I’ve long promised a post on Austrian Business Cycle Theory, and here it is. For those who would rather get straight to the conclusion, it’s one I share in broad terms with most of the mainstream economists who’ve looked at the theory, from Tyler Cowen , Bryan Caplan
and Gordon Tullock at the libertarian/Chicago end of the spectrum to Keynesians like Paul Krugman and Brad DeLong.
To sum up, although the Austrian School was at the forefront of business cycle theory in the 1920s, it hasn’t developed in any positive way since then. The central idea of the credit cycle is an important one, particularly as it applies to the business cycle in the presence of a largely unregulated financial system. But the Austrians balked at the interventionist implications of their own position, and failed to engage seriously with Keynesian ideas.
The result (like orthodox Marxism) is a research program that was active and progressive a century or so ago but has now become an ossified dogma. Like all such dogmatic orthodoxies, it provides believers with the illusion of a complete explanation but cease to respond in a progressive way to empirical violations of its predictions or to theoretical objections. To the extent that anything positive remains, it is likely to be developed by non-Austrians such as the post-Keynesian followers of Hyman Minsky.
Update There’s a fascinating discussion linking to this post here. In French, but clear and simply written. Anyone with high school French and a familiarity with the issues should be able to follow the main points.
First, some history and data. Austrian Business Cycle Theory was developed in the first quarter of the 20th century, mostly by Mises and Hayek, with some later contributions by Schumpeter. The data Mises and Hayek had to work on was that of that of the business cycle that emerged with industrial capitalism at the beginning of the 19th century and continued with varying amplitude throughout that century. In particular, it’s important to note that the business cycle they tried to explain predated both central banking in the modern sense of the term and the 20th century growth of the state. The case of the US is of particular interest since the business cycle coincided with a wide range of monetary and banking systems: from national bank to free banking, and including a gold standard, bimetallism and non-convertible paper money.
This NBER data goes back to 1857, but there was nothing new about the business cycle then (Marx, for example, had been writing about it for a decade or more). The US experienced serious “panics”, as they were then called in 1796-97, 1819 and 1837 [1] as well as milder fluctuations associated with the British crises of the 1820s and 1840s.
The typical crisis of the 19th century, like the current crisis, began with bank failures caused by the sudden burst of a speculative boom and then spread to the real economy, with the contraction phase typically lasting from one to five years. By contrast, recessions since 1945 have generally lasted less than a year, and have mostly been produced by real shocks or by contractionary monetary and fiscal policy.
According to the theory, the business cycle unfolds in the following way. The money supply expands either because of an inflow of gold, printing of fiat money or financial innovations that increase the ratio of the effective money supply to the monetary base. The result is lower interest rates. Low interest rates tend to stimulate borrowing from the banking system. This in turn leads to an unsustainable boom during which the artificially stimulated borrowing seeks out diminishing investment opportunities. This boom results in widespread malinvestments, causing capital resources to be misallocated into areas that would not attract investment if price signals were not distorted. A correction or credit crunch occurs when credit creation cannot be sustained. Markets finally clear, causing resources to be reallocated back towards more efficient uses.
At the time it was put forward, the Mises-Hayek business cycle theory was actually a pretty big theoretical advance. The main competitors were the orthodox defenders of Says Law, who denied that a business cycle was possible (unemployment being attributed to unions or government-imposed minumum wages), and the Marxists who offered a model of catastrophic crisis driven by the declining rate of profit.
Both Marxism and classical economics were characterized by the assumption that money is neutral, a ‘veil’ over real transactions. On the classical theory, if the quantity of money suddenly doubled, with no change in the real productive capacity of the economy, prices and wages would rise rapidly. Once the price level had doubled the previous equilibrium would be restored. Says Law (every offer to supply a good service implies a demand to buy some other good or service) which is obviously true in a barter economy, was assumed to hold also for a money economy, and therefore to ensure that equilibrium involved full employment
The Austrians were the first to offer a good reason for the non-neutrality of money. Expansion of the money supply will lower (short-term) interest rates and therefore make investments more attractive.
There’s an obvious implication about the (sub)optimality of market outcomes here, though more obvious to a generation of economists for whom arguments about rational expectations are second nature than it was 100 years ago. If investors correctly anticipate that a decline in interest rates will be temporary, they won’t evaluate long-term investments on the basis of current rates. So, the Austrian story requires either a failure of rational expectations, or a capital market failure that means that individuals rationally choose to make ‘bad’ investments on the assumption that someone else will bear the cost. And if either of these conditions apply, there’s no reason to think that market outcomes will be optimal in general.
A closely related point is that, unless Say’s Law is violated, the Austrian model implies that consumption should be negatively correlated with investment over the business cycle, whereas in fact the opposite is true. To the extent that booms are driven by mistaken beliefs that investments have become more profitable, they are typically characterized by high, not low, consumption.
Finally, the Austrian theory didn’t say much about labour markets, but for most people, unemployment is what makes the business cycle such a problem. It was left to Keynes to produce a theory of how the non-neutrality of money could produce sustained unemployment.
The credit cycle idea can easily be combined with a Keynesian account of under-employment equilibrium, and even more easily with the Keynesian idea of ‘animal spirits’. This was done most prominently by Minsky, and the animsal spirits idea has recently revived by Akerlof and Shiller. I suspect that the macroeconomic model that emerges from the current crisis will have a recognisably Austrian flavour..
Unfortunately, having put taken the first steps in the direction of a serious theory of the business cycle, Hayek and Mises spent the rest of their lives running hard in the opposite direction. As Laidler observes, they took a nihilistic ‘liquidationist’ view in the Great Depression, a position that is not entailed by the theory, but reflects an a priori commitment to laissez-faire. The result was that Hayek lost support even from initial sympathisers like Dennis Robertson. And this mistake has hardened into dogma in the hands of their successors.
The modern Austrian school has tried to argue that the business cycle they describe is caused in some way by government policy, though the choice of policy varies from Austrian to Austrian – some blame paper money and want a gold standard, others blame central banks, some want a strict prohibition on fractional reserve banking while others favour a laissez-faire policy of free banking, where anyone who wants can print money and others still (Hayek for example) a system of competing currencies.
