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 
What I find interesting is the idea forwarded by E.L Wheelright in 1978 (book name available on request)
in an introductory article titled “political economy and the Australian predicament”
“in a little known article published in 1933, Keynes argues that world peace can best be acheived by emphasising national selg sufficiency, rather than international market capitalism.”
Wheelright commented that Keynes foresaw that “interdependence among unequals leads to exploitation of the weak.”
When our shoes and other goods are manufactured prolifically (some would suggest too prolifically) in countries where apalling labour violations take place was Keynes right?
This article also notes that –
“the credit system appears as the main lever of overproduction and over speculation in commerce soley because the process of reproduction…..is here forced to its limits…for reason that a large part of the social capital is employed by people who dont own it.”
That was Marx (Vol 3 Capital) who is also insufficiently read. But is this not correct now? The managers of capital are now, more often in the publicly listed firm, those who dont own it or only own it parially as part of their remuneration just as easily replaced by new shares with an appointment on another board (CEOs and boards ie management quite distinct from owners, the shareholders, pursuing in many cases, hidden and quite different objectives to shareholders).
I will return to Keynes comments (p.21) which seem to strike a particularly deep resonance (in myself at least in the aftermath of the GFC).
“I sympathise, therefore, with those that would minimise, rather than those that would maximise, economic entaglement among nations. Ideas, knowledge, science, hospitality, travel – these are the things which should of their nature be international. But let goods be homespun whenever it is reasonably and conveniently possible, and above all, let finance be primarily national.” (National self sufficiency – 1933).
The last sentence leaves me wondering whether globalisation of finance over the past two decades was wise, and represents the economic pitfall of which Keynes warned in 1933.
People I think should think back to when they used to play monopoly and wonder what would happen if you didn’t get $200 every time you passed GO.
#178
Reason
“1. Consumption and Investment can only rise concurrently if their are unemployed resources to start with (which is why of course the central bank has lowered interest rates).”
There are always unemployed resources. A century ago the average work week was 50%+ longer (and harder work in general), we haven’t lost the ability to work we have simply gained the means necessary to allow us not to work that much. During the tech bubble people flocked back to school to get computer science degrees and many people did this while maintaining their old job. During the RE bubble tons of people got their realtors license in their spare time. There are also millions of acres of timber to be logged, new mines to explore ect, and then there is technology that can suddenly turn waste into usable goods (the invention of a better recycling process for example).
Secondly I do not agree with those who claim that Savings=Investment. While all I must come from S that does not automatically mean that all S is transformed into I. Take a farmer who stores 10% of his crop in his cellar each year in case his next crop goes bad. This storage constitutes real savings but cannot be called investment as it will not grow in nutrition and will actually deteriorate, leaving him with less each year. As a broader and more recent example take the average home purchase. Outside of bubbles, which we know are unsustainable, housing has generally increased at the rate of inflation over the years. Once you take out the cost of ownership (taxes, interest payments, repairs) its obvious that housing isn’t an investment (no matter how the national realtors association tries to present it that way). It also doesn’t fall neatly into the category of a consumption good either as minimal upkeep will cause it to retain the greater part of its value. Savings in this manner can be shifted toward I (renting out rooms, turning your house into a B&B) or towards C (taking out a home equity line and blowing it on pop rocks and mountain dew).
“2. You don’t seem very clear in distinguishing between the price of existing assets and the cost of new investment – which means to me you are drifting aware from the story of malinvestment.”
The rising cost of assets provides ‘cover’ against the rising cost of new investments. The higher the return on my invest appears to be (combined with the lower cost of borrowing) the greater cost that I can bear in making that investment. The initial boom comes because money is cheaper, but asset prices don’t start increasing until after the new money/credit starts being spent. Its this information lag that sucks in more and more resources from the economy, we use prices from yesterday under money supply X to estimate prices tomorrow under money supply Y.
“3. I’m quite interested in the idea that it is land prices that drive the big cycles”
I simply believe the opposite, its big cycles that drive land prices. Land is as close to ideal for lending against as you can find. Its easy to verify its existence and ownership and its impossible to steal. It is a natural place for leverage to accumulate because of these factors.
