There is a YouTube going around in which Ron Paul’s applause line at a rally is “We’re all Austrians now!” Conveniently enough, in this interview, Pete Boettke explains Austrian economics superbly.

Austrians want to talk about the institutional environment within which economic activity takes place. They want to talk about cultural frames of reference that form the priors that rational actors have. They want to talk about the fact that we each have different priors, because we’re diverse individuals who have different perspectives on the world. Somehow, we have to reconcile these differences through the exchange processes in the market. …It’s a very broad notion of social science, of which economics is a part, rather than the idea that economics is somehow separated from all the social sciences.

Read the whole thing. I could have quoted many paragraphs. More below the fold.On the topic of Austrian economics and Ron Paul, Matt Yglesias writes,

Unfortunately, however, it’s the Austrian school, which preaches despair and demands no action at all, that has the most effective political champion and the most dedicated followers. If I’m wrong, and the economy doesn’t recover in 2012, then these faddish views may gain more steam and perhaps we really all will be Austrians someday soon. But let’s hope not. The developed countries that have done best in the recession–places like Israel and Sweden–are the ones that have pursued the least “Austrian” courses of action, while the European Central Bank’s insistence on pursuing a somewhat Austrian-style course in Spain and Italy is creating a deepening crisis.

Separately, Yglesias writes,

I have a pet theory that one of the main reasons the policy response to the current economic crisis has been so bad is that we had the wrong crisis.

What he is saying is that the crisis we got is not the crisis that economists were predicting. This is a very important point. A lot of economists predicted crisis X. Instead we got crisis Y. And now the economists who predicted crisis X jump to claim credit for predicting the crisis. What Yglesias adds to this narrative is the claim that policy is responding to the crisis that was predicted rather than to the actual crisis.

I think that the best illustration of Yglesias’ point is the policy response to Freddie Mac and Fannie Mae. The crisis people expected was that a sudden move in interest rates would expose risks in their portfolio management. No one expected them to suffer from too many mortgage defaults. And even after the fact, many “reform”proposals call for a new entity that no longer takes interest-rate risk (the risk that didn’t hurt Frannie) but takes credit risk (the risk that killed them). In short, the reformers act as if we had the crisis they predicted, not the one that we had.

Anyway, in macroeconomics, the crisis that was predicted was a huge capital outflow, leading to higher interest rates and a depreciation of the dollar. This would have forced a reorientation of the economy away from consumer spending and housing and into producing internationally competitive goods and services. If you are a policy wonk, this requires all sorts of government management to help with this complex transition to a weak dollar with high interest rates. Yglesias writes,

But this is not the crisis we’re having. Interest rates are low. Headlines tell us that “U.S. Factories Could Suffer From Dollar’s Appeal”. I’m inclined to think that we will, at some future point, face the crisis we should have had and it will need to be addressed in complicated ways. But the crisis we’re having is, for all its horror and scale, a pretty banal monetary crunch

Circling back to Austrian economics, the crisis we are having does resemble the crisis that Austrians were predicting. That is, they thought that money was too easy and that this would result in malinvestment. In his essay on Austrian economics, Yglesias dismisses this because the decline in the economy proved to be so widespread. However, I would argue that the patterns of specialization and trade are so complex and interdependent that the crash in housing could in fact lead to widespread disruptions. It affects real estate agents, attorneys, firms involved in the manufacture and distribution of household durables, and so on. It has huge relative regional effects. It reverberates through the financial industry. It affects people overseas who had counted on an ongoing mortgage securities market.

I do not want to assert that the crisis we are having is precisely what Austrian business cycle theory predicts. I am not such a firm believer in any macro model. Let me finish with another quote from Boettke on Austrian thinking:

What the position makes you have is not libertarianism, or anything like that, but humility. The economist is nothing more than a student of society, and any economist that tries to represent themselves as a saviour of society should be subject to ridicule.