Rothbard (who seems to be the most popular exponent these days) blames central banking for the existence of the business cycle, which is somewhat problematic, since the business cycle predates central banking. In fact, central banking in its modern form was introduced in an attempt to stabilise the business cycle. The US Federal Reserve was only established in 1913, after Mises had published his analysis.
Rothbard gets around this by defining central banking to cover almost any kind of bank that has some sort of government endorsement, such as the (private) Bank of England in the 19th century, and arguing for a system of free banking that would avoid, he asserts, these problems. But, on any plausible definition of the term, the US had free banking from the Jackson Administration to the Civil War and that didn’t stop the business cycle (Rothbard offers some historical revisionism to argue that the Panic of 1837 didn’t really happen, but that wasn’t what US voters thought when they threw the Jacksonians out in 1840). And free banking in late 19th century Australia (our first quasi-central bank was the Commonwealth Bank established in 1915) didn’t prevent a huge boom and subsequent long depression around 1890. Overall, the US was much closer to free banking throughout the 19th century than in the period from 1945 until the development of the largely unregulated ‘shadow banking’ system in the 1990s, but the business cycle was worse then (how much worse is a matter of some controversy, but no serious economist claims it was better).
To sum up, the version of the Austrian Business Cycle Theory originally developed by Hayek and Mises gives strong reasons to think that an unregulated financial system will be prone to booms and busts and that this will be true for a wide range of monetary systems, particularly including gold standard systems. But that is only part of what is needed for a complete account of the business cycle, and the theory can only be made coherent with a broadly Keynesian model of equilibrium unemployment. Trying to tie Austrian Business Cycle Theory to Austrian prejudices against government intervention has been a recipe for intellectual and policy disaster and theoretical stagnation.
John Quiggin 
Professor Horwitz, what is your definition of money?
I apologise for coming a little late to this thread and I hope I have not overlooked a post that may contain the answer to my question.
Hmmm…still no simple explanation of the “benefits” and desirability of FRB.
For those who want to know what the “argument” is all about, I suggest you read Hulsmann’s Ethics of Money Production, Rothbard’s Mystery of Banking, Woods Meltdown, Murphy’s The Politically Incorrect Guide to the Great Depression. Or anything from Frank Shostak at Mises.org. These are all “hardcore” “dogmatists”/”cultists” who happen to be solidly anti-FRB, and explain their reasons in clear, simple, easy-to-understand terms.
By stating clearly that is it a form of embezzlement.
I’ve yet to see in print a good explanation of the economic (let alone moral) “desirability” of FRB.
Unfortunately Steve’s writings have not assisted me. Rothbard’s have.
TGGP: Google “Mike Whitney” and “Glass Steagall”.
Note: I’m NOT saying he is right.
I’m just saying the connection has been made between deregulation and the abolition of Glass Steagall and the subsequent disaster.
This connection has in fact been made by many (many!) liberal commentators. Whitney is just one of many.
[…] for the endless youtube clip that is Bachmann’s career. Mostly I want to use this to link to John Quiggin’s takedown of the Austrian school. It’s a good piece, that also links to may other critiques from across the […]
Eric #90
no actually I was just pointing out that the commenter in question was actually doing his side a disfavour, as were some of the other commenters. They should leave it to Steve Horwitz who at least seems to be used to dealing with unbelievers. Sorry, if I get my style from Monty Python.
Lord,
I don’t disagree that the credit cycle is a problem. And I am actually someone who pushes also for somewhat radical financial reform (less credit more base money in my case – and more pressure on surplus countries internationally). I have that in common with the Austrians, its just that I prefer science to faith and don’t worship anything, let alone markets.
Dogma, indeed. Ossified or not, we’re stuck with dogmatic economists bearing dubious theories.
The Austrians have (perhaps rightly) decided FRB and central banking are an unmitigated disaster. They refuse to analyze the world as it is, beyond predicting disaster. No wonder the theory is largely stuck in the past. The Australian economist Steve Keen has some good insights on this.
The Keynesians, meanwhile, cling to their arrogant dogma, believing they can tame an unbelievably complex system. They subject the world to half-baked theories that caused the 70’s stagflation and the current crisis.
Take your pick. It’s all politics masquerading as science. Marx takes the cake as the economist who caused the most destruction. Keynes is probably next.
JQ – thanks for an interesting post, and thanks to the commentators who have engaged civilly and constructively on the thread. More, please! 🙂
The initial contribution by Professor Quiggin is worthwhile especially because it indicated how far and patient a path minority views must travel if they are to prevail.
For example, recall that Milton Friedman used to be the wild man in the wings. Not too long ago saying that inflation is a monetary phenomena or that central banks should be subject to transparent rules that target price stability were career limiting in the extreme both inside and outside of academia. Memories are short.
Hayek was the principal critic of Keynes in the 1930s. The long exchange between them in British economic journals, starting in 1931, was labelled by John Hicks in 1967 as the great debate. Robbins used Hayek’s ideas to explain the depression in the UK in his 1934 book. To be fair, Robbins later disavowed this book.
It is not a crime to change your mind in the light of exposure to new arguments and self-reflection, but that does not mean you are automatically always switching to better answers.
There are plenty of ex-Keynesians too – heretics all in the eyes of those that still follow the old true light. As Mankiw put it in a recent summary ‘the primary disagreement between new classical and new Keynesian economists is over how quickly wages and prices adjust.’ What is left for New Keynesians to form a unique policy and methodological manifesto after adding in recent decades the natural rate hypothesis, rational expectations, long and variable policy lags, time consistent rules and the use of the real business cycle methodology with imperfect competition and incomplete markets? Is anything left for New Keynesians as their unique selling point?
Has the great battle seeded by Hayek and Keynes in the 1930s shrunk to a search for a coherent theoretical explanation for the sluggish adjustment of prices and wages to shocks. Alchian, Stigler, Barro and the industrial organisation literature on relationship specific assets and long-term contracting have answered this search. Mises, Hutt and Rothbard’s reliance on regulation and union monopolies as the explanation for wage rigidity and large scale unemployment has been augmented.
