Why Don't Entrepreneurs Outsmart the Business Cycle?
A common argument against Austrian theory, writes Brian Stanley, is that entrepreneurs are too smart to be fooled by Fed intervention. The argument claims that entrepreneurs recognize the Fed actions and ignore the Fed by proceeding as if the interest rates were where they would be if they were set by the free market and not by Fed intervention. If this contention is true, the business cycle theory is wrong in its conclusions about what causes the boom and bust cycle. In fact, it isn't possible to determine what the natural rate should be. Small businesses particularly can't be expected to recognize and react to Fed intervention, and there is no evidence that even large, sophisticated businesses can perform any relevant and meaningfully accurate calculations and forecasts. FULL ARTICLE
Comments (138)
Stephen W. Carson
This is an outstanding article.
It is where I will now direct people who have this question about whether the effects of monetary manipulation can be avoided by people being aware of that manipulation.
Published: August 28, 2007 9:42 AM
Anthony
I agree, an article like this was direly needed.
Published: August 28, 2007 10:01 AM
quincunx
Free credit is seductive, especially when your only alternative to riding the cycle is not getting on at all - but then you aren't an entrepreneur.
It's too bad that socialized money is considered 'capitalism', and 'globalization' in the US is really borrowed socialized money.
The US is a sinking ship - unless we can find another sucker to sign up on a Plaza Accord-like agreement. I don't think we can find another sucker, so I guess we'll just have to wage relentless wars on our creditors (either physically or through monetary inflation).
Buy silver!
Published: August 28, 2007 10:21 AM
mark
If critics of ABCT think business will compensate for the effects of inflation then they must think that inflation won't change anything. Why then do they advocate inflation?
Or have I missed something?
Published: August 28, 2007 10:25 AM
Anthony
RE theorists do not advocate inflation; in fact they state that demand-management policies are useless.
Published: August 28, 2007 10:49 AM
Tim Kern
When I teach basic economics, I summarize what you’ve said (I believe I do, at any rate): “Economics problems in my class are a lot like real problems you’ll encounter in real life. In your prior classes, the teacher would give you answers which you were expected to remember, in order to get an ‘A.’ In a job, you’ll be told to get something done, without having the benefit of having already been given [the teacher’s version of] the perfect solution. Further, in the real world, you’ll have only half the information you need, in order to make your decisions. Worse than that, half of the information you do have will be incorrect – and you won’t know which half. But you still need to make the decisions, and you still need to do the project.”
I also believe that, when some of one’s competitors are making a known mistake (e.g., making low-cost loans to high-risk borrowers), all competitors need to follow suit or risk going dry before the problem corrects itself. The effects of this poor decision-making process are lessened, of course, by the government’s propensity to use taxpayer money to bail out poor investment decisions – therefore making the “poor” decisions really the “right” ones (provided the bailout comes in time, which will happen if the problem is gross enough – further encouraging the profligate behavior).
Published: August 28, 2007 10:53 AM
Bill Anderson
This is a very good article for a number of reasons. First, Rational Expectations, while being useful, operates on the assumptions that individuals learn ALL of the "lessons" after experiencing an event one time. Now, I wish that were true; if so, I could remember how to set everything perfectly on my DVD player after following instructions the first time.
Second, even assuming that individuals learn ALL of the relevant lessons, we have to then assume that no new players come into the system after the first "lesson" is learned. This is to say that all of those who were "fooled" the first time and have now "learned their lessons" are the exact same players in the system when the artificial interest rates appear once again.
Third, people seem to forget the presence of the state and its moral hazard policies of covering for bad loans, as it has done in the subprime market. Let me give an example that might help.
There are a number of places in this country near the shore that are hit with hurricanes, destroyed, and then rebuilt, compliments of the Flood Insurance Program. In ordinary circumstances, insurers would not cover these properties unless the owners paid very, very high premiums. The FI Program creates a huge moral hazard.
Now, according to RadEx, once a home was destroyed by a hurricane or flood, we would see the owners "learning their lessons." A market situation would dictate a RadEx situation, but because of the subsidies of flood insurance, we see people behaving very differently than they would otherwise.
That is one thing that Gordon Tullock and other critics of the ABCT forget; they assume that those who malinvested paid the full penalities when, in reality, that is not the case. Thus, their RadEx "discrediting" of the ABCT is not relevant.
Published: August 28, 2007 11:38 AM
Jonathan Bostwick
Entrepreneurs do defend themselves from government intervention, to the determent of everyone else, by becoming politically influential.
Published: August 28, 2007 11:42 AM
Wade McGriff
Outstanding!
Published: August 28, 2007 12:03 PM
dug
Even if an entrepreneur knew that the customer walking in the door had received every cent of their money directly from the Fed creating it out of thin air the prudent decision is to sell to them anyway. The problems arise when demand increases to the point where an investment in additional capacity must be made. But even then just because the bubble will burst doesn't mean demand will return to the pre-bubble configuration. As an example radio, TV, computers, internet, cell phones and many other high tech gadgets have benefited from credit booms at their genesis yet that demand persisted after the bust while other industries went by the wayside. So the real world decision is always between turning away certain demand in the present vs the possibility of excess capacity and unprofitability in the future (which is a fact of life in business with or without monetary intervention). It's hardly surprising that people continue to make the same "mistake" in those circumstances.
Published: August 28, 2007 12:04 PM
James
It's good to see this criticism of ABCT addressed. It's also worth pointing out how bogus neoclassical assumptions lead to some odd conclusions...
Sure, entrepreneurs could adjust their plans to take into account monetary policy and this might well help them to some extent. But in the real world information is not costless as it is in the neoclassical model, so entrepreneurs can never completely overcome the efects of monetary policy because to do so requires information and there will always be a cost of obtaining and interpreting that information.
Published: August 28, 2007 12:08 PM
RogerM
What do critics of ABCT offer in its place? Sticky wages and prices! So how come entrepreneurs don't understand that the wages and prices are sticky?!
There is some evidence that business people do understand that some price/interest rate signals may be false. The oil industry has resisted excess borrowing for drilling by assuming that the current high oil prices won't last. Many have been assuming future prices of $20/bl. and planning accordingly. They remember how badly they got burned when oil prices plummeted in 1986. The problem is that when high prices persist for several years, many change their minds and decide that they were wrong and the signals were not false. Rough regressions I have done in the past show a five year lag (on average) between the beginning of higher oil prices and a peak in production. So it does take a while for price signals to convince businessmen that they are for real.
A lot of businessmen take advantage of low interest rates and then hedge against being wrong in the futures/options market.
The telecomm fiasco of the late 1990's is a good example of how difficult it is to judge whether interest rates are too low or not. In hind sight, they were obviously too low and high productivity rates masked the fact. Unfortunately, most of the data that businessmen need for decision making comes out way too late for it to be useful. Had businessmen been able to adjust the interest rate for productivity increases, and had they been Austrian economists, they might not have invested so much in telecomm.
Published: August 28, 2007 12:34 PM
Alex MacMillan
I also think the points made in this article were excellent. Except one, and this is a point I see Austrians make frequently. Callaghan made it in his book "Economics for Real People", which I enjoyed very much. The point is this: Stanley says, "the time preferences of market participants set interest rates [e.g. the natural riskless real rate of interest]" [] my remarks. An example might help a slow learner like me understand.
Having twice e-mailed Callahan and mentioning that I had bought and read his book, I thought he would respond to my question concerning this point. But as yet, he has not. My problem is this: I do not understand why the marginal productivity of capital plays no part in the determination of interest rates. The extreme example I have mentioned at this site in the past to make my point, and the example I presented Callahan, is the following. Suppose the only investment available is trees. The trees grow at such a rate that the growth in the net income after expenses from letting the trees grow is 2% per year. In these circumstances, wouldn't the real rate of interest be 2% and people's time preferences only determine the amount of investment undertaken each year? In general, I would, of course, expect people's time preferences and the marginal product of capital to jointly determine both interest rates and the volume of investment.
Can anyone explain the straightforward Austrian logic on the foregoing point without referring me to treatises by Hayek, or Von Mises, or anyone else.
Published: August 28, 2007 12:55 PM
asdf
Does the Austrian School ascribe, or at least acknowledge, a Schumpterian view of business cycles? Throughout this whole article there was not even a mention of innovation and the role that it plays in business cycles.
Published: August 28, 2007 2:22 PM
JM
Very good article. But it seems to me, that the response to the question "Why Don't Entrepreneurs Outsmart the Business Cycle?" is rather simple:
They cannot, because even the smartest entrepreneur/economist CANNOT KNOW WHAT WILL THE CENTRAL BANK DO.
Is a condo for (say) 1 million dollars a good bargain? If you expect the FED creating a huge inflation, it probably is. If you predict otherwise, the apartment is way too expansive. The point is, you CANNOT KNOW WHAT WILL THE CENTRAL BANK DO. Therefore, you cannot beat the FED. But at the same time this does not weaken the general points made by the ABCT.
Published: August 28, 2007 2:38 PM
C. Cathey
asdf-
The Austrian school to acknowledge the innovation business cycle theory but discount it. To my understanding, it is discounted for 2 reasons:
1) It assumes that we're at equilbrium between innovations and that innovation shocks the economy to a new equilbrium. Since we're not at equilbrium, we can't be shocked from 1 equilbrium state to another.
2) The purpose of entrepreneurs is to innovate - bring new technologies and/or business models to the market. How can a group bringing change to the market be caught of guard by that same change?
I think the audio files of Dr. Garrison and Dr. Salerno discuss this in great detail and of course with much better insight.
CC
Published: August 28, 2007 3:39 PM
Gabriel
Innovation certainly plays a role in determining which entrepreneurs will remain in business. The entrepreneurs who implement innovations that satisfy consumers will profit more than the entrepreneurs that do not. This results in Schumpeter's "creative destruction" in which some businesses (the less innovative) are destroyed while other businesses (the more innovative) are created in their place.
In "creative destruction," businesses are destroyed by the creation of better, more innovative businesses. One business replaces the other. There is a net gain to the economy.
The business cycle, on the other hand, is not characterized by the same series of events nor by the net gain to the economy. In the business cycle, we do not see one group of better businesses replacing inferior businesses. Rather, we initially (during the boom) observe that businesses in general become more profitable. Then (during the bust), we see businesses in general becoming less profitable, with some being forced into bankruptcy due to losses.
When creative destruction destroys business A, it is always possible to look and find business B who's innovations caused A's demise. But when the bust of the business cycle occurs, if A is destroyed, there is, on average, no business B who can be pointed to as the cause of the demise. Creative destruction and the business cycle are distinct.
Published: August 28, 2007 4:00 PM
Alex MacMillan
Still looking for someone to answer my queery concerning the Austrian position that the marginal productivity of capital does not matter for interest rate determination. Surely some Austrian at this site must know the logic involved.
RogerM usually knows about stuff like this. Roger, do you know?
Published: August 28, 2007 5:42 PM
What about the "law of commons"
Entrepreneurs like the rest of use have a problem with Fed created money. That is it is a race to get it first before the economy adjusts. So an entrepreneur is in exactly the same position that I am in that we both will succeed or fail based on when we get the money vs everyone else.
Furthermore, how can we expect entrepreneurs to stop at the funny money WHEN BANKS THEMSELVES CAN'T DO IT. Take Washington Mutual, a well run bank, is as deep in this mess as any other. AND BANKS GET THE MONEY FIRST!!!!!!
Published: August 28, 2007 5:52 PM
RogerM
Alex: "...wouldn't the real rate of interest be 2% and people's time preferences only determine the amount of investment undertaken each year?"
It seems that you and I have discussed this before. But I'll approach it from a different direction. Suppose the only investment available is trees and they produce a return of 2% per year because of growth. Suppose also that this rate was sufficient for the older generation because the money supply was fixed so there was no inflation. But now a new generation comes along and inherits what the older generation saved up. The new generation doesn't have the same values as the old one; they're not as future oriented. They plan to have just one child when they marry, or none at all, so they see no reason to save for the future as much as the previous generation. 2% seems really boring when they could use those trees now to build bigger homes, maybe three homes per family, one in the mountains, one on the beach and one near the job. Suddenly there's a huge demand for lumber and the forests start to disappear. Eventually, a shortage of lumber develops and the price of trees starts to climb. Now the value of the investment, and the return on the investment, includes not just the marginal productivity, but the potential for capital gains as well from the increasing prices of the trees. Say trees start to increase in value about 3% per year. That 3% added to the 2% growth raises the potential profit to 5%. At that point, the interest rate might become 5% because the potential profit is 5%.
From this example it's possible to see that the potential rate of return and the attitude of capitalists (people with money to invest) are what determine the interest rate, and not just the marginal productivity. If people are long-term oriented and value savings above consumption, a low interest rate satisfies them. But if people focus more on consumption, that is on the near term, it will be harder to get them to put off consumption now for consumption in the future. You're going to have to offer them a greater profit on their investment in order to get them to put off consuming their savings now.
In the tree example, the trees will continue to disappear and the lumber shortage grow worse until the potential gain is high enough to persuade capitalists to delay their present consumption. If the new generation isn't totally hedonistic, maybe only half the forests will disappear. But if they're like Baby Boomers, they'll cut down all but one or two trees and the shortage will grow so acute that it takes a return on investment of 25% to get them to stop consuming and start investing. That 25% ROI would then be roughly equivalent to the interest rate.