“I remember being very impressed in 1990 in the UK seeing “for Rent” signs on almost every building in Regent Street and thinking how much changes in rents can correct for financial flow of funds problems, and wondering why the landlords preferred to have their clients leave rather than lowering the rent to what they afford at the time”
The problem is leverage. If you’ve borrowed money to buy the property (as most do) there is an amount of rent you can’t go below (the cost of servicing your debt), lowering your rent can only take you so far and still leaves you at risk of default/damage to your property. If rents don’t recover shortly a landlord is going bust either way so he might as well take a stab at trying to find one of the few renters who are willing to pay the high enough price while still keeping his property open should rents suddenly swing back up. They’ve made bets on rents staying level or increasing rents decreasing is basically an automatic loss for them.
mmm.
I don’t find any of your answers convincing.
Yes full employment is a bit of a misnomer, but none-the-less it is easy to see when resources are so short that substantial shortages and inflation are being caused.
S=I is the result of national accounts conventions, so redefine the terms if you like – who cares?
I don’t understand your point 2 at all.
I remember reading a paper on big crashes that said they only lead to really big difficult to solve problems if inflated land prices were involved. And as I mentioned before – I think Henry George had a point.
I don’t think many landlords on Regent Street are leveraged!
to reason:
the central bank traditionally targets the short end of the yield curve. in the us, the fed intervenes via open-market operations to nudge the fed funds rate (rate at which commercial banks loan funds amongst themselves to meet reserve requirements) towards its target. the fed also will make loans directly to banks at the discount rate, which it sets. now the americans are indulging in quantitative easing, essentially conjuring money out of thin air to support the long end of the yield curve as well (thereby transferring risk from the long treasuries to the us currency).
now the fed sets rates particularly low, as greenspan did post-9/11, banks could avail themselves of this very cheap money and ride the yield-curve (buy treasuries yielding 4%ish), or else loan against real estate, and earn very sizable margins.
if you could borrow at 1% would you not do so, and could you not make a fortune? this is not peculiar to the odd episode, the japanese have done the same for decades; it allowed the banks to repair their balances sheets after their equity/property market bubbles popped . very cheap short-term funds on offer from the boj to the commercial banks form the basis of the yen carry-trade.
from an austrian perspective, the central bank’s raison d’être is to avoid bank runs. the natural tendency of fractional reserve banks is to cartelize, in order that one run doesn’t trigger off a chain-reaction of redemptions at other banks. the state is happy with this arrangement because the central bank acts as a buyer of last resort of treasury paper. the fact that the effects of money supply growth are lagged and non-uniform, renders inflation an attractive covert tax. easier to blame unions, oil companies, businessmen etc. for rising prices than it is to blame the central bank. (mind you, everbody’s happy when the money growth flows into financial assets, the political #$%@ hits the fan only when the money flows into articles of basic necessity – foods, energy, etc.)
excessive money supply growth vis-à-vis trading partners can result in balance of payments deficits; higher local prices encourage production offshore whilst sucking in imports.
finally, real versus nominal: real is an elusive beast – any sort of cost-index is arbitrary. what you might include in your basket is going to be different to my selection. and that’s not taking into account the many political considerations that come into play (think: the usa when they decided to excise house prices from the cpi and instead inserted owners’ imputed rent).
I guess I see some common link in the views of Austrians here on the tendency of frb banks to cartelize with the central bank being a buyer of last resort treasury paper as mentioned above (excessive money supply growth being problematical), the views of Marx on the credit system being the “lever of overproduction” and the ideas of Keynes against globalising financial systems in preference that “they remain national.” (not nationalised – just national).
Is there a link between the three views given the problems that have arisen in global financial firms?
“Is there a link between the three views given the problems that have arisen in global financial firms?”
Yes, their methodology is similar and the subject of their investigation is ‘capitalism’- as they experienced it. It seems to me their methodology lends itself to the formation of ‘schools of thought’ and IMPNSHO opinion, this is a problem.
Agree Ernestine.
Id just like to hear the Austrian view (even though there is within school disagreement) on what would happen to the ordinary man in the street seeking to borrow money for a car, a house, a small business etc were frb to be removed. Should frb be removed completely or just the fraction changed?
What would happen to interest rates, asset prices like houses etc Would it mean banks were constrained from excess lending? Would it curtail speculation and overproduction in speculative assets? Would it inhibit financial / banking cartelization? Should banks be permitted to “cartelize” and become globally large? Doesnt this mean that any economies of scale they get on account of their size, being generated by the revenues from larger markets for lending, internally give incentives to increase credit availability and become even larger? Wouldnt this contribute to “malinvestment” in financial products (financial asset bubble)?