Rothbard considered that the Keynesian prescription for unemployment rested on the persistence of a money illusion: the belief that while, through unions and government, workers will keep money wage rates from falling, but they will accept a fall in real wages via higher prices. By suggested this illusion was temporary in its effects on labour supply, Rothbard was anticipating rational expectation formation and entrepreneurial learning in the labour market and the need to larger and larger inflation surprises to avoid rising unemployment. Failures of malinvestments and the shift of newly unemployed labour to other sectors together with further inflation rate surprises explains stagflation.
Hutt wrote a sophisticated analysis of idle resources in 1939. Hutt described some unemployed as prospecting for jobs in a world of incomplete and costly information. Hutt differentiated between preferred idleness, pseudo-idleness (or job search) and price-driven idleness. The last results from regulation and monopoly preventing wage adjustment. Alchian acknowledged Hutt’s contribution is his own pioneering 1969 paper on resource unemployment and information costs.
Contrary to what Professor Quiggin suggested, pre-Keynesian economics includes a vibrant business cycle theory. Depressions and panics were not ignored nor denied. They had a theory of unemployment. Classical economists maintained that large scale unemployment is caused by wage rates not being allowed to fall freely.
Contributors to early 20th century business cycle theory included Irving Fisher. He contributed to the quantity theory of money and developed a debt-deflation theory of depressions. Fisher’s papers included ‘The Dance of the Dollar’ and his proposals for a compensated dollar rule to stabilise the price level. Fisher’s 1926 paper was republished in 1973 in JPE with the cute title ‘I discovered the Phillips Curve’. Aaron Director and John Hicks published sophisticated analysis of wages and unemployment before 1936.
Pigou, Marshall and Wicksell wrote extensively on the business cycle. Wicksell contributed to the quantity theory of money and the Austrian theory of business cycles, which uses Wicksell’s concept of a natural rate of interest.
The earliest contributors to monetary economics were Richard Cantillon in 1755 and David Hume in 1752. Lucas acknowledged Hume’s founding contributions to the quantity theory of money in his 1995 Nobel speech, including recognition of Hume’s discussion the short-term non-neutrality of money due to information constraints.
There is even a 18th century version of Friedman’s helicopter drop in Hume’s writings: waking up one morning with your money magically doubled. Hume wanted to explore the short and long term effects of monetary shocks while abstracting from the relative price effects in Cantillon’s theory of the business cycle.
Ricardo and Thornton debated the proper response of monetary policy to supply shocks such as famines in a quantity theory framework.
Is the Austrian policy response so far wide of the mark of contemporary optimal stabilisation policy? What are the components of such a policy?
The first stabilisation idea would be that governments should not be an independent source of instability! Is this advice much different from the outcome of the 250 years long debate over rules versus discretion?
Thomas Humphrey of the Richmond Fed well documented the history of monetary theory since the 1760s as a perpetual struggle between two camps. The first is the mercantilists, who feared hoarding of money and deflation and always prescribing low interest rates and plentiful cash as a stimulus to real activity. They would gain the upper hand when unemployment was the dominant policy concern. In the other corner are the classicals, forever fighting a rearguard action about inflation is always a monetary phenomena. They prevailed when price stability is the chief concern. The classicals oppose policy discretion and sought clear-cut rules that committed governments and their agents to price stability.
Is Friedman’s fixed rate of monetary growth rule, designed to constrain discretion and still avoid deflation, that far from Hayek’s proposals about monetary stabilisation?
Another optimal counter-cyclical policy response is that governments should avoid policies that stifle productivity. Who could disagree?
What about the idea that governments should not raise taxes in recessions? Is this not the recommendation of the tax smoothing literature? Keep tax rates stable over the business cycle to avoid random shocks to the incentives to work, save and invest.
An alternative critique might be to note that Austrian economists may not be as thorough as they could be in applying the concepts of dispersed knowledge, tendency to equilibrium and entrepreneurial discovery and learning to the labour market.
Kirzner and Rothbard argue that markets were always in disequilibrium. They only tended towards equilibrium because of the actions of entrepreneurs. Does this disequilibrium not imply there is some unemployment in the labour market?
Why should the tendency toward equilibrium be stronger in the labour market than elsewhere? The labour market is a process like any other market: it is a communication network that mobilises dispersed knowledge. Why should knowledge unfold in the labour market through entrepreneurial discovery any faster than elsewhere?
Information costs are particularly high in labour markets as compared to other markets. Because of this, behavioural and entrepreneurial responses to information gaps are likely to be particularly pronounced in the labour market. There should be disequilibrium wages, entrepreneurial errors, mispriced resources, and a process of entrepreneurial learning and error correction.
Hayek held that unemployment is always a pricing problem. True, but the correction of erroneous wages is neither instantaneous nor free.
Alchian, Demsetz and Barzel were on the mark when they pointed out that all too frequently the process of market change and reaching a new equilibrium is assumed in analysis to be a free good – a process with no resource costs.
As Kirzner has argued, entrepreneurs thrive on alertness to disequilibrium prices. They buy and sell to win profits from their discoveries thereby correcting mispricing.
Employers and workers must search for and discover each other. Workers and employers are entrepreneurs. The knowledge and forecasts about wages and locations of job seekers and vacancies each needs to improve co-ordination of supply and demand will not be discovered immediately.
97 Thanks for your answer ABOM (thats a bad shortening but your nome de plume is so long). I find your comments interesting. I dont see how the repeal of Glass Stegall was in line with any economic view.
#102 You can add Walter Block to the list of Austrians who think FRB is fraud.
A while back, Block and Bryan Caplan were engaged in an email debate:
http://www.lewrockwell.com/block/block110.html
Jim Rose,
I didn’t see much in your discussion that I disagreed with. But what exactly was the point?
Alice: You’re right. It was not in line with ANY economic theory. Keynesian. Austrian. Not even monetarist.
It was simply in line with what the bankers wanted. What the bankers want (in the Anglosphere at any rate) they generally get.
Thats what i thought ABOM too and Im not an Austrian. Im Keynesian but open minded. I think that means we agree and Im sure there may be other things we agree on. Im quite interested in the ideas on FRB and the psychology of malinvestment. I cant see a better example of this than the recent GFC (if it isnt malinvestment what is it?) and it sounds the same as speculative investment…unproductive and dangerous and a sure sign that all is not well.
