University of Guelph-Humber

It’s not a new allegation.  During uncertain economic times such as these, common thought accuses finance of playing an overly excessive role in society.

As Dr. George Bragues, assistant vice-provost and program head of Business at the University of Guelph-Humber explains, “The allegation is that too many people are working in finance, too much of the economy is tied up with finance – and that’s not a good thing.”

He continues with the accusation:  “Stock markets wastefully use resources that could be better used in the real economy.  Instead of shuffling paper around and engaging in speculation, people should be doing more tangible things and providing more useful services.”

While there isn’t debate over finance’s excessive role, there is much discussion over where to point the finger.

Dr. Bragues states his conclusion quite simply:  “To the extent the stock market ever absorbs capital, it is only during stock market booms.  But it’s not the fault of finance; it’s the fault of the central bank.  Bull and bear markets cycles are, at bottom, politically driven.”

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And herein lies an old debate triggered by an old allegation.

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Austrian-American economist, Fritz Machlup, originally took up that debate in the 1920s and 30s when the stock market crashed, which led to the Great Depression.

In a book he wrote in 1929 entitled The Stock Market, Credit, and Capital Formation, Machlup sets the stage for discussion:  “When at certain times a large part of the credit supply is “taken up” by the stock exchange, because it is the strongest bidder on the credit market, critical observers remark that “it is a shame that the stock exchange should have secured credits of which industry could have made much better use.”

Machlup argues that the stock market simply works as an intermediary between the saver and the entrepreneur, and generally does not engross or absorb capital from society.  But he does make a noteworthy exception when it comes to late stage boom periods – or uncertain economic periods, such as these.  In this situation, he states that markets do engross capital, depriving the rest of the economy of it.  But in answering the key question as to why this happens, Machlup turns to the central bank’s actions.

Dr. Bragues expands on the phenomenon:  “When the central bank adds money to the system or plays with interest rates, it distorts the structural production and causes uncertainty among traders.  Uncertainty leads to steady growth trends, which then cause a certain psychological dynamic for speculative fervor to begin among the general public.  This is when people start speculative buying and selling.”

“But eventually, people realize the party’s over, and all leave at the same time.  This is when the whole house of cards comes crashing down,” says Dr. Bragues.

The economic theories used to put central bank policies at the core of the issue rely on a set of theories that – like the stock market – has seen its share of ups and downs.

“Austrian economics is a school of economics that has been making something of a comeback lately,” says Dr. Bragues.

Austrian economics encompasses a set of ideas that can be used to analyze and explain how the economy works.  It doesn’t give specific positions on issues, but rather gives a set of theories that can be used to explain everything from war to stock market behaviour.

Once part of mainstream economic thought, Austrian economics were “put in the dust-bin of history during the 1930s,” jokes Dr. Bragues.  Its relevance to today’s economy is at the root of its current rise in popularity.

He continues:  “In trying to account for the recent economic situation, I revisited the Austrian literature some time ago.  Its theory of the business cycle seems to be able to explain past and present financial crises.  Since then, it’s really core to my understanding of economic situations.”

This weekend, leading academic economists from around Canada, the United States and Europe, will be gathering in order to further their understanding of Austrian economics in light of current events.  The Wirth Institute for Austrian and Central European Studies, an institute housed by the University of Alberta, is hosting the conference at which Dr. Bragues will be presenting a paper he wrote.

In taking Machlup’s Austrian views outlined in The Stock Market, Credit, and Capital Formation (1929), Bragues’ paper revisits old monetary analysis of the stock market in order to shed light on new circumstances.

When asked about the main question put forth in the paper, Has Fritz Machlup stood the test of time?  Bragues answers with an enthusiastic ‘yes’.

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