So if the interest rate happens to equal the marginal productivity of the trees, it's an accident; the current generation of investors happen to be future oriented enough that the marginal rate of productivity is all they need.
Published: August 28, 2007 8:52 PM
RogerM
asdf: "Does the Austrian School ascribe, or at least acknowledge, a Schumpterian view of business cycles?"
If I understand the Schumpetian business cycle, innovation and technology advances cause the cycles; recessions are periods of slow advance in technology/innovation and rapid growth entails advances in technology. While it's true that economies grow rapidly with rapid innovation and grow slowly with less innovation, that is a description of rapid and less rapid growth, not of business cycles. Business cycles are difficult to define, but for the most part, they involve a period of wealth destruction and large numbers of business failures. It's hard to see how innovation can destroy wealth.
Also, innovation tends to affect individual industries, not the economy as a whole. For example, neo-classics think that a jump in oil prices causes across the board price inflation, but it doesn't. If people have to spend more on gasoline/diesel, they will cut back on purchases of other goods, such as clothing. Therefore the price of clothing will fall (or fail to rise as fast) pretty much in step with a rise in oil prices. The mix of goods in the economy changes, but not the economy as a whole.
Similarly, a slow down in technology in the auto industry will cause cars to become more expensive relative to other goods, say computers. People will buy fewer cars but more computers. Again, the product mix changes, but not the total output.
Maybe there is more to Schumpeter's views than I'm aware of, but I don't see how technology/innovation changes can affect the whole economy. Also, innovation should take place randomly so that advances in one industry will be offset by slow downs in other industries. If there isn't an overall cause, then winners and losers should offset each other and there would be no cycle. That cycles exist indicates that something is upsetting the random nature of things and causing more than the normal number of companies to prosper at the same time and later more than the normal number of companies to fail at the same time.
In the ABCT, total output actually declines across the board, pretty much in all industries, though mostly in the capital intensive industries. Only Austrians have an explanation for errors occurring across many industries at the same time.
Published: August 28, 2007 9:19 PM
Yancey Ward
Alex, you seem to explicitly request no links, but I think this discussion by Robert Murphy may be what you are looking for. You really don't have to completely understand the math to follow Murphy's argument, but it eventually forms the foundation for understanding your question and the Austrian answer to it, which Murphy gets to in the conclusion.
Published: August 28, 2007 9:31 PM
Anthony
Personally, I think the ABCT offers a better explanation of cycles than the RBCT.
Published: August 28, 2007 9:43 PM
Eric
Good article.
Maybe someone can explain this one to me:
Why do more errors occur at the higher orders of production then the lower ones. I've seen this mentioned a lot, but w/o explanation.
Published: August 28, 2007 9:53 PM
Anthony
From the article: "The entrepreneurs then undertake projects that weren't profitable at the higher rate. Because long-term projects are normally inherently riskier than short-term projects, the new projects are disproportionately long term. These are projects related to the higher stages of production, those far removed from the low-level stages where goods for immediate consumption are produced. Such long-term projects create the infrastructure that allows for increased production in the future, and they are financed by the savings built up by consumers in a previous period when their time preferences were higher and they tended to save more and spend less."
Essentially, investments involving higher-order goods become more lucrative. They're also riskier, and I believe more difficult to liquidate when the bust arrives.
Published: August 28, 2007 10:22 PM
Dan Mahoney
This author seems unaware of the vital aritcle,
"Towards a General Theory of Error Cycles,"
in the QJAE (you can download it from this site).
I encourage him to read it.
Published: August 28, 2007 10:25 PM
Dan Mahoney
I forgot to add: by the brilliant Guido
Huelsmann (author of the forth-coming biography
of Mises).
Published: August 28, 2007 10:26 PM
Don Lloyd
If I am a profitable manufacturer of widgets, I am going to be vulnerable to the boom/bust cycle even if I make no errors at all.
The expansion of credit produces two results, a lower rate of interest as the holders of loanable funds try to entice reluctant borrowers to accept loans and a large increase in the number of only marginally at best credit-worthy borrowers who actually get funded as standards must be lowered to actually place loans.
As a widget manufacturer, all these new loans tend to finance my potential competitors. This means that my factor prices get bid through the roof and that my final products end up competing with the final products of my new competitors, now bankrupt and liquidating their products for pennies on the dollar.
The only valid decision available to me would have been to sell my business when the low interest rates boosted the discounted present value of my projected future earnings before they disappeared.
Regards, Don
Published: August 28, 2007 11:38 PM
David White
JM writes:
"The point is, you CANNOT KNOW WHAT WILL THE CENTRAL BANK DO. Therefore, you cannot beat the FED."
Ah, but who in his right mind -- i.e., what "Austrian" -- doesn't know that the Fed is going to cut-cut-cut in a vain attempt to save an economy that will soon be in free-fall. And who in his right mind, then, would pass up the opportunity to, say, take out a home equity loan at a superficially low interest rate (as interest rates already are) and buy precious metals, paying for them with "money" that will soon be worthless.
And let's be clear about that: On average, the Federal Reserve Note (not the constituional dollar) has lost a little more than one percent of its value for every year that the Fed has existed. The Fed is now in its 93rd year of existence, and the FRN has lost more than 95% of its value, meaning that it will become worthless before it sees its hundredth birthday.
Can't beat the Fed? On the contrary, it's beating itself to death as we speak. And anyone who knows this can profit accordingly.
(And no, this doesn't change the soundness of the ABCT one bit, as businesses, for the most part, don't know what to do with the easy money.)
Published: August 29, 2007 6:26 AM
Stéphane
Thanks for this very clear article.
I am trying compare your explanations with the usual keynesian view of depressions deepening due to animal spirits. Part of his argument revolved around the idea that at some point, entrepreneurs and stock investors base their decisions more and more on what they think their peers think. This kind of process is well know in game theory and can lead to bad "equilibriums" such as in the prisoner's dilemma. Hence the conclusion that governement intervention is necessary, or otherwise individual choices will lead to a bad collective outcome.
What is striking here is that the psychological mechanisms underlying the Fed's decisions seems to create precisely such a dangerous game. For a while, it adjusts the money supply in order to reach a certain price index or interest rate. But educated investors soon learn how the Fed thinks, and anticipate its decisions, making them less and less "efficient". So the Fed tries to outsmart the market, and so forth. In this arms race, one can see exactly the same process at work which Keynes described in the famous "beauty contest". Except that it is created - and not prevented by - government regulation.
Published: August 29, 2007 10:49 AM
Stéphane
Thanks for this very clear article.
I am trying compare your explanations with the usual keynesian view of depressions deepening due to animal spirits. Part of his argument revolved around the idea that at some point, entrepreneurs and stock investors base their decisions more and more on what they think their peers think. This kind of process is well know in game theory and can lead to bad "equilibriums" such as in the prisoner's dilemma. Hence the conclusion that governement intervention is necessary, or otherwise individual choices will lead to a bad collective outcome.
What is striking here is that the psychological mechanisms underlying the Fed's decisions seems to create precisely such a dangerous game. For a while, it adjusts the money supply in order to reach a certain price index or interest rate. But educated investors soon learn how the Fed thinks, and anticipate its decisions, making them less and less "efficient". So the Fed tries to outsmart the market, and so forth. In this arms race, one can see exactly the same process at work which Keynes described in the famous "beauty contest". Except that it is created - and not prevented by - government regulation.
Published: August 29, 2007 10:51 AM
Robert
I am working on rewriting my proof of the logical invalidity of Austrian Business Cycle theory. I intend my rewrite to be more terse.
Published: August 29, 2007 5:49 PM
Eric
Ok, we have that longer term investments are risky. That makes sense since there's more time for something to go wrong. But why would only the higher orders of production, i.e. digging the iron out of the ground, engage in longer term investments?
Why would the iron mines, require longer investments than say, the auto makers, who since they use the iron are a lower order producer.
Even a local consumer level store, such as wal-mart, might take up long term investments, say, in building new stores.
I don't see the direct relationship between higher order and longer term. It may sound ok, but I don't see the proof of the statement. What axiomatic approach determines this relationship? Or is this a case where Austrians do look at past data?
Published: August 29, 2007 7:11 PM
thomas benjamin
I found the article very interesting and helpful. I am going to go out on a limb here and propose a possibly silly 'toy economic system' the analysis of which may have interesting ramifications in relation to this article. Consider a society that has a single central bank, pure fiat money (not credit money as the article suggests [to me, at least] we have), a single money substitute--sight drafts drawn on the central bank (such sight drafts are negotiable instruments), a single central bank policy--whenever the central bank is presented with a sight draft it either prints the amount of money ordered by the draft or credits an account that amount, and anyone (including businesses) can create valid sight drafts of any amount they wish to present to the central bank. Could business cycles exist in such a system? Could inflation and hyperinflation? What would the mediate gratification for work be in this system? Could entrepreneurs be misled into making investment errors in such a system (indeed, what could be counted as 'investment' in such a system)? Would there be a flight into real goods in such a system? If anyone who reads this comment would bear with my ignorance in imagining such a silly economic system would they be so kind in answering my questions? Thanks
Published: August 29, 2007 7:41 PM
Eric
thomas
Interesting puzzle. My first impression is that if anyone can create a site draft, that you'd have almost immediate hyperinflation and in short order nobody would use the central bank or it's fiat money for trade.
Mises and Rothbard point out that such a system cannot be "sprung" on people, but I'm not so sure. In a free world, people can refuse to accept fiat money. But if a ruler says, accept this money or you die, then I think it can be done. And I did read that it was done once in China.
But you will need to add more to your toy system, such as rules about legal tender, punishments for disobeying etc.
Fun exercise though.
Published: August 29, 2007 8:52 PM
Anthony
Eric, hopefully someone else more knowledgeable than myself on monetary economics will be able to answer your inquiries. I am only now beginning my second year of economics, so there are still gaps in my knowledge.
Published: August 29, 2007 9:31 PM
Mike
Thomas,
Perhaps I'm not following what you're suggesting but I think Eric is correct that the currency would be wrecked immediately by hyperinflation.
The only way it could even be attempted is through brutal coercion, as it would be obvious to everyone that they are being forced to trade something (their goods and services) for nothing (money people can get in any amount they want from the CB). It sounds like you should just have people going into stores, writing dollar amounts on scraps of paper, and walking out with goods. You are essentially severing the link of cooperation that creates society - mutually beneficial exchange. I think the fraud would be much more apparent to the average person than the current system.
If I've misunderstood what you've proposed let me know.
Published: August 29, 2007 9:40 PM
RogerM
Eric: "But why would only the higher orders of production, i.e. digging the iron out of the ground, engage in longer term investments?"
I think there may be some confusion over "long term investments" and "roundaboutness". In ABCT, increased investing lengthens the entire production process. The length of time in which the investment is tied up is not as important as the length of time from the first stages of production until the consumer good is ready for sale. For example, a fisherman can make a small net in a short time and use it to catch enough fish to feed him for the day. But if he decides to build a boat so that he can employ a larger net and catch more fish, the production process from start to finish (fish ready to eat) takes much longer with the boat process. In other words, capital intensive methods of production take longer from their start until consumer goods are ready. Some call that the lengthening of the production process, or an increase in the roundaboutness of production.
Largely, what makes the higher stages of production more volatile is that they use more machinery, which is very expensive. Distributors and retailers use very little machinery (capital goods) and are more labor intensive. The value of those capital goods are very sensitive to interest rates, falling with rising interest rates and rising with falling ones. Also, because of their huge expense, companies tend to borrow money to purchase them. That makes those industries very sensitive to interest rate changes. So when the interest rate is too low, it encourages more borrowing from the capital intensive industries. Consumer goods industries don't borrow for machinery so much, being more labor intensive.
Also, when higher order industries, the capital intensive ones, borrow and expand production, they hire workers and pay them wages. Those workers go out and compete with existing workers for the limited consumer goods available and prices start to rise. Consumer goods are limited at this stage because it takes a long time for the increase in production of higher order goods to translate into increased production of consumer goods.
Rising prices create rising profits for makers of consumer goods, so a lot of people want to invest in those industries. Wages lag behind rising prices, so suddenly labor is cheaper. The demand for more consumer goods and cheaper labor means businessmen will switch from capital intensive (more roundabout) processes to more labor intensive, direct production of consumer goods, which takes less time. It may be that the producers of consumer goods just delay purchasing the new equipment they had intended to buy and have their workers work more overtime. But the switch to more labor intensive methods of production in turn hurts the makers of capital equipment (machinery) who just borrowed a ton of money to increase production. So you can see that most of the expansion and contraction in the economy takes place in the higher order, capital intensive industries. The closer your industry is to the final production of consumer goods, the more stable it will be in terms of employment, but the wages will be lower because workers use less machinery that improves productivity.
Coming from mainstream econ, as I did, it took me a long time to get my head around the ABCT. It's so different from mainstream econ. But once I digested it, I thought it was the greatest, and still do.
Published: August 29, 2007 10:06 PM
RogerM
Alex: "...wouldn't the real rate of interest be 2% and people's time preferences only determine the amount of investment undertaken each year?"
