Many people are confused about what is going on in the economy right now. I thought I'd provide a post that describes how it would be viewed by adherents of the main branches of modern economics.
The two most credible strains of economics are the Monetarists and those of the Austrian School. Keynesians represent a third school.
Monetarist theory is associated with Milton Friedman and current Fed Chairman Ben Bernanke, among others. No politicians, to my knowledge, are associated with Monetarist theory.
The Austrian School is associated with economists Fredrick Hayek, Ludwig Von Meise, and Murray Rothbard, and politician Ron Paul, among others.
The work of both the Monetarists and the Austrians are clear expansions on the work of Adam Smith ("The Wealth Of Nations", well accepted arguments in favor of free trade and free association, and of the free market mechanisms that create wealth), and have few contradictions with it.
The Keynesians are associated with John Maynard Keynes, and by implication, Carl Marx and his contemporaries. The Keynesians would claim linage to Adam Smith, but their theories are inherently inconsistent with much of Smith's work, and directly contradict the theories of the Monetarists and the Austrians.
It should be noted that no respectable economist is now a pure Monetarist or Austrian. They are two competing theories that have many of the same underlying principles, and differ mainly on whether monetary policy can be used constructively. The Federal Reserve is a tool of Monetarism, and the Fed Chairman has no choice, under law, but to act like a Monetarist, attempting to use the printing of money promote economic growth.
It should also be noted that the current system, put in place by the government, is an attempt to use the (most controversial) aspect of Monetarism that theorizes that monetary policy can be used as a productive economic tool, in conjunction with Keynesian economic planning. This is somewhat ironic, in that any serious Monetarist will reject Keynesian planning in virtually any form. This is, in practice, why Federal Reserve Officials are constantly advising Congress to reduce government interventions, warning that there is only so much they can do to support the economy.
All current elected leaders (other than Ron Paul) subscribe to the Keynesian/Monetarist hybrid philosophy, whether they know it or not. (Pure Keynesians are extinct in serious economics circles).
So how would members of the various schools view the current financial crisis?
The Cause: It is a Keynesian style economic "planning" effort that the United States has employed since the beginning of the 20th Century. One would expect that they would attempt to explain the current crisis in terms of fixable shortcomings an otherwise good "plan" to improve on the free market's allocation of housing, as well as more Marxist explanations related to the greed of capitalists. This is exactly what we are seeing in the news. They assert that the aspect of the "plan" now causing trouble, i.e. an artificially high rate of housing development, followed by the bursting bubble, is only causing trouble due to a lack of proper regulations, and the resulting ability of greedy businessmen to run amok. (The relevant policies related to this part of the Keynsian "plan" include the home mortgage deduction, various direct subsidies for housing including the FHA and HUD, the creation of subsidized and government guaranteed mortgage insurance with Fannie Mae and Freddy Mac, and various "civil rights" type laws requiring banks to provide loans in poor areas such as the Community Reinvestment Act, along with the Federal Reserve policy of keeping interest rates artificially low).
The Solution: Fix the plan by outlawing certain behaviors that are incentivized under the structure created by the plan (such as uncreditworthy people buying houses, and investors taking high levels of financial risk). Massive government spending financed by printing money, and lower interest rates (more printing money) will create jobs and save the economy.
The Cause: The pure Monetarists believe that the problem was cause by a fundamentally flawed "plan," which would describe virtually any economic plan conceived by government. Their theories dictate that the unavoidable misallocation of resources caused by any large scale government planning effort would, as a mathematical certainty, eventually result in a major economic contraction. The plan, they would argue, turned the irresistible forces of economics toward a bad result. They would point out that the plan created an underlying structure in which people and lenders had a strong incentive to act just as they have acted. They would argue that more regulation (i.e. a less bad plan with more laws making it difficult or inconvenient for people to act in accordance with their structural incentives) could have slowed the progression of the unavoidable adverse economic effects of the plan, making them better able to mitigate the damage through activist monetary policy.
The Solution: Drastically alter the plan to slow the progress of it damaging effects. Better yet, eliminate government intervention in the economy completely. The resulting economic downturn can, to at least some degree, be mitigated by massive monetary expansion. Printing money and giving it to banks, and low interest rates.
The Cause: The Austrians believe, like the Monetarists, that the problem was cause by a fundamentally flawed plan. But they would focus on the activities of the Federal Reserve, and would assert that excess money creation, artificially cheap credit (i.e. the primary tool of the Monetarists), would alone have caused the problem, regardless of the so-called "quality" of the plan. The combination of the flawed Keynesian plan and the flawed Monetarist monetary policy is the worst of all possible worlds.
The Solution: There is no solution. We are in for a major economic contraction. The more the government does to try to stop it, the deeper and longer it will be. If the government again attempts to use monetary policy to "bubble" our way out of economic trouble, it will either fail, leading to the immediate downfall of our society, or, if successful, create a bigger bubble which will cause a far more severe crash in the near future, one from which there will be no escape. The Austrians would state that the best option is to reform the monetary system, creating "sound money" and stopping the government from printing money, which will cause a very severe, but relatively short-lived (say 3-7 years), economic contraction, after which sustainable economic progress could resume. It would also be best to abandon the Keynesian plan in its entirety immediately. However, if Keynesian planning continued under a "real" money system, the damaging economic effects of the plan would be impossible to conceal.
It is an unfortunate fact that the Austrians are the only branch with any success in predicting macroeconomic trends. In early 1929, both Hayek and Von Meise predicted the then-coming depression. More recent Austrians predicted both the Internet Bubble and the current Housing Bubble. They have been warning of the current financial crisis. The Austrians also predict that, prior to the ultimate disintegration of our society, great institutions of the Keynesian system, thought invulnerable, will crumble spectacularly, like pillars of sand. That is one reason why the recent fall of all five venerable investment banks on Wall Street and the largest insurance company in the world are very concerning events to students of economics: They are late-stage predictions of the Austrians, events that occur shortly before a "death spiral".
It is worth noting that the increasing frequency with which the predictions of the Austrians were coming to pass was a central theme of Ron Paul's presidential campaign.
The Keynesian/Monetarists and the Monetarists would predict that we are in for a mere recession. Unfortunately, neither the Keynesian/Monetarists nor the pure Monetarists have any record of macroeconomic predictive success. Neither branch would have predicted the severity of the current crisis, and the Keynesian/Monetarists would have thought it utterly impossible. Further, Keynesian (and arguably some measure of Monetarist) "solutions" to the Great Depression were not successful, in terms of measurable macroeconomic effects.
Finally, it should be noted that there is much argument in serious economics circles about whether the Great Depression could have been avoided. The Keynesians are not serious participants, as it was Keynesian policies that were tried and unambiguously failed during the Depression. However, the Monetarists (notably current Fed Chairman Ben Bernanke in this PhD Thesis) argue that massive monetary expansion could have turned the Depression into a mere severe recession. The Austrians say that is rubbish, and that massive monetary expansion would have only aggravated the situation by causing hyperinflation, to go along with the economic contraction.
The current solution being attempted by the Government is a combination of Keynesian and Monetarist solutions. For us economics buffs, it will be interesting to see whether the Austrians or the Monetarists are right. Just a very bad recession, or a hyperinflationary depression? Oh well, at least its good to live in interesting times.