Spectator says:
“The Austrians have (perhaps rightly) decided FRB and central banking are an unmitigated disaster. They refuse to analyze the world as it is, beyond predicting disaster. No wonder the theory is largely stuck in the past.”
Again, not all, and not even a majority of, Austrians believe fractional reserve banking is a disaster. Almost all agree that central banking is. It would be good to clarify that.
And it’s simply false to say they/we “refuse to analyze the world as it is.” Numerous Austrians have written pages on the current crisis, pointing to the very specific factors in the world as it is that caused the recession, including but not limited to the errors of the central bank.
Nor is the theory largely stuck in the past. Again, much has been written in the last 35 years on Austrian macroeconomics. If you choose to ignore it, so be it. But to claim it’s stuck in the past when many current writers have been working to update the theory and apply it to a variety of episodes in the last few decades is to, again, perpetuate a falsehood.
Is it so hard to come up with actual criticisms of the theory that critics have to make stuff up or introduce red herrings?
Steve, can you clarify what you mean by “central banking”? In particular, do you regard the various private or quasi-private 19th century institutions (the Bank of England in its days as a private bank, and similar) that filled this role before government stepped in as being “central banks”
If so, it appears as if central banking is something that emerges almost automatically under capitalism, just like FRB.
If not, then it seems to me that ABCT (in its anti-central bank variant) has a really big empirical problem with the 19th century business cycle, in addition to the problems I’ve already pointed out with depressions under free banking systems.
BTW, thanks for commenting and keeping your cool. I’m glad there is some new work going on in this framework – from the outside, and as someone who pays more attention than most, methodological and history of thought stuff, disputes over hardcoreness, Misesians vs Hayekians vs Rothbardians and so on are much more visible than new contributions, which is why I gave the assessment I did.
Just a brief response:
“If investors correctly anticipate that a decline in interest rates will be temporary, they won’t evaluate long-term investments on the basis of current rates. So, the Austrian story requires either a failure of rational expectations, or a capital market failure that means that individuals rationally choose to make ‘bad’ investments on the assumption that someone else will bear the cost.”
This seems like a fair assessment. However, if we want to reject the Austrian theory on this basis, we have to show both that rational expectations are true AND that these capital market imperfections do not exist. It seems rather likely to me that expectations are not strictly rational, and it seems likely that the possibility of bankruptcy (especially in the presence of limited liability corporations) makes the capital market imperfection you describe very likely. This effect gets stronger with bailouts.
“A closely related point is that, unless Say’s Law is violated, the Austrian model implies that consumption should be negatively correlated with investment over the business cycle, whereas in fact the opposite is true. To the extent that booms are driven by mistaken beliefs that investments have become more profitable, they are typically characterized by high, not low, consumption.”
Not true. Several Austrians (Garrison, Murphy) suggest that there’s a positive correlation between investment and consumption over the boom-bust cycle. Whether this violates Say’s Law, I’m not sure – of course, the economics profession doesn’t all agree on what Say’s Law even says.
“Finally, the Austrian theory didn’t say much about labour markets, but for most people, unemployment is what makes the business cycle such a problem. It was left to Keynes to produce a theory of how the non-neutrality of money could produce sustained unemployment.”
True, the Austrian theory is more interested in capital. (Thus, some Austrians dub it “Capital-based Macroeconomics”.) Of course, this comes from the fact that Austrians wanted to actually explain the “cycle”. Keynes, on the other hand, did not – and spends very little time in The General Theory explaining the cycle. He was really just interested in how the economy can get stuck in a bad equilibrium, and how policy can move the economy back out. So, he appeals to “animal spirits” to get fluctuations. Meanwhile, Austrians actually explain fluctuations, but appeal to government and union policies to explain unemployment. I find the latter to be the more intellectually satisfying option, myself.
Right. The new neo-liberal “models” that treat human beings and human actions as so many molecules bouncing around are so accurate. They must have predicted the bust, right?
For a detailed rebuttal of the article, I would suggest these two articles:
http://mises.org/story/3436
http://mises.org/story/1051
If anyone is feeling very intrepid, you could read Henry Hazlitt’s “The Failure of the New Economics.”
http://en.wikipedia.org/wiki/The_Failure_of_the_New_Economics
I have a simple question to the Austrians of whatever colour: Why is it that unemployment is rising after the collapse of the issuance of private money (eg Lehman)?
My notion of private money comes from general equilibrium theory (post 1950s). In this framework ‘private money’ is defined as securities (defined by an appropriate choice of a mathematical object)issued by private agents (characterised by a suitable choice of mathematicl objects). There are many contributing authors to this body of literature. The paper by Duffie, “Money in General Equilibrium Theory”, cap. 3, Handbook of Monetary Economics, Vol 1, North Holland, 1990, may suffice here as a representative reference.
My earlier question on the definition of money in Austrian business cycle theory is sincere.
The question of what is money (as a concept suitable for theoretical work that has policy applications) as a serious question has long been recognised by economists considered less abstract than G.E. theorists. See L. Papademos and F. Modigliani, chap 18 in the above mentioned reference text.
from the above article–
“If investors correctly anticipate that a decline in interest rates will be temporary, they won’t evaluate long-term investments on the basis of current rates.”
What an absurd statement. This is utterly false on it’s face. This just happened with the housing bubble. Virtually every Keynesian hack economist was cheering the greatness of the housing market. Meanwhile the Austrians; Schiff and Paul most notably, were warning of the impending doom.
You have a poor understanding of banking history in the US. Please, read anything by George Selgin or Larry White or Kevin Dowd or Milton Friedman on the matter. It’s easy to see that the US never had anything close to free banking. In the Jacksonian period and throughout the national banking period leading up to 1913 there were very seriously damaging restrictions on branch and interstate banking and on competitive note issue.
“Virtually every Keynesian hack economist was cheering the greatness of the housing market”
Umm, not this one, and none of the other Keynesians I know.