I had a few more thoughts about this today. I think a good way to look at interest rates is to see them as prices for money. In the same way that prices are subjective, so are interest rates. While the cost of production influences prices, it's still not the major determinant. In the same way, marginal productivity of capital will influence interest rates, but not be the major influence. If interest rates are the prices for renting someone else's money for a period of time, then supply and demand becomes the major determinant of price. Demand for money to invest is determined by profit opportunities; greater opportunities for profits increase demand for borrowing money.
The supply of money to invest is determined by the desire to consume today. If you have no desire at all to save for tomorrow and want to consume everything you have today, then nothing will tempt you to save/invest, or supply loanable funds. If everyone was like that, the supply curve of loanable funds would be vertical on a graph. In that case, the interest rate could be 1,000% and still no one would loan money. The opposite situation would be a case where people saved every dime and consumed nothing; everyone would die. Fortunately, most people try to balance the future and present, so the supply curve slopes upward: higher interest rates encourage more savings/investment, lower rates discourage both.
The marginal productivity of capital plays a role in this, mainly on the demand side, by increasing profitable opportunities. But other things, such as capital gains, also play a big role in creating profit. It's not just the marginal productivity of capital that matters, but the total profit to be made. A low marginal productivity of capital can create huge total profits with the right amount of leverage.
Published: August 29, 2007 10:23 PM
Anthony
RogerM, thanks for your explication of the ABCT. On your comment on supply of loanable funds, would you say that this is ultimately another way of saying that it is strictly determined by Time Preference? That is exactly what it seemed like to me, and is what I have been taught so far.
Published: August 29, 2007 10:48 PM
TLWP Sam
You're talking of paper money, "why not scibble numbers on my own paper and go into a store?" reminds of what can replace trading in gold chips? History has shown the gold standard to be bunk. Indeed the history of the gold standard has confirmed the 'if you're not actually holding the gold in your hand then you don't really own it' notion. Why couldn't I write on a piece of paper 'this piece of paper is good for five ounces of gold' and walk into a traditional bank too? The way of gold standard money in which the ratio of gold to paper is conveniently changed or suspended when needed doesn't inspire confidence. Even worse, in days of precious metal coins, the percentage of precious metals kept getting diluted proportionally to the desired monetary expansion.
The truth is the main form of currency is direct gold chips and a possible secondary form is one of personal contracts/I.O.U.s. The fact that a bill has 'it's good for x amount of gold' is no more reassuring when considering the number of bank runs during the 'gold standard'. And I don't even want to think about how a digital pulse likewise is supposed to represent gold either!
Published: August 30, 2007 12:44 AM
Eric
RogerM, That was quite an explanation. Many thanks.
I guess my problem is that I come from a math background. In my analysis (theorem proof) courses, any bad link in a long chain of reasoning was enough to invalidate the proposed theorem.
In your explanation, you have many chains of cause and effect. But these are not as clearly logic based as the proofs I had in my math classes. I think that since we are dealing with human actors, and not physical entities or even just logical propositions, that the “if and only if’s” and “if this then that’s” are not always so black and white (true or false).
And so we seem to be getting into an area that is probably closer to fuzzy logic or at least something with probabilities instead of true and false.
As to each actual pair of links, if there is only a likelihood (say greater than 50%) that the one link follows from the other, then I’m not sure just what it is we can say about a collection of these links. Since each link deals with humans, there's always the possibility that they will act in error - somtimes getting lucky or sometimes not. So, to say that one group makes more errors than the other (higher order vs. lower order) may only mean there's a 70% chance this will occur, but there's still 30% chance it won't in this case.
And once we get into chance, then it seems that only statistics and data can get us out of this dilema. But the Austrians say no, never do we use stats - at least I seem to keep hearing this.
And if the links are not absolute, then I don’t know what sort of logic Mises was using in his praxeology. It seems that the Austrians are as sure of their theorems and proofs as the mainstream is in their equations and charts. I think the Austrians are much closer to the truth, but I’m afraid the truth is not so clear cut as I would like it to be.
Published: August 30, 2007 12:45 AM
Robert
Eric, you're right to doubt. The theory is logically flawed.
The fact that entrepreneurs make mistakes from misperceptions of technology, tastes, and prices is neither here or there. The claim that entrepreneurs will tend to lengthen the production process when the interest rate is lower is a claim about what they would do if they did not make mistakes.
But I'm surprised that RogerM would accept claims about the "marginal product of capital". I thought that was one of those areas where Austrians know the mainstream is wrong. My name links to a demonstration.
Published: August 30, 2007 4:12 AM
Daniel M. Ryan
A side point on lengthening the structure of production: As Murray N. Rothbard noted, capital goods are valued for their services, which are added to raw materials to add value. Replacing a mill that has a ten-year lifespan with a mill that has a fifty-year useful life lengthens the structure of production, even though the wood gets out of the mill and to the buyer just as fast, if not faster. That's because the value of the wood is not just the physical product, but the milled wood, or the wood-as-milled. If the years of service that the mill adds to the wood increases, then (ceteris paribus) the production structure has lengthened. There are more "mill services" available to the wood producer, in terms of time length.
Published: August 30, 2007 4:56 AM
Anthony
"And once we get into chance, then it seems that only statistics and data can get us out of this dilema. But the Austrians say no, never do we use stats - at least I seem to keep hearing this."
No. The Austrians use a different methodology to the mainstream, but only certain of the theorems are purely axiomatic. A lot of them rely on empirical data (e.g. time preference.) Further, Austrians are not averse to statistics and empirical data in the demonstration of the workings of certain theories. The ABCT would be one of the theorems more heavily based on empirical data. This is a good paper on how Austrians actually derive their theorems:
http://www.veritasnoctis.net/docs/aristotelianapriorism.pdf
And here is an empirical examination of the ABCT:
http://mises.org/journals/qjae/pdf/qjae9_2_4.pdf
Published: August 30, 2007 7:38 AM
Eric
TLWP
I think you are unfairly speaking of 'the gold standard' and bank runs as though the runs occurred even during the gold standard. The cause of the runs had nothing to do with a gold standard, but rather the facade of a gold standard. Nobody was running to the bank to withdrawl the gold they had deposited, because they hadn't actually deposited gold. Perhaps they went to the bank with gold at some time and sold it for paper money which they then deposited.
The problem with bank runs is I believe correctly analysed by the Austrians. And Rothbard is explicit in this, fractional reserve banking is a fraud.
Saying a fractional reserve system is operating on a gold standard is like saying 10000 pages of a free-trade treaty is free trade. Saying it don't make it so.
As to the current solution to bank runs (even though we just saw one) is to allow for infinite inflation by the central bank. No wonder the banks created the Fed (in secret). Only force could set up this sort of system.
Published: August 30, 2007 12:31 PM
RogerM
Eric: "In your explanation, you have many chains of cause and effect. But these are not as clearly logic based as the proofs I had in my math classes."
Exactly! That's why Austrians make qualitative, not quantitative forecasts. For example, it's an accounting fact that profits will increase when prices increase, but wage increases lagging behind price price increases is only a probability. It usually happens, but the extent of the lag varies as does the amount of the wage increase. The lag in wage increases makes labor cheaper relative to other inputs, such as raw materials, but the ratio will vary and the response of businessmen to it will vary.
Still, the whole purpose of regression (econometric) modeling is to capture the average responses of people under particular conditions. So quantitative forecasts can be made, but you have a wide margin of error. It's not at all like engineering models that have almost no margin of error in them.
I had an econ teacher who got his PhD in physics first, then got another PhD in econ, largely because a mentor told him that econ uses the same math tools as physics. You can use the same tools, but the results won't ever be the same because econ deal with human behavior, not unchanging laws of physics. Theoretical economics has tried to force econ to work like physics with math and failed, but they keep purshing their failed ideas on the rest of us.
In econometric modeling, or simple regressions, you get a number that tells you how well your equation fits the historical data. It's called R-square. R-squares rarely get larger than .60 using historical data, which can be interpreted as meaning that your equation (model) explains 60% of the variation in the data. The other 40% might be explained if you knew which variables to use and had data for them, but usually you don't. Human behavior involves too many variables.
Published: August 30, 2007 12:31 PM
Eric
RogerM
Now that explanation makes a lot of sense to me. I would be much more comfortable with Austrian "proofs" if they stated the margin of error that they believe is inherent in their proofs. But when I read them, it's not apparent that there might be a 60% chance that, say the higher orders go for the new money more than the lower orders. That I could accept. But the words seem to imply the number is 100%.
Not that I expect numbers as exacting as 60% but at least distinguish between 100% and say 51%. That's a pretty large difference and might indicate just how much variabliity is in the system.
Published: August 30, 2007 12:44 PM
Anthony
Eric, I am not sure that that is what RogerM meant exactly. It is true that Austrian theories containing empirical elements in them are less than 100% certain and are contingent on these facts. It's also true that they could be quantitavely expressed and formulate predictions of such a nature (certain Austrian economists do engage in such modelling.) I think what RogerM was elaborating was the difficulty in using natural sciences methods in economics, and why quantitative statements in the field tend to be somewhat unreliable. Hopefully he'll correct me if I'm wrong.
Published: August 30, 2007 1:54 PM
Anthony
RogerM, out of curiosity, what do you think of the statements made by Robert in this thread?
Published: August 30, 2007 1:55 PM
Eric
Anthony,
Here is an example of the wording that I find problematic. The word “must” in the below statement (taken from the 2nd pdf reference you gave above) signifies to me that the author is saying that the probabilities here are 100%. If, as RogerM says, these are qualitative, then the wording should have been “may”. We’ll have to see what RogerM has to say on this.
“Any policy induced lowering of the interest rate must simultaneously increase consumption spending, lowering saving, as well as increase investment in productive activities. “
Published: August 30, 2007 3:46 PM
G
Eric,
If you accept the premises of an argument, and the logic is valid, the conclusions that follow must be sound. The axioms of praxeology shouldn't be applied any differently than those of mathematics. Of course in math, the premises of an equation are clear and obvious, while the premises of something written in a natural language like most of Austrian economics are not necessarily so clear. But in either case statements with true premises which adhere to the fundamental axioms must be true.
I do think empirical evidence would help make some Austrian assumptions more acceptable, even if they might prefer their premises by true a priori.
Published: August 30, 2007 3:55 PM
Anthony
Eric, if all else is equal (and this is the crucial point), that statement is 100% true. It is based off the law of demand and supply. The more axioms and empirical facts a theory contains, the more uncertain and subject to scrutiny it becomes (that is to say, theorems such as the ABCT.) But that is a pretty basic statement. Another example would be "all else being equal, if supply rises prices must fall". As I have mentioned before, though, the case of Time Preference is far more contentious. So it depends on the theorem in question to what level it is apodeictically true or not.
Published: August 30, 2007 7:36 PM
Yancey Ward
Anthony,
As far as I can tell, Robert appears to be a Sraffian economist. The essence of his argument in the link he provided first is that changes in interest rates do not change investment in the way that ABCT would indicate. From what little I remember about Sraffa, his proponents believe that the interest rate could be pushed to zero by central banks and this would have no effect on production but would only redistribute income towards labor and away from capital. I will leave it other, more qualified commenters to address this. The actual empirical world would seem to me to show him to actually be wrong.
Published: August 30, 2007 9:48 PM
Thomas Benjamin
Thanks to all for your comments. I will try to answer some of the questions raised. First, I will make the assumption that the fiat money in my 'toy' system is legal tender (since Mises suggests in HUMAN ACTION that that condition is irrelevant) but that gold and silver (etc.) clauses in contracts are legal. That having been said, what about Gresham's Law? Wouldn't the 'good money' (i.e. commodity money) be hoarded and the 'bad' money (i.e. fiat money and sight drafts) be used (indeed (not to belabor a point) in our present economy, where are all the private mints and all the people flocking to exchange their FRN's for the privately minted gold and silver coins minted in accordance with the Coinage Act of 1792)? Also, as regards the immediate hyperinflation allegedly implicit in my system, how would that hyperinflation implicitly come about? As I understand it (and this may show I don't so please correct me...) the Austrian 'definition' of inflation (aside from Mises' contention that inflation is a "rapid, big, cash-induced [decrease --my comment] in purchasing power", HUMAN ACTION, pg. 423) is an increase in general price levels that comes into existence when relatively more money is injected into an economy than new goods or services injected into that same economy. If this is the correct interpretation of the Austrian definition of inflation then how in my system can inflation or hyperinflation come into existence when it is the demanders themselves injecting fiat money into the money supply (I assume it will happen but through other means than the mere writing of sight drafts). Since businesses can write sight drafts too it would seem that, save for construction time, retooling time, etc. goods can very nearly be immediately produced in response to consumer demand, thus (seemingly) eliminating inflation. What about Say's Law--how would that work to eliminate inflation in my system? These questions that naturally come to me when I ponder my 'toy' system seem to make this system intriguing (at least to me). To my mind, at least, my toy economic system is one with zero savings, zero investment (at least as the term 'investment' is commonly understood), and zero inflation--which is to me a paradox. Hope this helps clarify things.