They’d be massive deflation for a few years and then people would mostly buy stuff after saving for it. A lot of savings (in gold) would be held by people outside the banking system and limited lending would occur on the “fringes” or “innovative” sectors of the economy. Growth would slow dramatically, but then people would have much higher real savings, so they’d live a much more relaxed slower lifestyle (like the ’50s say).
Asset prices would plummet then stabilize. Interest rates would generally be very low but positive in real terms (they’d be deflation over time). Speculation would be very (very!) limited and bankers would be considered similar to used car salesmen.
Malinvestment would still occur occasionally but because the banking system as a whole is a much (much!) smaller part of the economy, it wouldn’t affect the rest of economy as much as it does now.
It would also require a revolution in thinking that is probably not going to happen in our lifetimes until the current idiots in power die off.
“There’d be massive deflation”. I’m tired after a big night out and can’t see straight, let alone type straight. Apologies.
The Austrians will always have a problem with state engineered moral hazards. If the banks want to operate using “fractional reserve banking” let them justify it to there shareholders, insurance companies and be transparent when lending this hypothetical money to the borrowers. Go for it, as long as they don’t have to be bailed by the state.
The question for each investor and borrower is then a simple one. Do I want to be part of a bank with this level(X) of risky behaviour ?
ABOM: Your answer doesn’t make sense to me. There’s no one who can buy the malinvestment at the current prices, so why don’t prices fall? A house in Miami isn’t worthless, so why doesn’t the price of the house drop until someone buys it.
Plus, if your example of liquidation is typical, then GDP wouldn’t drop during recessions — demolition is economic activity, and shows up in GDP.
It would fall in a free market. Dramatically.
But remember this is collateral for the banks. The banks don’t want the market to “work” because it would render them insolvent.
The sudden price movements that SHOULD occur after a speculative bubble to clean up the mess are the very things banks (and governments) fear and hate.
Hence the bizarre scenes of banks destroying perfectly good, brand new houses in California that took months (or years) of planning and effort to build.
Tragedy to us. Another day at the office for the banks.
P.S. If you think the demolition activity will overwhelm the natural slump then you’ve been puffin’ too many muffins. Only war has been sufficient historically to overwhelm the natural slump.
That’s what vicious governments eventually resort to when they’ve tried everything else.
I hope this has been informative for at least a few open-minded segments of our degenerate society.
I think a few people are wondering what the H*ll happened and why no one warned us about the impending disaster.
People (like me) WERE screaming (for years!) but were marginalized, killed off, or blocked from influential positions in govt and academia because we didn’t toe the party line.
If you think the Soviet Union was the only govt with thought policy, then you’re as naive and clueless as your average…well…your average mainstream economist.
Yes it has ABOM…quite funny comment of yours. I have no problem with what you are saying at all. Call it quaint but I always throught the idea of financial intermediaries and institutions was to grease the wheels of the economic system – not to dangerously overinflate the tyres or ramp up the gearing system for race track conditions, rather than ordinary driving.
But one question remains unanswered – why not just change the fraction (I assume decrease the fraction of reserves that can be lent out by banks) to test it first, rather than to denounce FRB in its entirety? I have no problem with deflation inj asset prices like houses. I think the current overinflation in many countries risks precluding the younger generation from self sufficiency. They say the pastoral (and urban construction and financial) boom in Australia in the 1870s and 1880s resulted in banks owning a much larger percentage of the wool clip when it all came to grief in the 1890s. Perhaps in this instance banks will be left with a lot of real estate (removing yet more assets from the ownership or reach of the ordinary man – That cannot be beneficial to the economic system to use a silly current catchphrase “moving forward.” )
Agreed, increasing reserve requirements is the way to go.
But this triggers a sudden deflationary contraction so no central bank or govt (at least in the Western democracies) has had the guts to do it.
In fact, reserve requirements have been systemically reduced until in the US there are no reserves to speak of at all!
It’s like a drug addiction – once you start reducing reserve ratios the pain of going back is too great, and the temptation to keeping sliding down the sippery slope overwhelms the gutless polis and bureaucrats.
Only a revolution, removing the current corrupt system, would allow us to get back to either full reserves or at least a sane reserve ratio.
Thanks for being Keynesian but open-minded. How refreshing!