And, BTW, yours is the kind of comment (quite a few more upthread) that leads people to regard all Austrians as dogmatic and ignorant.
#121 Will McBride, that goes for you too.
There is a lot of quibbling about who is more hardcore, softcore, academic, the “real” economists, dogmatic, cultish, etc.
It is my opinion that when the dust settles, and the third experiment in central planning (after Communism and National Socialism) is an utter failure, the Austrians will largely have been vindicated. Only this time, the experiment is global in nature, with all the paternalistic Western social democracies engaging in the same facets of central planning (namely inflationary monetary policy, regulation of the economy and the citizenry by unelected bureaucrats, and the ratcheting up of the police state to enforce the latter).
The Austrians stand opposed to this experiment in central planning even though they know that it is largely inevitable unless the masses decide they will not stand for it any longer. Because the masses are largely the ones benefiting from the welfare state in the short term, this is unlikely to happen.
There are those who say that essentially Austrian economics is pie-in-the-sky and utopian, a central bank is inevitable, etc. This is largely true, in the same way that feudal Kingdoms were inevitable before the writings of Locke, Smith, et al produced the American Revolution. Does this mean that men like Locke, Adam Smith, Bastiat, (and Galileo in the sciences) and others shouldn’t have pursued what they thought was a higher truth, and natural laws that guide the universe? Each one of them would have curried more favor in their day by simply becoming court historians and falling in line.
The mainstream economists today are “court economists,” wishing to curry favor with the fraternal academic establishment and wishing to see their neo-Keynesian fallacies and gibberish models enforced by fiat in Washington.
In the long run, the reputations and ideas of the court historians are all dead. It is those who use logic and reason to discover inherent truths that are remembered.
John,
What’s the complaint about Will McBride’s post, other than perhaps the snippy first sentence I guess? The rest of it is historically accurate, which suggests the first sentence, though not put tactfully, has some truth to it.
One can acknowledge that the US has never had “free banking” and still accept that it should never have it. Will’s point is, by itself, just a matter of historical fact.
Ernestine Gross,
Generally, Austrians define money as whatever is used as a general medium of exchange. In the US economy, we’d generally look to something like M1 + Savings Accounts, or maybe MZM.
As far as the question you ask re: issuance of private money and unemployment… I think it depends which Austrian you ask. Personally, I’d claim that there’s no necessary connection between the two. Unemployment is rising because the misallocations have been revealed, and unproductive processes are being shut down. So, the increase in unemployment is really there for the same reasons that any frictional unemployment exists – it takes time to find a job. As far as private money issuance declining – I’m not entirely clear how the concept of private money “looks” in the real world. But, I’m going to guess: private money is money “backed” by bank debt (ex. deposits). In this case, private money issuance would contract also as a result of the revelation of malinvestments, and the resulting increased likelihood of defaults. So, to protect their balance sheets, banks hold less risky assets – for example, cash – rather than giving loans that create more money. Of course, I might be misunderstanding the meaning of private money. If you could clarify it, I imagine you could get a better answer.
Steve, the snippy first sentence is the problem, which leads me not to take the rest seriously, particularly as it’s not a “matter of historical fact”, but a semantic quibble over whether the institutions prevailing in what’s commonly called the “Free Banking era”
http://findarticles.com/p/articles/mi_qa3678/is_199604/ai_n8755671/
actually constituted free banking according to some unstated definition.
This kind of dispute is one of the things that gives Austrians a bad name. IIRC, Lawrence White, quoted as an authority above, says Scotland had free banking, while Rothbard rejects White but says that the Jacksonian era really was free banking. And no one has yet answered my question on C19 Australia.
This semantic quibble is one for free banking advocates to resolve among themselves.
I’ll just observe that (as with similar defences of communism and capitalism) if the response to “free banking has failed” is “it’s never been adopted in the pure form necessary for it to work” then I’m not really interested. People whose ideals are so fragile that the performance of their real-world approximations can’t be taken as evidence on their desirability should not engage in policy debate.
Lucas M. Engelhardt @ 126,
Examples of securities which constitute ‘private money’, fullfilling your requirement of being a medium of exchange are:
1. Frequent flyer points
2. Corporate acquisitions financed by means of the raider’s shares on issue.
3. Most derivative securities
4. IOYs, denominated in currency units or in quantities of commodities.
These securities are not included in the index set of monetary aggregates.
Fair enough John. I agree there are two different uses of “free banking” in play here. You refer to the historical period as a “real-world approximation” and I deny that that’s a fair characterization. Surely we can have a conversation about what is or is not essential to make something sufficiently an “approximation” to be relevant as historical evidence.
Your claim is an assertion open to discussion and historical evidence, no? And if the various ways in which the historical episode differed from what advocates of unregulated banking are arguing for MATTER, then the history is suspect as a claim that the desired system can’t work.
You want to dismiss that possibility tout court it appears. I think it’s a conversation worth having.
Ernestine Gross @ 128,
I think you may have missed a word in the definition that Austrians use:
“general”.
Money is what is used as a “general” medium of exchange. The examples you give are not “generally” accepted (for example, very few retailers would accept forward contracts for oil as payment) – at least to my knowledge.
JQ – you said “To put the point less tendentiously, can you point to any current or historical instances of capitalist systems with non-FR banking systems (that is, banks that lend money and fulfil the other standard functions of banking; I’m not counting people who just look after your gold for you), or any reason to suppose that capitalism could function under a 100 per cent reserve requirement?”
Under 100% reserve backed banking, you still have lending through time deposits. The only thing that can’t be lent under such a system is demand deposits, just to be clear.
Steve – Have you read Jesus Huerta de Soto’s work, Money, Bank Credit, and Economic Cycles? It makes clearer arguments for 100% reserve backed (demand deposit) banking than Rothbard did. Interestingly, it also addresses the almost two century period where the Bank of Amsterdam operated on 100% reserves.
JQ – The two century period described from the same book is a real world example of 100% reserve banking, even though it is several centuries past.
Lucas M. Engelhardt @ 130,
No, I did not miss the word “general”. I treated this word as ’empty’ (no analytical content). If you don’t wish this word to be treated as meaningless then you’ll have to give me a concise definiton and adhers to your requirement that ‘money’ is a medium of exchange.