Published: August 30, 2007 10:27 PM
Thomas Benjamin
Mike, Thank you for your comment--found it very helpful. I do have a question for you. If money (in whatever form) is merely a medium of exchange, how does the change of form destroy mutually beneficial exchange? What one always exchanges is always good for good at least as I understand things. Gold and silver were valued as media of exchange because people deemed them the most marketable goods, and because they were the most marketable goods they could be offered in later acts of exchange. Marketability seems to be the operant word here. You having what I want and I having what you want is, and always shall be, the true basis of exchange regardless of the form of the medium of exchange. A medium of exchange is a good which people acquire neither for their own consumption nor for employment in their own production activities, but with the intention of exchanging it at a later date against those goods which they want to use either for consumption or for production. Government fiat merely makes the paper 'valuable' for exchange, nothing more. If the people of a society choose through their representatives or otherwise to make a piece of paper, specially printed, suchwise valuable, it is their right. Scarcity, in a world without government (specifically in regards to media of exchange) is the invisible hand which makes a commodity 'valuable for exchange', otherwise scarcity is (at least to me--rightly or wrongly) is irrelevant and has nothing whatsoever to do with inflation or deflation (as my comments in my previous blog entry here suggests). Inflation is caused by other factors. Hope this helps clarify my position. I await your corrections and comments. Thanks.
Published: August 30, 2007 11:57 PM
TLWP Sam
Personally I wondering if people used a silver/gold currency would Gresham's Law mean people would be tempted to spend the silver and keep the gold?
Published: August 31, 2007 1:36 AM
G
TLWP,
Gresham's Law only applies when government sets the value of one currency. So if the value of neither gold nor silver was set, people wouldn't be inclined to hoard one over another for monetary reasons.
But if we have legal tender competing with gold or silver, people will horde the gold or silver, because their market value is higher (and because they are not inflationary, hording dollars would be silly).
The bimetallic standard in the US suffered from this problem, where changes in the market value of gold or silver wouldn't be reflected by changes in the legal exchange rate between those two currencies. The result was that if one metal grew more valuable, it became advantageous to horde the other metal. This can cause massive disruptions in the supply of money, and all the same problems those disruptions carry today. A bimetallic standard is a really, really dumb system of currency to have.
Published: August 31, 2007 3:27 AM
adi
I know something about Robert Vienneau's claims against Austrian econ (having sometimes commented on his webpage);
1) There is no causal relation between "degree of roundaboutness" and rate of interest in a sense that lower interest rate would cause more capital intensive methods being applied.
2) Some outside factors might very well influence distribution of income. Suppose that the rate of interest is fixed. Then rate of money wages can be determined from the n simultaneous equations where is n-1 commodities, one parameter (interest rate), money wage and n values of commodities on right hand side.
Sraffians use heavily linear economic systems and must also postulate more about equilibrium relations than we Austrians.
Published: August 31, 2007 7:25 AM
Mike
Thomas,
You have it partially correct. Money is a medium of exchange, a marketable commodity used to trade for other goods and services. Which commodity this will be is chosen by the free market. The point is whatever eventually becomes money MUST be chosen by the market not by government decree.
Just because government prints scraps of paper with numbers on them and forces people to use them doesn't give them value (witness the current mess in Zimbabwe). This arrangement can only exist through coercion. Absent coercion, Gresham's law works in reverse - people stop accepting scraps of paper and demand things they value for their goods and services. Good money drives out bad.
In the system you propose, you have done away with money (a commodity freely chosen by the market and used as a medium of exchange) and put in it's place a money substitute which can be printed up at will by anyone and enforced by legal tender laws. By getting rid of money, you get rid of mutually beneficial exchange. It's even worse than our current money substitute because of the inflation problems described below.
I think you are confusing the Austrian definition of inflation. It is simply an increase in the money supply. This: "an increase in general price levels that comes into existence when relatively more money is injected into an economy than new goods or services injected into that same economy." is specifically left out of the Austrian definition of inflation. A rise in prices is often an effect on inflation, but defining it as such, leads to confusion such as yours. I think the confusion in the scenario you lay out stems from thinking of inflation as an increase in the money supply in excess of the demand for money. Therefore, if the demanders control the money supply, there can be no inflation. The Austrian definition is quite clear on this - any increase in the money supply is inflationary. So if anyone could print any amount they wanted, you would have almost instant hyperinflation.
My explanation was probably clear as mud, sorry. Murray Rothbard's "What Has the Government Done to Our Money" is a great little book that deals with a lot of this if you are interested, and it is free on this site.
Published: August 31, 2007 8:52 AM
RogerM
Eric: "The word “must” in the below statement (taken from the 2nd pdf reference you gave above) signifies to me that the author is saying that the probabilities here are 100%."
I can see both your and Anthony's points on the matter. Knowing that Austrian writers never intended to make quantitative forecasts, I think I took it for granted that they didn't mean everyone. But I can see how someone might take it that way. Lower interest rates will increase investment and as a result increase consumer spending because more consumers will be working as a result of the increased investment. Also, it will reduce savings. That's the qualitative forecast. Quantitatively, which is what I think you want, the effect may be large or it may be small, depending upon a lot of other variables. And it may take a while for the effect to appear. For example, in the middle of a deep recession, lowering interest rates don't have much impact at all because people are struggling to refinance older debt and can't take on any more. Japan in the 1990's was like that. They had interest rates close to zero with little effect, except that it caused people to borrow in Yen and buy US debt.
It might be better for Austrians to say something like "lower interest rates tend to cause greater investment..."
Anthony: "what do you think of the statements made by Robert in this thread?"
I haven't read his writings, but I have read those of neo-Keynesians, monetarists and neo-classicals and don't find them convincing. They tend to not see the big picture. For example, monetarists see the problem of price inflation that monetary inflation causes, but they tend to think the effect is evenly distributed across all industries. No one addresses the capital structure like Austrians. In fact, they don't seem to think it exists.
Adi has an interesting post on Robert.
Published: August 31, 2007 1:13 PM
RogerM
Robert: "I do think empirical evidence would help make some Austrian assumptions more acceptable, even if they might prefer their premises by true a priori."
I think Austrians are unfairly criticized for their opposition to empericism. It's not that they totally ignore data or history. Mises and Hayek taught that you must approach data and history with a sound theory in order to make sense of it. If you don't, you'll fall for all kinds of stupid ideas. As I mentioned before, approaching data without theory is called "data mining" and it's a very unsound practice, the opposite of what good statisticians do.
But the fundamental axioms of Austrianism come from observing human action. So when someone observes from history or data that people have bought more of a product even while the price is increasing, that doesn't mean that the fundamental principle that people buy more of a good when the price is lower has been proven wrong. It would mean that something else is at work that has overpowered the fundamental principle. One explanation could be that people expected a shortage. Another could be that the money supply expanded rapidly changed the relationship between money and the good.
In fact, you'll find a lot of Austrian writers using graphs to explain or add credence to their points. Graphs are just a form of empirical evidence.
Published: August 31, 2007 1:25 PM
Anthony
Well said Roger. I think a major problem faced by Austrianism is that Mises (and even Hoppe) were not clear enough in what they meant by Austrian apriorism (especially with regard to the synthetic a priori.) Luckily newer Austrian authors have taken to the task to disentangle praxeology from Kant, and better elaborate what exactly it consists in. At some point I am hoping these newer authors will publish a book on an Aristotelian grounding for the discipline.
Published: August 31, 2007 1:32 PM
Alex MacMillan
RogerM and Yancey: Thanks for your responses. I hate to post and run but I have been out of town and otherwise occupied with a golf tournament since I posted my question concerning the Austrian theory concerning the determination of interest rates. I have only just returned and see that the two of you have posted responses to my question. I shall read them this weekend, though I am again very busy with golf. But this is the last weekend for that. By the time I respond to your posts, you will probably have ceased to view this particular blog topic. If so, I'm sure I'll have another chance to either thank you for your explanations or queery them.
Published: August 31, 2007 4:56 PM
Thomas Benjamin
Mike, Thanks for your help. I have a different question related to the others. In HUMAN ACTION, pg 475, Mises states, "It may happen one day that technology will discover a method of enlarging the supply of gold at such a low cost that gold will become useless for the monetary service. Then people will have to replace the gold standard by another standard". If we imagine a society using a gold standard coming into possession of such a technology and the government of that society by legislative fiat forces the society to remain on the gold standard, will that situation also cause hyperinflation (though possibly not as quickly as in my former example)? Also why are people still mostly using FRN's when it is now perfectly legal to have gold and silver clauses in contracts? Is there some underground group (a diffuse "Galt's Gulch", so to speak) that uses only gold and silver coins, privately minted or otherwise? This puzzles me. Again thanks for your help.
Published: August 31, 2007 7:43 PM
Thomas Benjamin
Mike, I took your advice and read Rothbard's book. It was excellent and answered many of my questions. Are you familiar with William Barnett II and Walter Block's paper "On the Optimal Quantity of Money" available through this website? If so, what is your opinion of their views?
Published: August 31, 2007 9:50 PM
Mike
Thomas,
Yes, I think if people no longer wanted to accept gold as payment, it could be produced at virtually no cost, and government forced people to use it, that could cause hyperinflation as well. Commodity money doesn't make it impossible, paper money just makes inflation easier for governments.
It is a very good question why people use FRNs. Many people have different opinions. I think it dates back to FDR outlawing gold ownership, forbidding gold clauses in contracts, and stealing all the gold that backed the bills everyone was holding. At that point no one had any choice but to keep spending them as the always had. Then the new bills just came with different small print on them. After a number of years the restrictions on gold ownership were relaxed and of course we can trade in gold if we like today, so why don't we? I think it must have to do with a number of factors. People tend to cling to what they're used to using as money. Also I think the size of government and the amount of FRNs it demands and doles out has something to do with it. I speculate there is maybe even a realization among major players who would have to be involved in a return to gold for it to really work, that if it ever started to happen, the government would just confiscate the gold again. Your thoughts?
Published: August 31, 2007 11:42 PM
Yancey Ward
Thomas,
Money is the most exchangeable commodity. While it is possible to use gold contracts today, it is still impossible to use them for any transaction you wish- this means gold is not money today. For example, if you wish to pay your taxes, the government will require your payment in FRNs. It is illegal to require payment of a dollar-denominated debt in any other currency-the two parties must agree to do so.
The dollar will have to be destroyed before gold returns, and even then I don't think we are likely to see it. Whatever debris of government resurrects itself from the ashes and calls itself the new government will simply revert to form and issue the NewDollar.
Published: September 1, 2007 2:18 AM
Robert
Yancey Ward writes "From what little I remember about Sraffa, his proponents believe that the interest rate could be pushed to zero by central banks and this would have no effect on production but would only redistribute income towards labor and away from capital." This claim is totally irrelevant to demonstrations that Austrian Business Cycle theory is logically invalid.
RogerM's comment that he doesn't find the writings of "neo-Keynesians, monetarists and neo-classicals" convincing is irrelevant to anything I wrote. I don't even fit into any of those categories.
From adi's comments, I see I have work to do to be more clear. On his point (1) - this critique extends past aggregate measures of capital intensity or of the period of production. I think point (2) can be put aside in making an internal critique of Austrian Business Cycle theory. And, contrary to point (3), I claim that for that purpose, I do not need more assumptions about equilibrium than the Austrians. (This would be more debatable if I was putting Sraffianism forward as the only explanation of the economy you need.)
Published: September 1, 2007 8:48 AM
TLWP Sam
Actually I think I may have asked that question to goldbugs before (why not use gold anyway?). But of course everyone understands, if unconsciously, Gresham's Law and aren't going to spend gold when they can just as easily use ordinary money. Why use a gold coin and get ordinary money as change? Especially as most goldbugs are hoping that hyperinflation is just around the corner.
Published: September 1, 2007 9:51 AM
Yancey Ward
Robert,
I apologize, I was a bit unclear about who I meant was wrong as demonstrated by the empirical evidence. I meant that I thought Sraffa and Sraffian analysis was wrong. I never wrote that my comment about Sraffa had any direct bearing on the validity of your critique of ABCT (Is Sraffian analysis appropriate in this particular case?). Indeed, as far as I could follow your argument, you were only addressing the idea that ABCT is wrong about which direction the malinvestments would proceed- toward lower or higher order goods. I, myself, am a bit of agnostic on the issue and wonder whether or not it even matters.
However, I will ask out directly- do you believe that lowering interest rates during credit expansion, in the way central banks do today, causes malinvestments- investments that will be unprofitable when the interest rate rises?
Published: September 1, 2007 12:00 PM
Thomas Benjamin
Mike, as to your question, I think that it all depends on the government's desire for power over our lives. Rightly or wrongly I deem the U.S. and any country that uses fiat 'money' vast operant conditioning chambers (i.e. 'Skinner Boxes'), their economies "token economies" (look up relevant papers under that term on the Web--I bet you'll find them fascinating), and tokens as secondary reinforcers (token economies are methods of utilizing secondary reinforcement to shape behavior). That is one of the reasons I posed my 'toy' economy--under such an 'economy' the 'rats' would be in control of their own lives....I still have a few questions more to ask you as regards my 'toy' economy...1. If my toy economy has done away with money, has any nation with a fiat currency done away with money, too? 2. Is the problem with fiat 'money' that the cost of production is virtually nil so that it is very, very easy to produce (that is what Rothbard seems to suggest in his little book...) 3. Re. your comment "I think the confusion in the scenario you lay out stems from thinking of inflation as an increase in the money supply in excess of the demand for money. Therefore, if the demanders control the money supply, there can be no inflation"--am I misunderstanding Rothbard when he states in his chapter entitled "The "Proper" Supply of Money" in WHAT HAS THE GOVERNMENT DONE TO OUR MONEY that increases in the money supply in excess of the demand for money IS inflation ("What happens, then, if the supply of gold [ah ha! commodity money!--my comment] increases, DEMAND FOR MONEY REMAINING THE SAME [my emphasis]? The "price of money" falls, i.e. the purchasing power of the money-unit will fall all along the line.")? 4. Is Yancey Ward's definition "money is the most exchangeable commodity" valid and equivalent to what you say the Austrian definition of money is? I await your comments....