Slippery slope – not sippery. Sippery was what I was doing last night! Apologies again…
I agree ABOM in entirety with your last post. Im also interested in Ubiquities comment at 212. If much emphasis is placed on the rights of the individual to exercise his or her own free choice – then how is manadatory super really useful to that? A portion of the ordinary man’s wage is withheld from him. He has the choice over a number of financial firms as to where he makes only the initial allocation – but only those firms that exist in one sector – the financial sector. Those firms must surely have an interest in inventing new products within the one sector – the financial sector to retain as much as of teh benefits of the ordinary man’s savings or surplus generated by the savings that they can. I know people will say financial firms invest in a lot of different sectors and thus the risk is spread – but do they really? If they can engage in agency agreements to attract more retention of the funds in their own sector(standard and poors, moody’s etc or popular initial share offerings), will they do this – I mean really spread the risk? Does mandatory super embed incentives for financial firms to become creative inventing ever more financial instruments to actually retain the profits / surplus in their own firms or other complicit firms?
Does mandatory superannuation really carry free choice and transparency for the ordinary man and his savings or does it just end up contributing to the “malinvestment” in the financial sector?
I am replying to Lucas M. Englehardt @146 not for the purpose of contributing further to the length of this tread but merely to tidy-up a point.
Your “math up” of the your concept of money resulted in:
‘Money’ is that element in the set ME which fulfils a condition “z” on the set ME, where the set ME: = {Ø}.
I can say that your notion of money is definitely a special case of the definition of a concept of ‘monetary objects’ which I wanted to test.
However, I don’t know how you could possibly speak of ‘increasing’ the ‘money supply’.
By way of departing from this thread, I found many of the discussions in this thread interesting.
This post has reached 220 comments. Is that a record JQ? What is your record for a single post?
I can see two potential avenues from a combination of ideas posted here. Lower the fraction that banks can lend incrementally and at the same time give individuals some, if not all, free choice over what they can invest their superannuation into, outside the financial markets – eg their home mortgage. This would offset any deflation of asset values (and an ability for banks to eg foreclose) with an increase in ability to pay off any outstanding debt on those existing assets, and at the same time this would limit the ability of financial institutions towards “malinvestment” which to me, seems just to suggest excess focus on “speculation” rather than economically sound investment. By making it harder to obtain credit, only credit worthy investments are likely to survive?
to alice:
as to your question why not just change the fraction of reserves that need to be kept – this doesn’t guarantee the end of the boom/bust cycle. it just means the cycle’s frequency is shorter, and the amplitude narrower. logically commercial banks want the smallest possible reserve requirements because the more they loan, the more they earn. (this desire is only tempered by the fear of the bank-run. add deposit guarantees and central banks acting as lender-of-last-resort into the mix and you kill this moderating factor).
anyway, the universal policy approach in this crisis has been to save the banks at all cost. there’s no free lunch and the currency is going to suffer depreciation. as people wake up to the erosion in purchasing power over the next couple of years, they hunt out safe-havens and we’ll see the next bubble. commodities. rising prices of basic stuff, in the midst of economic stagnation. get out your flairs, it’s back to the seventies, just worst.
Newson – by a hairs breadth I think we came very close to bank run in this recent crisis. I dont object to a cycle that is shorter, with a narrower amplitude more preferable. I had colleagues presenting the idea that the run on house prices in Sydney was unsustainable ….in 1999! Still it continued on.
The seventies inflation, I believe, called a lot of women into the workforce (common mythology likes to discount it as feminist advances, equal pay, freedom to leave unstaidfactory marriages etc… and whilst this may have played some part (and the pill)… when severe inflation arrives as it did in the 70s, it seems more realistic that if the household cant afford to maintain their real living standards on a single worker’s wage rises alone, they will offer another worker to the labour force instead in order to maintain theirb standard of living. Hence Mum got a job to help out (and stayed)? I know my mother was the first woman in our street to get a job in the early 1970s. I think she wanted a second car if I recall, and it was just that bit out of reach. Where I grew up (not a wealthy area -a war service loan area) it was very unusual (I cant recall any in my street – they were always at home) for women to work when I was a child. After that quite a few women followed into employment.
In the US, at least, reserves are up, well above the regulatory minimum.