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Yes, but then Austrians can’t use history to establish anything. All we have is assertions that something else will be better, even though that something suspiciously resembles what we had in the past and were not happy with. At best it is assertions and wishful thinking.
Austrians explain a business cycle, but not the business cycle. There are more reasons than low interest rates for booms. In this one it was far more relaxed lending standards than low interest rates. Austrians suffer from an extreme anti-government bias that taints all their reasoning. Central banks make mistakes. So do markets, and no, they are not all due to government however fervently Austrians want to believe. The ability to make mistakes also implies the ability to correct them. We live in a more complex world than Austrians admit. While money is predominately created by the central bank, they are not alone in creating credit. While interest rates are powerful, other things are as well. While one answer for everything may be satisfying to the zealot, it leaves a lot to be desired for the rest of us.
Like I said, John, you show yourself to have zero, I said ZERO, knowledge of the original material under discussion here.
Mises 1912 book had hardly more than a line hinting at an explanation of the business cycle.
A one line suggestion – a one sentence “theory” — was there. That’s it.
The basics of the theory were worked out by Hayek — starting with his Federal Reserve paper.
Hayek even writes later that he was surprised to go back and look at Mises’ book to find basically the cycle “theory” was one sentence — so he had to construct the whole thing for himself, beginning with that Federal Reserve paper.
If you’d ever read a Hayek interview, you’d have found him talking about this.
But as far as I can tell, you never read any of the primary literature.
If you have, tell me what.
John wrote:
“I said “Austrian Business Cycle Theory was developed in the first quarter of the 20th century, mostly by Mises and Hayek” and you accuse me of error on the basis that Hayek wrote in the early 1920s. More importantly the basics of the theory were already in Mises 1912, so writing as if it began with Hayek is a pretty big error.”
Ernestine Gross @ 132,
I feel like we may be talking past each other here. So, I’m going to back up a bit.
Your question was what definition of money Austrians (Prof. Horwitz in particular) use. Prof. Horwitz didn’t answer (at least that I can find), so I offered what I think is the typical Austrian definition and how we’d generally measure that empirically. I also expressed some confusion over precisely what “private money” is.
You offered examples of “private money” that aren’t, strictly speaking, “money” according to the Austrian definition – and aren’t included in the typical measures of money.
I interpreted this as an attack on the definition of money that I offered – looking back, I think this was a misinterpretation. (Correct me if I’m wrong.) Given this interpretation, I noted that your examples didn’t fit the Austrian definition of money. Now, if my new interpretation (the list was a clarification for what “private money” is) is right, then my comment regarding “generality” was off-the-mark, as you weren’t trying to give examples of something that would fit the Austrian definition.
Where the discussion seems to be at this point:
By my choice of definition, I suggest that money being “generally accepted” as a medium of exchange has important consequences – and as such “general acceptance” is analytically important. You suggest that “general acceptance” is unimportant, and that only the “medium of exchange” part matters. Let me know if this is not a fair assessment of where we are. So, what is left for each of us: I should establish that “general acceptance” matters. You should establish that it doesn’t.
Argument 1: an anecdotal example to establish the microlevel. Suppose two cases: in case 1, I am given US$200. In the other, I am given US$200 worth of frequent flyer miles. I would contend that the impact of each on my behavior will be different. The frequent flyer miles is likely to change my spending patterns in a very specific way – in that I’ll move more toward spending on travel and travel-related expenses. Now, if I was going to travel anyway, then the frequent flyer miles just freed up US$200 for other uses. So, in that case, we’d expect them to have the same effect. However, a priori, we can’t say whether this is the case or not. So, since the two are different in some cases, there is an analytical difference between a “general” medium of exchange and a “specific” medium of exchange. Whether this analytical difference is empirically relevant is another question.
Argument 2: the macro level. Consider two cases again. In the first case, there is a 10% increase in the money supply. In the other, there is an equivalent increase in the number of frequent flyer miles given. Just as in Argument 1, it is quite likely that the increase in frequent flyer miles will lead to a change in consumption patterns. Odds seem very small that the consumption pattern shift will be the same in the two cases.
If capital is specific at all (and Austrians are not alone in claiming that it probably is), then what matters is not just the aggregate quantity of consumption (which very well may be the same in each case), but the composition of consumption. So, the increase in the quantity of Austrian money and the increase in the quantity of “nonAustrian” private money would even have different macroeconomic impacts.
Now, I imagine this isn’t a concise definition – and it’s certainly not easy to state mathematically – but I think it demonstrates my point.
I’ll also note that the “specific private money” to “generally accepted money” spectrum is a continuum. It’s certainly possible to have some media of exchange that are very specific – maybe even only accepted by a single entity for a single transaction (paying for a merger with stock, for example), and it’s possible for some media of exchange to be somewhat more general (local currencies like the Ithaca Hour). Generally, I’d say, the more generally accepted the medium of exchange, the closer a substitute it will be for Austrian-type “money”.
Lord,
Low interest rates enable loose lending standards by reducing the apparent risk of default.
A bank might not loan money to a certain borrower at 10%, since they don’t think he will be able to pay it off. However, at 5% he may be able to, so they give him the loan. The lower the rate is, the more high-risk borrowers become eligible.
So artificially low interest rates and loose lending standards are necessarily coupled. While I agree that there are additional factors that contribute to cycles, this one is man-made and observable.
the bank of amsterdam breached its own 100% reserve charter fairly soon after its founding, making overdrafts to the city of amsterdam, the dutch east india company, and the van leening bank. (though it did take a while before its real nature as a frb became public knowledge, and its notes slipped below par).
i disagree with professor horwitz and the free-bankers, they usually end up making utilitarian arguments for frb. as others say, the business cycle predates the central bank. central banking makes the cycle longer and of greater amplitude (localized crisis swapped for systemic crisis), and is antipathetic to austrians of all stripes.
i personally like hülsmann’s take on the austrian business cycle. (http://mises.org/journals/qjae/pdf/qjae1_4_1.pdf).
it’s great to see mises and hayek get a bit of an airing downunder. even kevin rudd’s got caught up in the enthusiasm.