Published: September 1, 2007 11:58 PM
scott
"if the demanders control the money supply, there can be no inflation"
i dunno. if a bread maker spends hours aquiring flour and yeast to make bread and a demander (fiat-er) spends seconds making money to get the bread - and this takes place repeatedly - would not an 'inflation' take place?
the demander (fiat-er) exchanged money for bread - money received from non-economic activity.
many 'fiats' made in seconds and few loaves of bread taking hours.
wouldnt there soon be wads of fiats chasing fewer and fewer loaves - wheat growers couldnt keep up with the sudden ability of consumers to buy all this bread?
isnt that what inflation is?
Published: September 2, 2007 3:46 AM
Björn Lundahl
Rational expectations theory, the ABCT and time preferences
As I see it if the rational expectations theory can disregard the ABCT it can also easily disregard the Keynesian and Monetarist business cycle theory.
Keynesians and Monetarists believe that economic expansion is maintained because of increases of aggregate demand and recessions/depressions are caused because of reductions of aggregate demand. Well, if the central banks initially expand credit, factors of production will immediately rise because of rational expectations and there will therefore not be any increases of aggregate demand and an expansion will not take place. The same goes with an opposite situation when the money supply does not increase any more. Prices of production will immediately be deflated and a lack of aggregate demand will therefore not take place. In other words, the rational expectation theory would also disregard the Keynesian and Monetarist explanation of the existence of a business cycle.
But as we all know business cycles do exist so it must also exist an explanation or explanations of their occurrences even if we do not know the very answer.
One plausible answer is the one that has already been mentioned in the article and that is that entrepreneurs cannot know a priori, for example, the true free market rate of interest. Did for example Gordon Tullock know what the true free market rate of interest would have been during the great monetary expansion started by the Fed in the US the year 2001 (started in the third quarter)? Who are the “experts” that knew? Doesn’t Austrian economics teach us that it is impossible to calculate in absents of markets? Doesn’t that also imply that it is impossible to calculate correctly if market prices are manipulated by governments?
Even if entrepreneurs knew (which is impossible) they can profit by the artificial economic situation created by the central bank. For example when the Fed increased the money supply, as mentioned, vigorously back in 2001, entrepreneurs could borrow money and speculate in real estate and stocks. If they sell before the recession they could reap very large profits. On October 9, 2002, the DJIA bottomed out at 7,286.27 and today it is 16, 569.09! Even if speculators sold too late they know that the Fed will inflate again and that prices of stocks will sooner or later be back to the inflated level and also pass it to reach new heights. The money supply generally always increases and if each individual (and each investment company) even in the worst scenario do not borrow too heavily they can wait and pay the interest through reaping dividends and through their incomes.
From Answers.com:
The stock market crash in 1987
“The Crash was the greatest single-day loss that Wall Street had ever suffered in continuous trading up to that point. Between the start of trading on October 14th to the close on October 19, the DJIA lost 760 points, a decline of over 31 percent.
The 1987 Crash was a worldwide phenomenon. The FTSE 100 Index lost 10.8% on that Monday and a further 12.2% the following day. In the month of October, all major world markets declined substantially. The least affected was Austria (a fall of 11.4%) while the most affected was Hong Kong with a drop of 45.8%. Out of 23 major industrial countries, 19 had a decline greater than 20%.[4]
Despite fears of a repeat of the 1930s Depression, the market rallied immediately after the crash, posting a record one-day gain of 102.27 the very next day and 186.64 points on Thursday October 22. It took only two years for the Dow to recover completely; by September of 1989, the market had regained all of the value it had lost in the 1987 crash.”
http://www.answers.com/stock+market+crash?gwp=11&ver=2.0.1.458&method=3
The growth of the money supply,
Frank Shostak:
“An easy monetary stance coupled with fractional-reserve bank lending has given rise to an abundance of money out of "thin air." Between Q3 2001 to Q4 2004 the average yearly rate of growth of our monetary measure AMS stood at 7.5%. This should be contrasted with the rate of growth of 2% in Q2 2001 and 0.9% in Q4 2000. The illusory prosperity that the bubble activities have generated in fact amounted to the consumption of real savings and to a weakening of the pool of real funding — the heart of real economic growth.”
http://mises.org/daily/2667
Time preferences
Regarding time preferences I would say that if it is only one given investment opportunity possible and only one alternative in increases of productivity, time preferences still determine interest rates because of the fact that values (values on time) are derived from humans and not from production. In this example time preferences and productivity coincidentally happens to be the same. The same, for example, goes with a consumer good and marginal utility. If only a certain production and supply of consumer goods are technically possible to achieve, marginal utility still determines their prices and not the other way around.
Published: September 2, 2007 5:30 AM
Anthony
Thomas, creating your own money to sate your demand is hardly counter-inflationary. If you can acquire more funds, not by being productive but just by deriving them out of thin air, what would stop you from printing ever-increasing amounts of money to sate ever-increasing demands? Keep in mind that governments can print their own money, and that economic theory states that this is a major cause of inflation. It would not differ in the case of private individuals.
And Yancey's definition is correct, yes.
Published: September 2, 2007 6:58 AM
Thomas Benjamin
To Scott and Anthony: Thanks for your comments. I guess the question I would have for you both, and for Mike, too, is this: Do you believe that in my toy system, in order for inflation (and hyperinflation) NOT to occur, there must be many acts of altruism (altruism defined as objectivists define altruism) and this is the meaning of Mike's contention that in my toy system "You are severing the link of cooperation that creates society--mutually beneficial exchange"? Also, Scott, in your example, why aren't the wheat growers fooled by the sudden ability of consumers to buy bread into 'misallocating' resources (which they themselves can 'purchase' by writing sight drafts) to produce excess wheat so that prices don't greatly rise (since Mises correctly points out that a stable purchasing power for money is an illusion)? Or am I just not understanding....
Published: September 3, 2007 12:03 AM
Mike
Thomas,
Sorry, I haven't been able to respond to you, I'm trying to meet a deadline and I'm currently buried in work. Hope to get back to the discussion soon.
Mike
Published: September 3, 2007 10:26 AM
Anthony
Scott, I don't think it'd take much altruism; just extraordinarily far-sighted self-restraint. I say extraordinarily because of the unusual amount of coordination it'd require.
Published: September 3, 2007 7:42 PM
Yancey Ward
Thomas,
You aren't, by any chance, a follower of mutualism, are you?
Published: September 3, 2007 7:53 PM
Thomas Benjamin
To Scott and Anthony, ...Also what about Say's Law? If "supply creates its own demand", how can there exist but a temporary rise in [wheat and bread] prices [existing until the 'underproduction' is corrected] even in a economic system using fiat money and even if human desires are practically limitless (which our wheat farmers should have taken into account...) wouldn't the law of marginal utility and decreasing marginal value put a brake on profligate use of sight drafts?
Published: September 3, 2007 8:00 PM
Thomas Benjamin
Yancey, I believe that any society that 'chooses' a 'fiat' type of 'money' (by default through elections) and either confiscates or 'demonitises' the reigning commodity money becomes, by default, a mutualist society (especially if it allegedly espouses a free market)--a real 'common-wealth', so to speak and therefore the type of 'toy' economic system I am contemplating might occur (and has been attempting to occur, though without much success...). My 'espousal' of my toy economic system is an exercise in understanding if and how the use of these 'sight drafts' might be, in some real sense, 'false claims' against individuals in this mutualist society or a 'false claim' against the entire 'mutualist' society, if 'false claims' at all, and why. I hope this helps. Your thoughts?
Published: September 3, 2007 9:26 PM
Anthony
The point of Say's law, I believe, is that production occurs for the sake of consumption. Leaving that aside, you're correct that MU does constrain how much of a good one might consume. The problem is compounded and worsened though given that a) consumers have virtually limitless funds with which to bid up the prices of goods they desire b) they consume a variety of goods. Consequently, the amount of this currency in circulation would be extremely high. Money supply will greatly outstrip advances in productivity. At least that is how I perceive the problem; maybe someone more knowledgeable than myself can explain it in better terms.
Published: September 3, 2007 9:52 PM
Thomas Benjamin
Anthony, With regard to Say's Law, to quote Mises from PLANNING FOR FREEDOM (pg 65 according to THE QUOTABLE MISES): "With regard to economic goods there can never be absolute overproduction". This would suggest to me that the money supply could only 'momentarily' "greatly outstrip advances in productivity". If "supply creates its own demand" then demand is the driving force that increases supply, that is, if there is only relative overproduction it is because there is, at the time of 'overproduction' underconsumption which, in my toy system the ability to produce sight drafts will remedy (at least at first glance...). If money is merely a medium of exchange, nothing more (and pure fiat money is, by definition, just that--a medium of exchange, nothing more...) then it is merely a signal signifying desire or demand. There is always a flight into real goods (and values) whenever a purchase is made--no one wishes to hold a medium of exchange over real goods and values unless she/he is uncertain about which goods she/he wishes. If one could have all the medium of exchange one wishes it is silly to hold the medium of exchange since it can be produced whenever one wishes. By the law of MU the amount of one good one might consume (desire) decreases and the desire for new goods spurs the creation of that good (yet the notion that 'supply creates its own demand' would seem enough to spur supply so that it is initially greater than demand, i.e. underconsumption). Your example of consumers with virtually limitless funds bidding up the price of goods beyond all bounds presupposes the bidders rank of value for that particular good is exactly the same for all bidders and that seems to me to be false. That is why in my 'toy' economic system the demanders create the supply of money--obviously then supply equals demand for money and therefore the supply of money directed at a particular good indicates the demand for that good--a signal for the producers of capital goods to produce enough so that the purchasing power of the medium of exchange does not greatly increase. Since that seems to require that the producers of capital goods concern themselves with an altruistic concern, i.e. the purchasing power of the medium of exchange, perhaps that makes me a type of closet mutualist, but as I wrote to Yancey, the use of pure fiat money makes the society de facto mutualist and therefore it might be wise to pursue a policy of at least nominal cooperation in such a society--that way inflation might possibly be avoided. Your thoughts?
Published: September 4, 2007 11:00 PM
Anthony
"Your example of consumers with virtually limitless funds bidding up the price of goods beyond all bounds presupposes the bidders rank of value for that particular good is exactly the same for all bidders and that seems to me to be false."
Why need it be exactly the same? If one can print as much money as they want, there is no constraint left to satisfying their preferences (productivity normally is that constraint.) As I said, it need not be just in one market - the market as a whole will be flooded with money, far outstripping productivity rises (I think Mises would be referring to a commodity money system in his quote, not one where money can be inflated madly.)
Published: September 5, 2007 6:54 AM
Anthony
Should be, "not one where money supply can be increased madly."
Published: September 5, 2007 6:55 AM
Thomas Benjamin
Anthony, In answer to your question, suppose bidders A and B are bidding on scarce commodity--real estate in a location desired by both. At least in my limited understanding bidding can only continue until either A or B say "I value that piece of property until the price of that property hits p--after that I no longer value it". Now assuming that each can write sight drafts of any amount that still does not change the relation between price and value i.e. "I value that piece of property until the price of that property hits p--after that I no longer value it". Suppose the bidding continues until price p is hit and either A or B offer p(2)>p (let us say that A will not value the property at any greater price than p) and C, who owns the property wishes at least price p(2). By my example the exchange occurs between B and C. Now if A (who has unlimited funds in my toy system offers p(2)then B must offer p(3)>P(2) but that means that A actually had an equal preference to B regarding the property (of course with unlimited funds A could find a similar, nearly equal location whose owner would take price p). What I would say happens in my toy system is that a 'flight into real values' would be immediate, i.e. that one would have to decide what one really desired, since money would be no 'object' (forgive the pun...) and go for those. Since desires are, though 'unlimited' still for the most part finite (for our time and effort needed to enjoy our goods is finite) there is a limit to what anyone would want. Also, aren't goods beyond our immediate need for them, 'mediate' goods used to obtain a actually desired good? If we really sat down and honestly looked at what we really desire and what we mediately desired to obtain these actually desired goods (consider how advertising works...) we would most likely find that what we actually desire is actually very little and therefore would circumvent inflation in my system. By the way, in your comment on altruism and self-restraint, were you saying that to Scott or me? If to me regarding my toy system, what would be the far-sighted self-restraint and coordination needed to keep my toy system from inflation defined in term of hierarchies of values?
Published: September 5, 2007 9:20 PM
Yancey Ward
Thomas,
You would not "circumvent inflation". What would happen is that the inflation would be so bad that the value of the site drafts would fall to zero. People would stop accepting site drafts regardless of how many zeroes you put on them. In your toy system this would happen within days, even if your system got off the ground in the first place.