ABOM, the mechanism that you suggest has occurred to me (and lots of other people, I’m sure). But the theory, as you describe it, since like it would be trivially easy to reconcile with sticky-price models in the Keynesian tradition. Prices are sticky for the reason you’ve mentioned (banks are unwilling to let markets clear for collateral reasons), so output adjusts instead. So that’s good, right? Austrianism and the mainstream aren’t so far apart after all.
to alice:
there was a grave systemic risk after lehman bros. collapse. really, banks are still suffering a solvency crisis, not a liquidity crisis. for this reason, bernanke’s medicine is not going to work in the manner he hopes. banks’ balance sheets still don’t reflect realistic prices (a genuine market doesn’t exist for many of the banks’ assets because of bail-outs etc).
prior to the central banking system in the usa, crises occurred every few years; banks failed, were liquidated, deflation occurred until assets were repriced, and then the cycle started again. cycles were localized and therefore not as deep as today. the central bank and fdic cured the local bank run at the expense of the currency (usd has lost 98?% of its value since 1913), and giving us instead far bigger systemic crisis.
the next step would be to create a global central banks to save the frb system from the weakest central banks (now the fed), but personally i think that’s politically unsaleable.
in many ways, since gold was completely demonetized by nixon, money supply has grown almost exponentially. monetary inflation favours those who are able to surf the bubbles – ie asset-holders. wage-earners do it much tougher, hence wives having to join the workforce in order to keep up. i am not optimistic about living standards in the coming years, and i think that this is another point on which austrians are united. there’s no magic bullet.
Well, at least “Austrian but Open Minded”, especially @210, has demonstrated how completely self-stultifying at least hard-core “Austrian” economic thinking is, and that it has no accurate diagnostic analysis and insight into the “reasons” for and “nature” of credit, and its inter-relations with large-scale industrial production, economic “growth” (qua increases in per capital output or the real distributable surplus product), and the distribution of income. Of course, if one thinks that “fraud”, (which is merely a legal construct anyway), is the worst thing that can happen, then one has an amazingly sunny, optimistic indifference to worldly consequences. But then the a priori self-righteousness, rooted in an entirely irrealistic account of atomistic individualism, by which any violation of the purely voluntary basis of human relations is the worst outrage imaginable, makes it very hard to discuss or argue with hard-core “Austrians”, since, not only, in any realistic world, is voluntary or intentional human agency a highly conditioned and limited “thing”, such that all human relations involve “violations” of volition, but the very notion of “economics” concerns the cross-secting non-volitional constraints on human agency in a “systematic” perspective. Hence the diagnosis of “Austrian” ideology as an idyll of “free market” economics as reactionary utopianism, originarily rooted in a pseudo-aristocratic, quasi-feudal hierarchical ideal of “liberty”, which belies the very economy that it ostensibly advocates.
Have you ever noticed how pompous and wordy embezzlers and shysters (such as Madoff) always are?
Walt – yes, outputs “adjust”. But markets seizing up and not working – at all. For a very, very long time (look at housing destruction in CA right now).
But Austrians would much prefer prices to do the heavy lifting, not output. That is the crux of the difference between the banks and the free marketeers. In a downturn, banks HATE markets (and prices) working. Austrians don’t.
It’s that simple.
“By markets seizing up and not working”. I vow to stop drinking heavily. Promise!
ABOM. Lol. It has been an interesting discussion and open minded.
Dont bomb out on us now..!
The last few days have indicated clearly to me that the marginal price of alcohol in Australia does not sufficiently endogenize the societal costs associated with its consumption, despite the heavy taxes associated with the aforesaid consumption.
Two solutions appear likely: Either my income will decline sufficiently (due to lower productivity) to make said comsumption of alcohol non-viable, or the production and sale of said product will actually kill me.
As a libertarian I’m OK with either option, but on a personal level I really need to clean up my act!
Newson #226 – it seems to me that global financial firms almost necessitate “global central banks” as you mentioned. It barely seems worth the while to have national central banks when the excessive risk taking was global in nature but Im still not sure Im in favour of even permitting financial institutions to be global at all..its caused a lot of problems and with massive stds (structurally transmitted debt).
I’m on the same page with Alice on many things here I think. I think like her, I see our financial system as problematic, not just at a national level but international. It does seem to me that absolute opposition to FRB is a fundamentalist position that potentially causes more problems than it solves. The Austrian’s perhaps need to come to terms with the fact that hoarding is as serious a problem as inflation and that mild inflation (putting a price on hoarding and enabling real price adjustment to occur with long-term contracts) is not necessarily the end of the world. I tend to regard slippery slope arguments in democratic countries as inlikely – so long as their is a range of preferences in the electorate, and move in one direction tends to alienate an increasing proportion of the electorate. And I would argue this is what the historical record in fact says to us.
