A few recent posts have sparked some back and forth in the comments regarding the financial crisis and whether or not the Austrian School of economics can provide an accurate description of what happened and how to move forward. My view, based on what I have read, is that what we now call the financial crisis had two related but distinct parts.
The first part was the subprime crisis and it is here that the Austrian view of the business cycle has great success at describing events. The (really) short version goes something like this. An increase in the money supply, without an increase in productivity, will result in inflation. This is a standard monetarist view. The problem, the Austrians note, is that the inflation doesn't occur equally throughout the entire economy. It's just not possible to drop money from a helicopter evenly over an entire country.
So the expansion of money occurs and it flows more to some sectors of the economy, like housing, than to others. The problem with this is that the people making decisions in the marketplace, aren't able to tell whether or not the increased prices in a sector are the result of real changes in the market, like greater demand, or if they are just the result of inflation. When people see the higher prices, capital naturally flows to those sectors. If the high prices are the result of real changes, then this is a good thing. The increased capital will increase supply and eventually drive down prices in that sector. If, on the other hand, the higher prices were the result of inflation then a bust is sure to follow. The expanded supply has no corresponding demand and the sector collapses.
The transition after the collapse is painful because capital has specific uses and can't always be easily converted from one sector to another. High home prices might mean we get more capital devoted to making asphalt shingles than we need. This means we have less capital available for making things that people want, like iPads. And let's face it, if you were stuck in an airport for two hours which would you rather have to pass the time?
The change in prices due to an expansion in money supply is what is called a nominal change. Through the mechanism of distorted signals that I just described, the Austrians demonstrate how nominal changes can have real effects in an economy. This is an important insight and one of the reason Austrians are opposed to inflationary policies by governments and central banks.
The second part of the financial crisis was a bank run. In this case, I don't just mean the institutions that give you a toaster when you open an account. I mean any institution that was in the business of borrowing money for the short term and lending for the long term. This is what many of the major financial institutions were doing. Lehman Brothers, by borrowing in the short term commercial paper markets, then buying long term housing backed bonds was doing exactly this. The problem came in when the folks lending to Lehman no longer wanted to do so and the bonds that Lehman was holding were suddenly recognized as being worth much less than they paid for them.
The Austrian critique of this part of the story has to do with our fractional reserve banking system (where only a portion of deposits have to be kept on hand) that is itself a monetary expansion. Austrians will argue for 100% reserve banking, but I don't think even this would stop bank runs in times of crisis. Additionally, isn't it at least possible that our banking system, even with its expansionary fractional reserves, has resulted in real economic gains when capital is provided to an entrepreneur who takes out a loan in order to bring a new product to market, develop a better way to make a new product, or meet an increase in demand?