Published: September 6, 2007 8:37 AM
Thomas Benjamin
Yancey, Why? It would seem to me that the situation you describe would only happen if sufficient numbers of people under that economy confused money with wealth (can you prove inflation would occur if only one person in that economic system were to be profligate with the numbers on the sight draft?). Suppose the society my toy system existed in was populated by only Austrian School economists, or better yet, Objectivists. Could these folks who by their writings know the difference between wealth and money and know the value of productive effort resist the urge to be profligate with the numbers on the sight drafts (assuming they would not band together via contract and contract for goods and services through the commodity money of their choice in that alternate free market...yet is it done today? As long as you have freedom to contract do you not therein have a free market?...)? It seems to me that a fiat money, being a pure medium of exchange, is merely a tabula rasa reflecting the values and understandings of those who control its supply and in the case of my toy economic system, that is everyone in the society. I suppose that one could show that one person who was profligate with the numbers on a sight draft or who was a nonproducer could cause some inflation (inflation defined as ANY increase in the money supply)assuming that real wealth (the supply of economic goods available) remained constant. If one assumes that real wealth in constantly increasing (as it would if Say's Law held--and I believe it does)then the profligate writer of numbers on the sight draft and the nonproductive could cause inflation only if the amount of fiat money they injected into the economy (the rate of growth of the money supply) exceeded the rate of growth of real wealth (which is of course possible) but then what if there was a limit on what anyone would want, as have suggested in my previous comment. Can you show if that held that inflation could still arise?
Published: September 6, 2007 8:14 PM
scott t
"Money is the most exchangeable commodity....this means gold is not money today."
I guess fiat paper (faith backed) could be 'more' exchangable in an absolute sense than gold - but less commodified perhaps??
according to rothbards description of money here..."overcome the double coincidence of wants of barter by picking a commodity which is already in
widespread use for its own sake. In short, they will pick a commodity in heavy demand, which shoemakers
and others will be likely to accept in exchange from the very start of the money-choosing process. Second,
they will pick a commodity which is highly divisible, so that small chunks of other goods can be bought, and
size of purchases can be flexible. For this they need a commodity which technologically does not lose its quotal
value when divided into small pieces. For that reason a house or a tractor, being highly indivisible, is not likely
to be chosen as money, whereas butter, for example, is highly divisible and at least scores heavily as a money
for this particular quality.
Demand and divisibility are not the only criteria. It is also important for people to be able to carry the
money commodity around in order to facilitate purchases. To be easily portable, then, a commodity must have
high value per unit weight..."
faithat money generally fits this description. but golds advantage, i guess, is that it also fits but isnt subject to the 'print-for-all' inflation that takes place with fiat money.
Published: September 7, 2007 8:50 PM
Thomas Benjamin
scott t., I think that the reason that it is widely held that commodity money is not subject to the type of 'print-for-all inflation' you speak of is best summed up in Hulsmann's paper "Optimal Monetary Policy" (which you can get on this website) on pg 36, "The quantity of paper money can be profitably increased at the whim of its producer, because he produces at virtually zero cost. By contrast, increasing the quantity of commodity money entails significant costs and is therefore much more limited [scarce--my comment]. Additional quantities will be produced only if consumers can be expected to patronize this increase more than increased quantities of the other goods that could also be produced with the same factors of production." As regards the value of commodity money vs. the 'valuelessness' of fiat money, Hulsmann continues on the same page, "The essential reason for its [fiat money's--my comment] inferiority is that it does not attract a non-monetary demand" [hearkening back to Mises "Regression Theorem"--my comment]. It is for this reason and the others you mentioned that fiat money would not stand the competition of the market-chosen commodity money and therefore would not be produced by the free market. It is important to understand, as Say did, that goods are the real prices for other goods, and that the real driving force behind the production of wealth is the desire to have as many exchange opportunities as possible--money is therefore ONLY a medium of exchange, nothing more. Mises himself considered the possibility that if technology discovered a method of enlarging the supply of gold (or any commodity money) at such a low cost that gold (or the commodity money in question) would become useless for monetary service (HUMAN ACTION, pg 475). This means, to me at least, that any money, regardless of kind, is inflatable, and therefore also uninflatable. The question is, under what conditions? These reasons, and the reasons I gave to Yancey Ward in my previous comments is why I think my toy economy is a good thing for Austrian School Economists to ponder because we have been under the fiat (actually fiduciary)money regime for many years and the "crack-up boom" has unfortunately not occurred (yet). Why? This is a question I would definitely want answered, inasmuch as it can be....
Published: September 7, 2007 9:59 PM
Yancey Ward
Thomas,
Lets examine your toy system in detail, shall we? I go to Tom's farm and buy bacon, eggs, and milk, and in exchange I give him $100 in site drafts. I eat, and I don't have to do anything other than write a draft note for this. Tom, for his needs, can go to Scott's farm and do the same. Indeed, he soon discovers that he doesn't need to run his farm at all since he can always write site drafts for whatever he wants. Scott soon discovers the same thing, and he stops producing as well. What quickly happens is that production falls, and you have a lot more people chasing the remaining production with pen and paper in hand, but the remaining producers now realize what is happening and refuse to accept site drafts. The site drafts have fallen to zero value or, in other words, they have hyperinflated to the point of uselessness. I forgot who wrote it above, but by foisting such a system upon society you have destroyed the means of productive cooperation. And once the lesson is learned that site drafts are worthless, it will be nigh impossible to ever instate them again, and if you try to do so by force, your society will be hunting and gathering to survive.
Now, you think an Austrian society could make this work, and I guess that your idea is the following: site drafts become contracts to deliver real goods in exchange. Let us say that I am a shoemaker, and I go to Tom's farm for my bacon, eggs, and milk. I give in exchange for food a piece of paper that on presentation to me will entitle the bearer to a pair of shoes. To make use of the site draft (contract), Tom will have to find someone who either wants a pair of shoes, or is willing to take the note in exchange for goods. This is just a barter system with paper as claims to goods replacing the goods themselves. What would happen? It is easy to see what would happen. As a shoemaker, I start producing these notes to support myself, but I stop making shoes. Eventually someone comes to me with a site draft I have written demanding shoes, but I have no new ones to offer. Sure, the bearer could take me to court to and force me to either produce shoes or take some other property I have in exchange, but in the latter case he is left with something he didn't want in the first place. So, why exactly would we use your system? We can use commodity money any time, unless we are forced to do otherwise.
I think your system is a crock that won't lead to productive cooperation, and absent coercion, won't be employed on any level.
Published: September 8, 2007 10:29 AM
Fundamentalist
Thomas: "we have been under the fiat (actually fiduciary)money regime for many years and the "crack-up boom" has unfortunately not occurred (yet). Why?"
Very good question. I think some Austrians have gotten carried away with the fiat money issue. Any money can be inflated into worthlessness or restored to value by controlling the supply. The gold that the Spanish stole from S. America caused inflation in Europe for almost a century. In the US, silver became so abundant that we stopped using it as money. Paper money would work just fine if someone had the ability to control the supply.
The real problem is not paper money, but credit expansion. Most of our money never becomes paper; it's nothing more than electronic digits exchanged between computers. That type of money increases with credit expansion, which is caused by lowering interest rates. Unfortunately, the Real Bills Doctrine (although they don't call it that) still controls the thinking of most bankers, especially Fed bankers. They believe that credit should be available to everyone who has a legitimate business interest; businesses should not have to scale back, put plans on hold, or go bankrupt because their isn't enough credit available. That's the RBD in a nutshell. I has been the banking doctrine since John Law set up his scheme in Paris 300 years ago. Bernanke has essentially quoted the RBD in recent interviews. The "credit crunch" (sounds like a breakfast cereal) has all the world's bankers worried and they will do all they can to alleviate it. It doesn't matter to them that they caused the "credit crunch" by making very bad loans. So they are determined to expand credit, that is, expand the money supply, to make sure than any businessman, no matter how stupid, can borrow money, and any home owner, no matter how broke, can buy a house. None of this new money will ever appear in paper form unless, someone withdraws a few dollars at an ATM to buy milk at Wal-Mart.
So the issue of fiat money is not nearly the problem that some people make it out to be. The real problem is credit expansion. By the way, your "toy" system is very similar to the system in the middle ages when gold was money, but most businessmen conducted business using pieces of paper called bills of exchange. Bills of exchange are essentially IOU's. Did they have business cycles then? Certainly. Great booms followed by severe depressions.
Published: September 8, 2007 11:41 AM
Thomas Benjamin
Yancey, thanks for taking the time to point out the flaws in my toy system. I certainly appreciate it. However, I have a couple of questions regarding your critique. Would you say that the assumption that the driving force behind the production of real wealth is, as I have stated, the desire to have as many exchange opportunities as possible (or at least enough exchange opportunities as necessary to satisfy ones wants)? Would you also say that Say is correct in his assumption that goods are in fact prices for other goods? Furthermore, would you say that it is a correct assumption that people want goods, not money and that money is merely a medium of exchange, nothing more? Would you say that the flow of a medium of exchange towards a certain good is a signal that people demand a certain exchange-unit denominated amount of that good and that that is a signal for producers of that good to produce at least that amount of goods and that that is a signal for producers of higher-order goods (i.e. producers goods) to produce the necessary amount of higher-order goods so that the producer of the first-order good that has been demanded by the flow of the medium of exchange to that good can keep up with demand? If this happens, is that still inflationary? Your two examples seem to suggest that people who could write sight drafts for any amount would cease to produce, suggesting that such persons confuse money with wealth--would Austrian School economists or Objectivists confuse money with wealth and write inflationary sight-drafts in my toy system? Why (and would you use Alan Greenspan as an example)? I guess one further question is in order--do Austrian School economists hold that the free market is efficient (and is such an assumption necessary for the defense of the free market and individual liberty)? I guess one further question is in order--would my assumption that the quantity of medium-of-exchange units chasing a good acting as a signal for the producers of first and higher-order goods to produce more of such goods in order to keep pace with the rate of increase of the 'money'-supply make me a 'mutualist'? By the way, thanks again for the examples--they certainly show that 'free riders'in my system would definitely produce inflation and hyperinflation (and would produce false claims on the producers).
Published: September 9, 2007 12:02 AM
Thomas Benjamin
Fundamentalist, Thanks for your comments. My question to you is this--can the booms and busts in the middle ages you speak of be shown to conform to the theory of business cycles put forth by the Austrian School economists (I assume by your comments you possibly do not hold the views of the Austrian School economists)? If you believe they cannot, what is your explanation of them? Could you direct me to articles on economic history that support your views? Your comments on South American gold during the time of the Spanish colonization and U.S. silver suggest that such articles exist--I would be interested in reading them.
Published: September 9, 2007 12:27 AM
Anthony
"do Austrian School economists hold that the free market is efficient (and is such an assumption necessary for the defense of the free market and individual liberty)? "
Yes, of course. They do not hold that it is perfect though. And no, the assumption is not necessary, unless one is a utilitarian, in which case the market may be shown to still be comparitively more efficient than any other institution, in spite of any problems it might be argued to have. A key note: Austrian economists do not hold modern capitalism is efficient; they only do to the extent that it is characterized by unhindered market exchanges, which is rarely indeed.
Published: September 9, 2007 8:45 AM
ktibuk
"My question to you is this--can the booms and busts in the middle ages you speak of be shown to conform to the theory of business cycles put forth by the Austrian School economists (I assume by your comments you possibly do not hold the views of the Austrian School economists)?"
You can get boom bust cycles in a 100% gold money economy. As fundementalist said the main problem is credit expansion and banks can expand credit, to certain degree, by fractional reserve banking.
Also real bills doctrine basically defends the position that you CAN eat your cake and have it too.
If you can't create capital goods out of thin air, creating credit out of thin air is actually stealing some existing capital goods from someone and giving to someone else. Some people actually defend this theft in utilitarian grounds that the reciever of the stolen capital goods are better in using it so productivity increases.
Published: September 9, 2007 10:05 AM
Fundamentalist
Thomas: "can the booms and busts in the middle ages you speak of be shown to conform to the theory of business cycles put forth by the Austrian School economists (I assume by your comments you possibly do not hold the views of the Austrian School economists)?"
Actually, what I wrote is from the Austria School. I meant that some people who post on this site place too much emphasis on fiat money. Mises, Hayek and Rothbard all realized that credit expansion was as great a danger. Credit expansion without an expansion of savings happens with fractional reserve banking, but other things can cause it as well, for example businesses giving credit to customers, or banks lowering credit standards, or mutual funds that allow check writing privileges, or some forms of life insurance.
"Could you direct me to articles on economic history that support your views? Your comments on South American gold during the time of the Spanish colonization and U.S. silver suggest that such articles exist--I would be interested in reading them."
Most books on economic history have this info. Rothbard has a good one on the middle ages. I like the incredible detail of Fernand Braudel, but you have to ignore his conclusions. He's an old Marxist. Jan de Vries on the Dutch Republic also has contemporary info about the Spanish.
Published: September 9, 2007 2:45 PM
andy
Robert, I have a few questions regarding your article.
Section 3: I don't understand what exactly you proved and how it contradicts the austrian notion of orders. You tried to show that the commodities cannot be classified into higher & lower orders...but how does it follow from the fact, that SOME goods is simultanously in all stages of production? How exactly does that contradict Hayek? In terms of ACBT it seems to me that the conclusion would be, that malinvestment cannot occur in such industry.