Lucas M. Engelhardt @ 132
Where we are at? From the perspective of the methodology of theorizing I am using, the answer is straightforward. We haven’t progressed at all. That is, my question as to the Austrian definition of ‘money’ remains unanswered.
You have introduced the following terms which have a common root but don’t have the same meaning. These words are “general”, “generality”, and “generally accepted”.
In my language, the ‘generality’ of a concept of money is demonstrated by showing, for example, ‘Austrian money’ (as yet to be defined) is a special case of the general definition.
I really would appreciate getting a concise description (characterization) of the notion of ‘Austrian money’ (not Schillings) because I want to test whether the generality of an existing concept of money covers also the ‘Austrian money’. This is how we progress – in mathematical economics.
Contrary to what you say, it is not true that I suggest that “general acceptance” is unimportant, and that only the “medium of exchange” part matters. The term ‘general acceptance’ was introduced after I wrote.
I don’t subscribe to theorising by anecdotes. To illustrate how easy it is to deflate these arguments, here are two empirical observations:
1. Parking meters accept only a small number of coins (government issued) or plastic (bank issued).
2. Toll roads in Sydney (an awful invention), including the road over the famous Sydney Harbour Bridge, require e-tags (a rip-off invention).
It seems to me our conversation has provided enough illustrative material in support of JQ’s thread and some comments (eg Lord @ 133).
Greg, thanks for pointing out my total ignorance of the topic. Admittedly, I’m not an expert. But you might find your time better occupied by explaining to, say Roger Garrison that he is utterly ignorant of a subject on which he claims to be an expert.
Given my original observation that Austrians (like most dogmatic sects) disagree among themselves as much as with the outside world, I’d be interested to know whether Garrison is a lonely heretic on this or whether some others think that Mises (and maybe even Wicksell) deserve some of the credit GR wants to monopolise for Hayek.
Again, my apologies to the handful of reasonable Austrians who’ve shown up here. But the majority of pro-Austrian commenters have confirmed my priors in spades.
As with Newsom (and admitting that I’m working from very sketchy sources) my understanding is that the status of the Bank of Amsterdam as a full-reserve institution was short-lived, and that, in that period it was more of a money-changer than a bank in the modern sense
Joe B, Lord
I hope Lord doesn’t mind me reposting for him.
But this
“Lord,
Low interest rates enable loose lending standards by reducing the apparent risk of default.
A bank might not loan money to a certain borrower at 10%, since they don’t think he will be able to pay it off. However, at 5% he may be able to, so they give him the loan. The lower the rate is, the more high-risk borrowers become eligible.
So artificially low interest rates and loose lending standards are necessarily coupled. While I agree that there are additional factors that contribute to cycles, this one is man-made and observable.”
Has a couple of obvious problems with it.
1. It doesn’t distinguish between real and nominal interest rates
2. Although the payments will be harder to made at 10%, the bank gets its money back sooner, and so is not so likely to worry about long term risks.
P.S.
Not to mention that you are assigning irrationality to the bank with the word “apparent”. If anybody should be able to calculate risks well it is a bank which specialises in it.
Newson, have you seen this excerpt from Jesus Huerta de Soto’s Money, Bank Credit, and Economic Cycles? (Page 99):
So over a 162 year period reserves were usually close to 100%, and may have dipped down to 80% at its lowest level. It sounds like the soundest example of 100% reserve backed banking in history. There is more than the excerpt above but I don’t want to take up pages with it.
Of course, what the “Austrians” seldom mention is that von Hayek LOST the theoretical battles of the 1930s. First, to Sraffa, then (twice!) to Kaldor. As regards Kaldor, his first critique forced von Hayek to totally rewrite his theory, which the second critique destroyed.
As one post-Keynesian economist notes, it “not only proved to be vulnerable to the Cambridge capital critique . . . , but also appeared to reply upon concepts of equilibrium (the ‘natural rate of interest’, for example) that were inconsistent with the broader principles of Austrian economic theory.” [J.E. King, A history of post Keynesian economics since 1936, p. 230]
In other words, the “Austrian” theory of the business cycle assumes that the credit market, unlike every other market, can be in equilibrium all the time. As von Hayek was forced to admit, to which Sraffa replied:
“only under conditions of equilibrium would there be a single rate, and that when saving was in progress there would be at any one moment be many ‘natural’ rates, possibly as many as there are commodities; so that it would be not merely difficult in practice, but altogether inconceivable, that the money rate would be equal to ‘the’ natural rate . . . Dr. Hayek now acknowledges the multiplicity of the ‘natural’ rates, but he has nothing more to say on this specific point than that they ‘all would be equilibrium rates.’ The only meaning (if it be a meaning) I can attach to this is that his maxim of policy now requires that the money rate should be equal to all these divergent natural rates.” [“A Rejoinder,” The Economic Journal, Vol. 42, No. 166]
Sraffa also noted that Hayek’s desire for “neutral” money was simply impossible in any real capitalist economy for “a state of things in which money is ‘neutral’ is identical with a state in which there is no money at all.” Hayek “completely ignored” the fact that “money is not only the medium of exchange, but also a store of value” which “amounts to assuming away the very object of the inquiry.” [“Dr. Hayek on Money and Capital,” The Economic Journal, vol. 42, no. 165]
Then there is the awkward issue that the state does not force banks to artificially lower their interest rates. They do so to make profits. To use a term that should be familiar with “Austrian”, the banks exercise entrepreneurial skills to make profits by meeting consumer demand. Yes, this results in disequilibrium but any market exchange in any real market will cause disequilibrium effects (regardless of what most “Austrians” assert).
Somewhat ironically, then, the “Austrians” think their speculation on banking, based on deducing conclusions from a few assumptions, count more than centuries of banking practice. This leads them to outlaw fractional reserve banking, so placing regulations on the entrepreneurial actions of capitalists.
If it were any other industry other than banking and if it were anyone other than “Austrians” suggesting it, they would denounce it as “socialism” or “statism”…
So what is left? Well, we have a theory which assumes that the credit market, alone amongst all markets, can jump from one equilibrium point to another and, moreover, would work just fine as long as the entrepreneurs within it do not act like capitalists and seek to make profits.