That doesn’t mean we don’t have big problems. Over and over we have seen that the combination of big lending and asset price inflations leads to financial crises. The extent to which this effects the general public is highly variable, and depends I think to what extent the borrowing is concentrated or widespread (as in housing bubbles). We need to have debt and asset prices incorporated into our macro-economic models, they are missing at present.
I could point out to Alice (and I used to work at a central bank) that in the past the central banks did attempt to control the money supply mainly through changes in the reserve requirement. However, they found that their efforts tended to be undermined by non-banks that were not directly under their control and being less regulated had a market advantage (so much for Austrian moral hazard). They therefore almost universally moved to use interest rates as their main mechanism for control. That did seem to work very well until recently, but the growth in debt was a big warning sign. But even before that started, the international inbalances in the flow of funds (big deficits with East Asia and Oil Producers) was flashing red. Neo-classical models just assumed that people would manage their own finances responsibly. They didn’t.
“But Austrians would much prefer prices to do the heavy lifting, not output. That is the crux of the difference between the banks and the free marketeers. In a downturn, banks HATE markets (and prices) working. Austrians don’t.”
1. Any lender will think the same even if they are “Austrian”. No one likes to lose.
2. I don’t think there is anyone who doesn’t want prices to do the heavy work – but if there are debts (always nominally denominated) or long term contracts the contraction will create imbalances.
Ubiquity #212
“The Austrians will always have a problem with state engineered moral hazards.”
Like bankrupcy, or limited liability?
In fact of all these “state engineered moral hazards” have a common thread – encourage risk taking – as risk takers (entrepeuners) are the lifeblood of capitalism. The trouble is not that risk is encouraged, but that no distinction is made between productive risk taking and unproductive (speculative) risk taking.
Reason,
I think the move away from monetary targeting was as much due to the econometric instability of money demand functions (largely blamed on ongoing financial innovation) as it was due to technical difficulties in controlling monetary aggregates.
Varying reserve requirements was only one method of attempting the latter. Other methods included direct quantitative controlls on banks assets and liabilities, targetting money using an interest rate instrument,using the bank reserves themselves as an instrument (tried by Volker in 1979-82 but not in a pure form), and over funding operations based on the credit counterparts identity (Thatcher from 1979-1985). Switzerland seemed to be the only country that had any success in attaining its monetary targets (I don’t know off hand what method they used).
Activist policy rules using an interest rate instrument have the added appeal that it is possible to simultaniously target inflation and the output gap; most of the time these objectives are mutually reinforcing and not in conflict. The results of such a policy have been pretty impressive in the past 30 or so years in the US and since about 1992 here, right up till the current financial crisis.
Now with US and UK interest rates at or near their lower bound, interest in quantative monetary measures is renewed. The Bank of England is currently persuing a quantative easing, essentially equivalent to monetary base targetting (there are no technical problems with hitting such a target).
All of which is, of course, anathema to Austrian economists…
– Tim
My comment in #237 could be rephrased
As baby, bath water, think about possible connections.
Tim,
If the Reserve Bank gets out of the business of setting interest rates and uses “quantitative easing” as the method of increasing the money supply it can use the market interest rates for money to adjust how much money it prints.
If it does it in clever ways by isolating the inflationary effects in the value of the asset being produced with the extra money, then it can get by with setting a growth target for the economy and so take the guess work out of how much money to print. My guess is that if we take the burden of the financial sector off the backs of the productive sector we will easily achieve real growth without inflation of >5% and probably closer to 10%.
If we change the way we fund investment and innovation we can get true productivity gains that will turn into real growth.
Kevin:
Far simpler and more accurate, if the target is monetary base (banks deposits with the RBA & cash dealers, plus currency) is to just create the apropriate amount of money and whack it into the appropriate market (say 10 year treasury bonds).
Growth in potential output (eg growth attainable without inflationary pressure) just isn’t as easy to come by as you suggest. The Solow growth framework paints a particularly grim picture of the possibilities for making the economy grow faster on a sustainable basis. More recent work by Paul Romer is more optimistic about such possibilities.
But under Romer’s framework, we would have to raise savings and investment to Chinese levels to get anything near Chinese growth rates (we wouldn’t get such good results, because some of China’s growth comes from absorbing technology from abroad coming from a technologically backward starting point; this just doesn’t apply to us).
There is no feasible way that rejigging our financial sector could generate such levels of saving and investment.