You suggest as an example of using one good to produce more of itself, which is quite clever :), especially regarding the Skousen. Agreed.
Section 4: I did not read much of Hayek but it seems to me, that for assuming just a change of interest rate...the model is too simple. It seems to me that you assume too many things, beginning with the question if you can find work at any wage you stipulate and ending with the assumption that with different interest rate the length of the production would be the same.
Section 5: I think this can be more easily phrased, that you can have 2 projects with different cost allocation and that it may happen that the shorter project is more profitable by both zero interest rate and high interest rate. Typically when the cost allocation is high in the future and very small in the present.
Although this is correct, and it would definitely need to be addressed by the austrian economists, it seems to me that practically such projects are of no importance. Most projects start with most investment in fixed capital - which almost instantly puts such projects out of the category of investments you used as your counter-example.
Published: September 9, 2007 5:16 PM
andy
Robert.. my comment to section 5 is not exactly right, you have used an example that uses pretty normal cost-time allocation, however at the first sight it seems to me anyway that the projects exhibiting such behaviour in normal conditions would be quite rare under normal conditions. Can you elaborate on the conditions of such counter-example projects, the difference in the gains to the shorter projects and the likelihood that such things would be common given the real-world conditions?
Published: September 9, 2007 5:44 PM
Thomas Benjamin
Anthony, Thanks for your comments. Please help me to understand what Mises was trying to say on pp 327-331 of HUMAN ACTION. My understanding of what he is trying to say is that he has essentially 'busted' the myth of market efficiency (if markets were efficient then entrepreneurs would have nothing to do...). Also, why isn't "perfectly efficient" the definition for 'efficient'?
Published: September 10, 2007 2:34 AM
Thomas Benjamin
To ktibuk and fundamentalist: Thanks also for your comments. They were very helpful. Fundamentalist: I will look up the writings of the authors you mentioned--these should be very interesting. My question to you both (and to Yancey as well for he hasn't answered it yet...) is this: given that credit expansion (and the authorization it gives to increase the fiat money supply) is stealing some capital goods from someone and giving them to someone else, does having the authority to create credit out of thin air give those who have such authority de facto control over the means of production? On a similar note, does the imposition of a fiat money system on a society as the only legal tender give those who control the supply of that fiat money de facto control over that society's means of production and make that society de facto socialist (or mutualist) with individuals merely having an aggregate of rights which are 'guarenteed' and 'protected' by government with respect to those means of production?
Published: September 10, 2007 3:03 AM
ktibuk
"does having the authority to create credit out of thin air give those who have such authority de facto control over the means of production?"
Not a total controlö, as in deciding what goods would be produced in what quantities. That is up to the market.
However, since this theft actually manipulates interest rates and interest rates are about time preference, this manipulation causes businesses to invest in relatively long term investments rather than relatively short term investments.
This is called malinvestment. But in the end since this credit expansion is not sustainable, these malinvestments gets to be liquated sooner or later when the credit supply contracts.
But the net winners, meaning the thieves are always the banks and governments.
Banks earn interest out of thin air, and governments get a free source of credit.
Published: September 10, 2007 5:40 AM
Anthony
Ah, you misunderstood Mises. Austrian economics stipulates that markets are dynamic, and not automatic processes like some neoclassical models paint them to be. Mises contended that the entrepreneur played a vital role in the market economy. It is with entrepreunerial intiative that efficiency prevails.
I don't understand what you mean by perfectly efficient. It is a relative concept.
Published: September 10, 2007 7:27 AM
Yancey Ward
Thomas,
Yes, goods are the prices for other goods, however, money is the exchange mechanism and the way to assign prices to goods so that you don't have to figure out that a pound of bananas is equal to a two loaves of bread by systematically going from bananas to pears to shoes.... to bread.
Without an exchange mechanism capable of serving this function, then we are limited to barter transactions.
And, yes, the problem with your system is the "freeriders", though, in all honesty, I see no reason to call them that since they are doing exactly what the system is designed to do. Human beings will, on average, tend to do the minimum amount of work to accomplish a particular goal.
And when I talk about your system becoming inflated, it is not a society-ending disaster. Your system would be quickly abandoned for a true commodity money.
Published: September 10, 2007 7:50 PM
Thomas Benjamin
Anthony, here is what I mean by perfectly efficient (in Mises' own words, HUMAN ACTION, pg 328), "In an economic system in which every actor is in a position to recognize correctly the market situation with the same degree of insight, the adjustment of prices to every change in the data would be achieved in just one stroke". This, at least to my understanding, is the way classical economics defines market prices. This assumption would make time series of prices "random walks". What concerns me is the application of Say's Law to the free market envisioned by Mises (and I believe Mises is correct). In an economic system where demand does not immediately catch up to supply there would be an increase in the purchasing power of the medium of exchange of choice until the supply of the medium of exchange of choice was sufficiently increased. If the rate of increase of the medium of exchange of choice outstripped the rate of increase of supply there would be a decrease in the purchasing power of the medium of exchange of choice until the supply of goods and services sufficiently increased. The question I ask regarding this is, why does a great supply of the medium of exchange of choice chasing goods not act as a signal for producers of producer's goods to increase production to such an extent that inflation would eventually 'go away'. This question is for ktibuk as well.
Published: September 11, 2007 12:56 AM
Thomas Benjamin
ktibuk, So what you are saying is that the central deceit of the 'banking cartel' (since they control the supply of fiduciary money) is to fool entrepreneurs into thinking that long-term projects are feasible when in fact they are not and because the 'banking cartel' controls the supply of fiduciary money (and therefore the assignment of prices i.e. the standard of value) it is impossible for entrepreneurs to outsmart the bankers? Also, how do bankers earn interest out of thin air when they did not loan it into existence in the first place (or did they...)?
Published: September 11, 2007 1:20 AM
Thomas Benjamin
Yancey, You say that it is human nature to do the minimum amount of work needed to accomplish a certain goal. In terms of the difference between the value of the price paid (the costs incurred--in this case work) and the and that of the goal attained (the goods desired), i.e. the profit it seems to me you are saying human beings are seeking to 'maximize profit', an assumption that Mises' conception of the free market (at least as I understand it) would find unnecessary. If the actors in my toy economic system did not behave this way, i.e. produced more in order to keep inflation from occurring, would that make them "Angels" (this term from Hoppe's paper "How is Fiat Money Possible?--or, The Devolution of Money and Credit", pg 62)? Would it make them 'altruists'? Would it make the society in which my toy economic system exists a 'Mutualist' society? Please let me know....
Published: September 11, 2007 1:50 AM
Fundamentalist
Thomas: “This assumption would make time series of prices "random walks”
You’re right about that. Random Walk theory depends upon every player knowing everything. But as Mises and Hayek point out, that is impossible. In the Random Walk and “perfection competition” models of mainstream econ, the Austrian view of econ is not efficient. But the Random Walk and perfect competition models are impossible to achieve, but even if they were possible, they would not be desirable because the “perfect competition” model actually destroys competitiveness by eliminating every tool of competition but price. I think the Austrian definition of efficiency would be that markets are unhindered by the state and no coercion is involved in trading.
Thomas: “What concerns me is the application of Say's Law to the free market envisioned by Mises.”
Keep in mind that Say’s Law applies only to a regime with a constant money supply. Where Say’s Law fails is when the money supply is artificially increased through credit expansion. When that happens, the supply of consumer goods temporarily falls below demand and prices increase.
Thomas: “…why does a great supply of the medium of exchange of choice chasing goods not act as a signal for producers of producer's goods to increase production to such an extent that inflation would eventually 'go away'.”
The “great supply of the medium of exchange of choice chasing goods” causeS prices to rise and does cause increased production. But that signal to increase the production of consumer goods is part of the business boom that causes the bust. In the Austrian business cycle, prices rose because the lower interest rates spurred investment in basic industries (mining, equipment manufacturing, etc.) first, not consumer goods industries. The increased investments in the basic goods industries increases employment and therefore demand for consumer goods at a time when production of consumer goods hasn’t increased. Wages lag behind price increases, so the price increases cause profits to jump. At that point, businessmen decide to produce more consumer goods using more labor because it is cheaper than buying new equipment. The basic industries find themselves competing with consumer good producers for scarce labor and input materials, and the basic industries lose out, causing business failures and lay-offs. The reduced employment in the basic industries reduces demand for consumer goods at a time when production of consumer goods is increasing, and causes prices to fall, or not rise as much.
In a constant money regime (that is, the stock of money remains fixed with no increase or decrease in supply or flow of money), you wouldn’t find the basic industries stimulated by artificially low interest rates, and prices would fall at the same rate that production increased. Even without a constant money regime, but one where the money supply increased only at the same rate as the increase in production, you wouldn’t have artificially low interest rates and therefore no business cycle and no price inflation.
If the increased investment in basic industries happened because of increased savings, instead of artificially lower interest rates, then basic industries would not compete for resources with consumer goods industries, because saving is just another term for reduced consumption. Reducing consumption frees resources in the consumer goods industries that the basic industries can employ. Prices of consumer goods then fall slightly, due to the decreased demand and lay-offs, but as soon as the labor transfers to the basic goods industries, the demand picks up and prices return to normal levels.
Published: September 11, 2007 9:51 AM
Anthony
Good reply Fundamentalist.
Published: September 11, 2007 10:59 AM
Fundamentalist
It just occurred to me that Thomas may be asking why production doesn't catch up with the expanding money supply and thereby stop price inflation. There are a couple of reasons for this. One answer is that production can expand in the long run only on real savings. Otherwise, if expansion is based on credit expansion alone, then basic industries and consumer industries compete for the same scarce labor/material resources. That's the main reason. The other is that just at the time that the real economy is cleaning up the mess the credit expansion caused, that is, in the recession, and returning a balance to production, the Fed gooses the money supply again. In other words, producers can never keep up with credit expansion. Finally, when consumer prices first rise, profits rise, too. But later, the prices of inputs (labor and materials) rise also, reducing profits, and killing incentive to invest. So while consumer prices may keep rising, businessmen don't increase investment to meet demand because profits have fallen.
Naturally, the economy will at about 3.5% annually; that includes 2.5% for productivity growth and 1% for population growth. That's also based on the current level of US savings and foreign savings invested in the US. But the Fed expands the money supply at about 8-10% annually.
Published: September 11, 2007 1:03 PM
Jason Cawley
Pardon me for coming late to a useful discussion. I have comments on several of the arguments presented.
First, one fellow wondered about the independence of interest from the real productivity of capital. This was well discussed in Bohm Bawerk, as one of the previous theories of the origin of interest that can be shown to fail on logical grounds. Essentially, the physical productivity theories all implicitly assume that the same physical quantity of the same good, has the same value at all times. But there is no reason for this implicit assumption.
In the case of the 2% growing tree, the choice it presents is to have say 100 board feet of lumber now, or 110 board feet of lumber 5 years from now. But which of these two is more valuable? That has nothing to do with the physical productivity "on offer", and everything to do with how much more useful in consumption terms lumber now is compared to lumber 5 years hence.
Now, the value of anything varies with the quantity of it available. If lumber now is infinitely more useful than any amount of lumber later, it is pointless to save trees for later use. But more realistically, some portion of available trees will be used now, and others left for later. Varying the quantity used for each will vary their marginal utility, until the two uses coincide. Naturally, shifting quantities from one use to the other will also change their prices - the price of trees will move with time.
If overall time preferences reflect an interest rate of zero - all goods at all times equally valuable - then trees should be left standing. If they instead reflect a 5% rate of discounting, then lumber will have to rise in price by 3% per year, for it to be profitable to leave trees standing. Until they are rising that fast, it would be profitable to use up more of them now.
Thus the rate of interest is set prior to consideration of how to use the trees, by independent time preferences. All the physical productivity does, is allocate resources between present and future uses, according to a schedule of usefulness, from high usefulness to low.
IR discounting and physical productivity interact to determine what quantity of resources should be allocated to which use (in the single asset example, use trees now or use them later - realistically, a whole schedule of investment alternatives with all gradations of time of use).
I'll address my next subject as a separate post, as some may be less interested in the above.
Published: September 11, 2007 2:36 PM
Jason Cawley
Next to the key issue of credit expansion. It is rightly raised by Thomas' thought experiment of sight drafts. The comments made on his idea strike me as unsound, because they overlook the very real possibility that anyone who wishes may simply refuse some people's sight drafts, while being perfectly willing to accept those of others. Sight drafts are simply credit, pure and simple. They contain no element of coercion, no implication of forced circulation, no implication of government backing of any kind.
To Ktibuk, sorry, banks are not thieves, and credit is not theft. If you think their gig is so great, you are perfectly free to join them, and put your reserve balances in bank stock instead of bank deposits. Almost needless to say, doing so would have done far better under fiat money than either holding fixed denomination debt, or formally monetary metals.
You are correct that banks create credit out of thin air. All credit is thin air. Strangely enough, this does not make all credit unsound, and therein lies the rub. Some credit certainly is, however. The error lies in the implicit assumption that no accepter of a credit should bear any risk, or that whatever asset is used as a medium of exchange can or ought to be riskless.
There is simply no such animal. Every good is fully enmeshed in the entire market and subject to all its vagaries. There can be better and worse forms of monetary standard, certainly. But no riskless ones.