Oh, and if all that could happen, the theory would still be wrong as the Cambridge capital critique applies to it:
http://robertvienneau.blogspot.com/2009/01/krugman-correct.html
specifically this paper:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1097803
I would suggest reading the post-Keynesians on the issue of business cycle. They base their analysis on empirical evidence evidence and a basic awareness of how and why banks issue credit (Minsky would be a good starting point).
As Steve Keen notes, Austrian economists think that “the current system of State money means that the money supply is entirely exogenous and under the control of the State authorities. They then attribute much of the cyclical behaviour of the economy to government meddling with the money supply and the rate of interest.” In contrast, Post-Keynesian economists argue that “though it may appear that the State controls the money supply, the complex chain of causation in the finance sector actually works backwards” with “private banks and other credit-generating institutions largely forc[ing] the State’s hand. Thus the money supply is largely endogenously determined by the market economy, rather than imposed upon it exogenously by the State.” He notes that the “empirical record certainly supports Post-Keynesians rather than Austrians on this point. Statistical evidence about the leads and lags between the State-determined component of money supply and broad credit show that the latter ‘leads’ the former.” [Debunking Economics, p. 303]
Moreover, as the failure of Monetarism shows, central banks could not control the money supply when they tried.
Jeremy at #131:
I’ve read parts of the book as well as his earlier writing on the subject, and I’m not persuaded.
I’d also like to ask John why it’s a crime for Austrians to have internal disagreements. Surely every other school of thought in economics does. And if we didn’t, wouldn’t we be accused of being (that much more…) dogmatic and cult like than we are already accused of?
And now I must sign off this conversation as two stacks of final exams await me.
Ernestine Gross @ 138,
I’m confused by your request.
You asked for a concise, Austrian definition of money. I say “general medium of exchange” – 4 words. After seeing that “general” was apparently less clear than I thought (since it was regarded as lacking analytical content), I – though not quite explicitly – restated the definition as “generally accepted medium of exchange”. Seeing as we both agree that how widely accepted a medium of exchange is does make a difference for the analysis (though I may be reading too much into what you say when I claim that – if so, let me know), I think we can agree that this definition cannot be shortened without “money” being something different.
Seeing as, apparently, we’ve gotten “nowhere” from your perspective, I’ll try something else. I’ll try “mathing up” the definition a bit, to see if that helps.
Let X be the set of all media of exchange used in a particular economy. x denotes an element of X. f(x) is a function that returns the percentage of exchanges in the economy in which x is used as a medium of exchange by at one of the parties. Defn. x is money iff f(x) > z, where z is a cutoff. Austrians would choose z to be “high”. Obviously, it is not a “precise” definition (as I can’t give a precise value for z). Also, it’s obvious that the lower z is, the more general the definition of money will be. (The theorem “If x is money under z, and z'<z, then x is money under z’.” is trivially shown.) Also, I haven’t bothered to define what a “medium of exchange” is. I’m hoping that we have the same concept of that, so that I don’t have to math that one up – since that statement is complicated.
That said, I think that something is lost in the translation – but that’s typical with translations, as there are subtleties in one language that don’t always translate to another.
Out of curiosity, what part of #133 has our conversation shown?
Thanks,John and all for the discussion. Here are two examples of recent contributions by Austrian economists.
First, Frank Shostak of Man-Financial Austrilia has written some very thoughtful articles simplifying monetary policy down to the idea of the impact on the subsistence fund, or real savings.
Second, continental (German, not Austrian) bank economist, Kurt Richebacher (just passed away in 2007) contributed to the field by applying theory to economic forecasting. By using aggregate data, he was able to correctly call the Asian crisis, the dot-com and housing bubbles, and the current crises. Note to Business Week: these are really useful economists, to quote Thomas the Tank Engine.
So, if anyone wants to learn, check them out.
to jeremy:
yes, i’ve read huerta de soto’s work, which i find covers the historical and legal aspects of frb in great depth.
as for the bank of amsterdam, breaches of its charter commenced only six years after the banks’ inception, but the secrecy of the overdrafts (to the parties i mentioned) meant that public faith in the bank’s integrity persisted. yes, i agree that the boa is the strongest historical model that frb adversaries have in their arsenal. over time, however, the bank strayed further and further from its original deposit bank concept, and eventually had to be nationalized.
to anarcho:
please note that those austrians opposed to frb consider that the law should uphold property rights for depositors as much as for other asset-holders. contemporary legal reality means that bank “depositors” are, in fact, bank creditors. this status doesn’t reflect the economic reality of the deposit transaction, and therefore is tantamount to deception. abolishing distinct banking regulation doesn’t mean tolerance of fraud.
steven keen’s empirical “proof” would be dismissed by market operators, whose job it is to parse and analyse every word uttered by the board members of the central bank, much in the way of the kremlinologists of yore. greenspan’s every syllable would be routinely dissected – cast your mind back to the “irrational exuberance” episode.
most times the central bank likes to signal its intentions so as not to scare the horses, and so the dance is carefully choreographed. the t-bill market always leads the fed’s discount rate moves.
i’m not familiar with hayek’s exchanges with sraffa regarding the trade cycle, but you’d find many austrians agree with you on hayek’s arguments about the socialist calculation debate in the 1930’s. most austrians would find hayek’s interpretation of this to be flawed; mises’ take was the correct one. see “mises and hayek dehomogenized” (http://mises.org/journals/rae/pdf/RAE6_2_5.pdf)
Ok, one last comment….
Newson writes:
“Most austrians would find hayek’s interpretation of this to be flawed; mises’ take was the correct one.”
Actually, no they wouldn’t. Among practicing, professional Austrian school economist, the overwhelming consensus is that Mises and Hayek were making essentially the same argument. The view you point to is a *minority* view among Austrian economists, not to mention non-Austrian historians of economic thought. (Of course, many non-professionals who read Austrian material might think otherwise, but that’s a different story.)
For the case that Mises and Hayek are not “dehomogenizable” see this article of mine: http://www.gmu.edu/rae/archives/VOL17_4_2004/1-Horowitz.pdf