– Tim
“yes, i’ll do some homework on sraffa, but don’t confuse my ignorance on this point with the austrian camp at large.”
I’ve read numerous books, including academic and popular introductions, on “Austrian” economics. Sraffa and Kaldor are rarely mentioned. Almost all fail to discuss these two in their accounts battles of the 1930s. I wonder why?
“those who like the rothbardian fully-reserved banks do so because the see the frb system as an abuse of property titles, ie fraudulent in a moral sense.”
And so they will make it illegal for those who do not wish fully-reserved banks to create and frequent them? How very “libertarian” of them… And how does Rothbard propose to enforce his (monopoly) “libertarian” law? Will savers employ private defence firms to regulate the banks for them? Or will they sue after the bank run? Good luck to them getting money!
“why are there no 100% reserve banks? you already know – because banks get to make more money, and when they get into strife, they get a helping hand from the state.”
Wow, so banks operate as capitalists and the “Austrian” solution is to force, by law, capitalist banks not to act as capitalists! Good luck with that…
But, according to “Austrians” there must be a market demand for 100% reserve banks. Why are not banks offering that now? The state does not force banks to not have 100% reserves. If they are right, then market forces would soon see these 100% reserve banks spring up… but as they are not, they turn to the state (Rothbard’s monopoly “libertarian” law code) to outlaw what centuries of market evolution has created…
“as far as empiricism, austrians don’t blindly try to analyse facts hoping to stumble across theory, they logically deduct the theory first, and then see whether there’s any factual evidence afterwards.”
And then, when the facts don’t fit the theory, they reject the awkward “factual evidence”! As the Mises quote I provided shows. Then there is von Hayek who wrote that economic theories can “never be verified or falsified by reference to facts. All that we can and must verify is the presence of our assumptions in the particular case.” [Individualism and Economic Order, p. 73] Or Rothbard: “Mises indeed held not only that economic theory does not need to be ‘tested’ by historical fact but also that it cannot be so tested.” [“Praxeology: The Methodology of Austrian Economics” in The Foundation of Modern Austrian Economics, p. 32]
Need I point out that a theory which is not refutable by any conceivable event is non-scientific? Or that making a few assumptions and logically deducing from them is a pre-scientific perspective?
Not to mention the awkward fact that the whole theory is based on something, equilibrium, which they proclaim does not and cannot exist in a real economy. Nor the awkward fact that even if the banks can be forced not to act like capitalists and if the credit market can be in constant equilibrium, it would still be flawed because of the Cambridge Capital Critique…
I agree with your comments at 237 Reason….and I do think this is a major problem area per your comment “over and over we have seen that the combination of big lending and asset price inflations leads to financial crises.” Im just not sure what the solution is. It seems to emanate from the financial sector…but Im unsure as to whether this is a fair assessment of underlying drivers ie to whether “big lending” has emerged as a response to other variables eg mandatory super in many countries and how financial firms coped with the sheer influx of money to the financial sector (meaning a government induced overallocation of resources resulting in financial innovation) or whether it is something else eg the expertise of global banking monoliths and their investor followers to influence the market (and share prices).
I acknowledge I think this is a monetary problem (and I think the financial sector has had the wherewithall or the right circmstances to simply create too much of it). There is too much but exactly why it was created and whether it was the fault of central banks is the key question.
They may have aided it by keeping interest rates too low but did they really cause the excess speculation? It seems doubtful to me. They may have inflamed it but I dont think they created it.
I have one other point I would like to make and that is how do companies secure price reductions? If we assume labour is a large cost then thats obviously the area they will focus on. How do you get around what seems to me to be a human characteristic that employees will have incentives to protect their own remuneration firstly, when price reductions are needed, and that some in organisations have more power over others (hierarchical oraganisational structures is the norm). Might there exists those that do have incentives to seek the retrenchment of those under them firstly (rather than reductions in their own wages) even if they, themselves work longer hours to cover the loss? I speak not only of rigidities at the lower end of the labour force like unions (although one almost question their relevance now) but of “natural” resistance to wage reductions right through an organisation, from the bottom to the top, leading to a tendency for output falls rather than price falls.
And if the fraction that can be lent needs to be lowered, (which seems quite a sensible way to control excess speculation) it would seem pointless to only apply it to major banks.
Austrians, clearly disagree on FRB. My humble opinion is that it is all well as long as its purely market driven (perhaps unrealistic in a society infatuated by the state).
