, Deficit hawks vs Deficit Doves

In the last couple of posts, we had concluded that it is okay to not address the debt problem being faced by the US/Europe right away in the middle of a recession. The prescription we had in mind was to focus more on creating jobs rather than tackling the rising debt because the debt is not coming due any time soon. This is similar to the stand taken by Keynesian economists (most prominent of them being the nobel laureate - Paul Krugman) but completely contrary to that of Austrian economists (economists from the Austrian school of thought, the most prominent believer of them being Congressman Ron Paul who was bested by Mitt Romney in the Republican primaries).

Debate has been raging on between the two schools for a long time showing that economics is more of an art than science. Check out the highly popular debate between the two Pauls (http://www.youtube.com/watch?v=WEoGKpnutyA&feature=related ) on YouTube. If you don't make head or tail out of this highly anticipated debate - fret not! Here's the lay economist to the rescue.

Actually, we were concerned that the conclusions made in the last two posts went against traditional wisdom dished out to individuals - a) live within ones means; b) do not live off of potential future earnings. After considerable head scratching, we believe we are able to understand the assumptions made by the Austrian economists (as applied to our village) and we are still standing firm behind our earlier prescription.

Let's visit our village to get an idea of what Austrian and Keynesian principles are (Please read: http://layconomics.blogspot.com/2012/10/stimulus-tax-cuts-debts-deficits-and.html for some background). There we had seen that when recession hit the village, Wesley had three options.

1. Tax-cuts and easing of regulations
2. Active government stimulus
3. Quantitative Easing

If Wesley is of Austrian school of thought then he should choose option 1 and simply step out of the way, cut taxes and regulations and let the markets take their own free course. If Wesley is of Keynesian school of thought then he should follow the other options 2 and 3, namely quantitative easing  and active government stimulus (Again, please see: http://layconomics.blogspot.com/2012/10/stimulus-tax-cuts-debts-deficits-and.html).

The Austrian economists believe the following (among many others):

1. The boom and bust cycles are due to the power of issuing GOUs bestowed upon governments.
2. Governments are capable of abusing their power of issuing GOUs to distort the markets and fund unpopular programs that the governments believe are necessary.
3. If the government issues unlimited GOUs (like we had discussed in http://layconomics.blogspot.com/2012/11/is-public-debt-really-that-terrible.html) then it will cause inflation by lowering the value of GOUs. Why? Simply because there are too many GOUs floating around in the economy (this is not true - as we will see later).
1. Actually, the scenario the economists paint is even more dire where they predict the collapse of the entire currency market (e.g. the US dollar) - where the GOUs have no value and people holding tons of GOUs will be left holding the bag unable to exchange the GOUs for any goods of value.
4. The government should completely step out of the way and let the markets decide how to revive the economy.
5. The capital for investment should come from savings and not from debt (GOUs).

In our opinion, (Very Important - we keep raising this over and over) given that:

1. all the basic needs of the modern society can be satisfied by a segment of the society,
2. humans are capable of producing more goods if sufficiently motivated (elastic capacity) and,
3. the same humans are capable of finding new needs and wants (where none existed before),

the Austrian school of thought is a little anachronistic. 

Please consider the following arguments:

1. Somebody should have the power to issue GOUs or non government equivalents (IOUs) - Without IOUs, in a society where some of the goods have a shelf life (e.g. fresh food), future investments/savings and the GDP are necessarily lower. Let's see why. Without IOUs, productive members of goods (destined for immediate consumption) will only barter with other productive members, leaving non-productive members out of the loop even if they can be productive in the future. This will also mean that those productive members will only produce as much as required for their own needs and for the purposes of barter. They will not produce for the non-productive members, even if they are capable, because they will get nothing in return (remember! IOUs don't count) and any extra produce, if not immediately consumed, is wasted. This means that IOUs are important and GOUs which are IOUs with governmental backing carry even more weight.
1. In the US, the power to issue GOUs lies with the Federal Reserve (printing of money) and the power to issue IOUs lies with the banks (via fractional reserve lending).
2. More GOUs/IOUs does not necessarily cause inflation - GOUs/IOUs issued for goods are necessarily for consumption by currently non-productive members of the society (unless people misuse them for hoarding goods and speculation - even then production can rise to meet this imaginary demand). Note that the productive members have the capacity to expand production to meet the demand from the non-productive members given life via said GOUs/IOUs.
3. Power to issue GOUs need not be unlimited - In a democracy, no government has the power to issue GOUs endlessly to fund unpopular programs.
4. Issuing GOUs/IOUs increases real GDP - GOUs/IOUs issued to productive members increases production of goods of actual value (since they are for the consumption by non-productive members).
5. GOUs are definitely more popular than taxes - After all, who wants to keep producing something for nothing.
6. Booms and busts are related to investments regardless of whether they are from GOUs/IOUs or savings - Austrian school of thought claims that GOUs/IOUs allow for massive mis-investments causing huge busts when the investments don't pan out in unison. However, the potential to mis-invest does not lie with the government alone. Even private businessmen have the potential to mis-invest enmasse based on the latest hot investment idea (the housing and internet bubbles come to mind).

Given these arguments, it is clear to us that GOUs are not the monsters they are made out to be. Does this mean that we can let the debt build on itself forever as long as we can guarantee that people are able to use their GOUs to obtain goods and services as and when they want it? In an ideal situation, yes. However, the health of the economy is heavily dependent on the sentiment of the members. If the society suddenly loses confidence in the GOUs (because they get spooked out by the number of GOUs floating around) then the newer members of the society might stop accepting GOUs in exchange for their products. All the members in possession of GOUs thinking they have a certain amount of wealth will end up with nothing. This should give us a good idea why the Austrian school of thought appeals to the rich. After all, this guarantees there is no chance, however remote, of their wealth suddenly transforming to nothing.