Reason @234 your claim (and Keynesians claim) that hoarding is a serious problem, is somewhat perplexing. For someone to hoard it means someone else must have “spent” in a closed economic system. So an individual can increase his/her savings by hoarding but the economic system as whole cannot increase saving.
Furthemore,savings in an economic system increases in two ways: an increase in assets increases savings. The economic system sees this as a increase in capital assets. If you increase the quantity of money in a economic system than cash savings will increase, but, this shouldn’t reduce spending either.
Reason @ 236 I am not sure of your point. But bankruptcy like hoarding is good at correcting balance sheets quickly. Currently this is a big problem in the GFC, the debt needs to be realised not inflated. I can appreciate the pros of a gradual deflating mechanism rather than a rapid one.
@237 you say
“In fact of all these “state engineered moral hazards” have a common thread – encourage risk taking – as risk takers (entrepeuners) are the lifeblood of capitalism. The trouble is not that risk is encouraged, but that no distinction is made between productive risk taking and unproductive (speculative) risk taking”
I am not sure how you would make a practical distinction between productive risk taking and unproductive risk taking ? Consesnus ? educate me. Who will decide what is productive and unproductive.
Again the issue is with state blowing out the risk to greater propotion than an entrepreneur acting without state induced moral hazard. The GFC is very very big financial mess because of state orchestrated moral hazard. No single entrepreneur could have caused a mess as mammoth as the global government (unintentionally) “co-ordinated” GFC.
Alice in regard to superannuation. It is forced savings. The fact that the scheme was enforced by the state and mostly put in the hands of faceless corporate entities (by the state) and the people were told there future was secure is the biggest fraud ever perpetuated on the Australian people, but no one is screaming ??? Clearly I don’t support this kind of saving. Minister Sherry has been working away in the background and in the name of protecting the peoples super will maneuver the government into a position were it will take control of superannuation of the Australian people. First they will have to change part of the constitution (I hope they fail). The least the government could do after all this is underwright the return on super. But they will have control.
Alice the extent to which money lent as a result of FRB surely must depend on each individual transaction were the lender and borrower in the market place determine the price of risk involved. You can’t fix something like that.But if FRB is regulated than how is the risk priced by the entreperneurial parties. They must depend on the guidance and wisdom of you know who.
Alice
I think the problem from the dual function of money as a means of exchange and a store of value. It is always problematic, because people want to “save” – i.e. accumulate rights to future consumption, but only produce in the present (or – yes thankyou “Austrians” for the near future). What they “save” is then not circulating in the present and so interrupts the circular flow of money (whatever the nature of the unit of account is). Productive savings always must mean investing in creating the capacity to produce in the future (which is always associated with uncertainty, because the future is uncertain). Financial assets and land, however provide a great temptation to attempt to solve this problem by buying assets now in the hope of gettting a higher price later. If banks support this process, the created credit can create a self-reinforcing process, bidding up the price the asset, requiring more loans in order to pay for it. All this we all know. To me, the problem is the speculation – we should insist people speculating in asset prices should use their own money.
Kevin, Tim Peterson,
I think you are both right. We should have less debt money and more base money, but no it won’t necessarily create a utopia.
Ubiquity
you must be the only one who doesn’t understand that bankrupcy is “state sponsored moral risk” just the same as deposit insurance is. And insurance is very often commercially sponsored moral risk (ask you friendly neighbourhood arsonist).
The fact is there is a balance between being too hard on mistakes and too soft of them, and often those societies that have been softer on them have done better. Picking up on one sort of insurance and ignoring others seems disingenious to me.
As for hoarding, you are getting confused between the monetary economy and the real economy. Let us for the moment imagine we have a strict gold standard and a closed economy. And along comes Scrooge, who thinks he can save for his old age by hoarding gold. This means that there is less and less money circulating and so (this being a marvelously flexible Austrian economy) there will be deflation. So even with nominal interest rates at 0, it becomes very expensive to borrow – and every debtor will be driven to the wall (i.e. a depression looms).
P.S. Why I think this hoarding story is important – it is what the neo-mercantilist attempt to in effect do with USD. Except that the monetary authorities in the US keep issuing more.
Ubiquity,
if you have trouble understanding how the hoarding works, maybe I should add the Scrooge is a landlord and gets him money (gold) steadily from rents and he puts 60% of it into his vault. The rest of the economy continues as normal but the amount of gold in circulation (Scrooge is a BIG landlord) keeps shrinking.