Nor can credit be outlawed without abolishing freedom itself, entirely. The frequent lines about coercion one finds in Austrian discussions of banking and the cycle dodge the key point, that there is in fact no way short of the most draconian coercion, to abolish the possibility of credit freely contracted and given.
That governments have tried to grant special rights over credit expansion, in the course of trying to institutionalize frankly haphazard controls over it, and that unsound governments have also used and misused credit placed in them or in institutions they have manipulated or controlled, may of course be granted. But none of that makes government action the essence of credit or credit expansion. It existed before governments got into the biz and will continue to exist under any form of monetary system, in which there is the slightest freedom left to merchants and entrepeneurs.
Government regulation of credit has focused on means to limit the rate at which it occurs, because abolishing it is impossible, and also would not be worth choosing. This is a legitimate aim and one they have frequently failed to achieve. But the complete absence of regulation in the matter yields Thomas' thought experiment, not perfectly sound money. And the most rigid gold standard imaginable would not stop credit expansion - in case everybody forgot, we left such systems by an endogeneous process of credit expansion around and away from the closely regulated base money.
We still do. When the Fed controls bank balance sheets, banks turn to off balance sheet debt creation through collateralized securities and the like. As the economic historian Kindleberger put it, "the process is sisyphean" - financiers invent new forms of credit, regulators close up the loopholes those exploited, and financiers then come up with new ways around the new rules.
The underlying reality driving credit creation is that banks actually have real economic credit, in the sense that their debts are in fact accepted by most as money, and would be independent of any government stipulations in the matter.
As Thomas' example shows, in order to maintain the continued acceptance of one's sight drafts as money, one has to limit their issuance. Banks do. The sort of regulations they follow are in their own interests; at most they address the collective action problem of some getting too frisky and making trouble for the rest.
In the past, those were simply allowed to fail in the bust ensuing any prolonged overexpansion. Now instead, with the Fed and government committed to preventing bank failures, the banks don't fail but also can't create credit quite as easily. So they have partners who aren't as regulated, and can still fail. Meanwhile, bank deposits have been made riskless enough that they return zero in real terms, without actually becoming riskless.
The credit mechanism is inherently unstable. The Austrians are right to tie the trade cycle to instabilities in credit expansion. They are incorrect in the association of credit expansion exclusively with government action. And they are incorrect that any regime consistent with economic freedom can abolish the instability in question.
Better and worse regimes or management can indeed limit the amplitude of cycles, and avoid major policy mistakes that can amplify them enourmously. But the bare cycle itself comes from the freedom to err that is involved in freedom itself. We cannot abolish it and should not attempt to do so.
In my next I will address the issue of short and long goods, where I think the Austrians have been incoherent, precisely as Eric sensed. Without it involving them being wrong about the overall causes of the cycle, their actual arguments on the point were blatantly false.
Published: September 11, 2007 3:04 PM
Jason Cawley
Now to Eric's question and the argument from higher and lower orders, as actually presented by e.g. Mises in the Theory of Money, and reiterated by Hayek in correspondance with Keynes.
The basic motivation is sound enough - both are looking for ways to explain why falsifying market signals about time preferences are a bad idea, and why overinvestment in the boom can have negative consequences. But the arguments Mises in particular deployed to address it are just hopeless.
He claims at one point that investments with the shortest lifetimes always have the highest returns, and that longer date investments are only made after all shorter ones are exhausted. This is false on its face. It is clearly motivated by analogy to standard Ricardo marginalism, trying to get the schedule of investments (by return, and therefore urgency) to match up to the schedule of extensions involved in having more capital overall.
There may also have been an intuitive sense involved, that Mises was thinking of the most urgent needs e.g. for water or food (imagine a Crusoe economy), imagined as pressing but low return, compared to less urgent but perhaps more lasting activities.
But it won't work. Very soon in his activities Crusoe will make himself a weapon, which may last him several months. And not long after he will make himself a shelter of some kind, that may last him years, if not (with improvements) his lifetime. All shorter turn around investments will emphatically not have been exhausted by the time he does so.
The reason is clear enough - even if his capital is so limited that the value of income a single period in his future, or a few, is still paramount, there may be long dated investments whose returns even in their first few periods is so high, that they beat out other short turn around investments.
Even if these long dated investments *also* have a very long tail of usage returns to offer, stretching out through a long period of time. In other words, the return schedule (including allowance of risk etc) at an appropriate discounting rate is the sole discriminator among competing uses of the available capital. And there is absolutely no necessity that short uses by filled first, and in fact they will not be.
Nor is there any logical connection between capital intensity and capital life. A gem trader may have neglible labor costs and very short turnover periods and still require substantial circulating capital, by value. Or a power company may have very capital intensive and very long dated assets. A canal might be constructed through the most labor intensive efforts with little use of anything else, then return a long stream of usage incomes. Or present labor and little else might yield present goods and little else, at say a coffee shop. There is simply no necessary relationship between the mix of labor vs. capital being used, and the lifetime of the stream of services that result.
There is a second fallacy involved in the standard Austrian argument about long dated capital. They implicitly treat the *value* of capital available as a fixed result of past savings. Clearly, the physical quantity of capital cannot be put into a meaningful relation to prior income limits without passing through valuation. But just as clearly, once capital is instantiated and exists, its *value* in future periods after the initial saving, need bear no systematic relationship to the amount originally saved.
Instantiated capital rises in value and falls in value with every change in the conditions of the whole market system. When entrepeneur expectations are not met, the total value of available capital falls, and past savings having been entirely adequate to finance the original investments is of no help in preventing this. When entrepeneur expectations are exceeded, the total value of available capital rises, and even if some of those initial investments were financed originally with gratuitous credit expansion, that credit will turn out to be wholly sound, after the fact.
The real issue is whether changing signals and conditions cause the entrepeneurs to miscalculate. They always can, and large systematic monetary disturbance is almost certain to bring about such miscalculation. But it is the miscalculation and misallocation that is doing the damage. And while there may be a tendency in that direction and it may be realized in the extreme cases with very high probability, there is no logical connection between a prior mismatch between savings and investment, and the subsequence returns realized from those investments disappointing the expectations present when they were made.
The one who came closest to getting these issues right was Hayek, when it spoke about some sets of future projections or plans, on the part of all the disparate economic actors in a given market situation, sometimes being mutually compatible, and at other times not being so. Even mutually compatible expectations *can* be disappointed - by real changes e.g. But mutually incompatible ones *must* be.
Why do the longer orders show up more in the resulting difficulties? Because their values are more sensitive to changes in the rate of interest, naturally. This is just standard DPV analysis and is not due to any exhausting of all short investments before long ones.
A house that will return a live in value of 1 per period forever is worth only 10 present value if the real rate of discount is 10% (1/ .1), and is worth 20 if the real rate of discount is 5% (1/.05). A good with a lifetime of a month is still affected, but its present value changes only from 1.004 to 1.008.
If the production price of a new house with present factor costs were 15, then it would look like a worthwhile investment under one prevailing interest rate assumption, and would turn out not to be, with a loss of a third of the invested capital, if that rate expectation is falsified. The short investment is subject to a similar sort of error, but the change in its present value is immaterial.
Errors of allocation through time are what IR uncertainties cause, and those errors are the real cause of loss through the cycle. Long dated assets are where the values are most sensitive to IRs, and therefore where misallocation of resources will occur, when one IR is expected to prevail through the life of an asset, and instead some other rate does prevail.
What is relevant about capital lifetimes, in other words, is simply that the first partial of value with respect to interest rates is higher for long dated assets, and therefore the error in their valuation due to errors in rate forecasting swamps any error in the demand or price expectations for simpler, short goods.
Forecast errors are emphatically still possible for short period consumer goods - a grocer can stock the wrong goods and get stuck with an inventory problem or have to sell them at a loss. But rate uncertainty specifically will not drive such errors. The cycle might still do so, indirectly, by inducing the entrepeneur to misforecast overall demand or its direction toward luxuries vs essentials, etc.
In sum, the Austrians are right that credit expansion drives the cycle, wrong that it can simply be eradicated by a few regulations or a different monetary system. The Austrians are right that real misallocations cause the losses involved in the cycle, wrong that misallocations can be eradicated. They are right that misallocations specifically to long date assets are the characteristic driver of the cycle, wrong about why that is the key sector (the real reason being IR-forecast value-sensitivity).
One man's opinions...
Published: September 11, 2007 3:52 PM
Jason Cawley
One additional point. Mises speaks of stopping the cycle by forbidding credit expansion, but he also at other times argues that the right target for monetary policy is to maintain the exchange value of money as nearly as possible unchanged, in order to avoid falsifying calculation by monetary factors. He does not seem to realize that the two aims are mutually incompatible.
No credit expansion would lead to a continual increase in the exchange value of money, as productivity improves. One might wish to advocate this, but it is clearly a monetary policy of conscious and deliberate deflation, and not a policy aimed at the stability of the exchange value of money.
In modern economies under fiat money, and with the instability of the credit mechanism already discussed above, it is clear that the goal of price stability would involve continued credit expansion. It would proceed at slower rates than we see in practice, but it would be non zero.
The price level has risen 3-4% per annum since WW II, which is not price stability. But the money supply has risen more like 6-7%. In more recent times, the former has run 2% core to 4% overall, and the latter in the historical range - with occasional faster periods.
Mises gives excellent arguments that price stability is a better aim for monetary policy than either inflation or deflation. But the practical consequence of accepting those arguments is to allow continual credit expansion at a non zero rate. We have erred on the side of inflation and too rapid credit expansion in recent history, certainly. But zero credit expansion, even could it be achieved without abolishing free markets, would not be choiceworthy, even on his own arguments.
Published: September 11, 2007 4:02 PM
Anthony
Jason, money is meant to be a commodity serving as the medium of exchange to overcome the inherent inefficiencies entailed in barter. Production must occur to trade a certain amount of goods for a certain amount of money. From what I could tell, individuals could merely issue sight drafts in Thomas' system without engaging in any productive activity whatsoever. Could this possibly be similar to either a free paper banking system or a commodity system?
Also,
"The credit mechanism is inherently unstable. The Austrians are right to tie the trade cycle to instabilities in credit expansion. They are incorrect in the association of credit expansion exclusively with government action. And they are incorrect that any regime consistent with economic freedom can abolish the instability in question. "
So what do you think is the most appropriate banking system to adopt a) in a pure free market b) in the present system, in order to minimize the problems experienced under the current order?
Published: September 11, 2007 5:54 PM
Thomas Benjamin
To Fundamentalist, Anthony, and Jason Cawley, thanks for your insights and comments. In my toy system, as I conceive it, consumers print sight drafts (priced at current prices) to obtain consumer goods. The producers of consumer goods then calculate the cost of producer's goods they need to satisfy the orders then write sight drafts for that amount at current prices to the producers of producer's goods. The producers of producer's goods then (if possible-- and here is where the catch may be according to Fundamentalist, if I understand Fundamentalist correctly...) produce the amount necessary to fulfill the orders, the producers of consumer goods produce enough to satisfy the orders, and there is no excess--in theory (of course reality is not so pretty...). However, if one starts with basic industries, why doesn't a heavy influx of sight drafts (assuming they are written for small amounts) to the producers of producers goods create such a glut of producer's goods that the price of such goods stay low enough so that producers of consumer goods can keep their prices low as well, thus staving off inflation? The problem of free riders in my system seems to be essentially the same as the problem of welfare in a liberal democracy. Giving, say, food stamps to poor people would necessarily increase prices but in my system it might be deemed a necessary evil to stave off, say, social instability. Because everyone is free to do the same, it might solve more problems than it creates since it may keep the necessarily unproductive and the unproductive by choice out of the way of the productive so that those who choose the life affirming path of productive effort may be free to associate only with those who share their values while leaving the rest free to live and possibly choose to be productive (I hold that productive effort is valuable in and of itself to maintain the proper mental health of man...). Also, why can't the 'excess funds' be swallowed up in R&D, hopefully creating the discoveries necessary to be able to increase production n-fold so that inflation would not occur?
Published: September 11, 2007 8:58 PM
ktibuk
Jason: To Ktibuk, sorry, banks are not thieves, and credit is not theft. If you think their gig is so great, you are perfectly free to join them, and put your reserve balances in bank stock instead of bank deposits. Almost needless to say, doing so would have done far better under fiat money than either holding fixed denomination debt, or formally monetary metals.
You are correct that banks create credit out of thin air. All credit is thin air. Strangely enough, this does not make all credit unsound, and therein lies the rub. Some credit certainly is, however. The error lies in the implicit assumption that no accepter of a credit should bear any risk, or that whatever asset is used as a medium of exchange can or ought to be riskless.
There is simply no such animal. Every good is fully enmeshed in the entire market and subject to all its vagaries. There can be better and worse forms of monetary standard, certainly. But no riskless ones.
Nor can credit be outlawed without abolishing freedom itself, entirely. The frequent lines about coercion one finds in Austrian discussions of banking and the cycle dodge the key point, that there is in fact no way short of the most draconian coercion, to abolish the possibility of credit freely contracted and given."
I wouldnt join them since my moral code doesnt permit me and I couldnt join them since everywhere banking is more or less a closed industry.
But that is besides the point.
Fractional reserve banking and fractional reserve banking with a fiat currency are both theft or fraud, whatever you wish to call.
Fractional reserve banking under 100% free market money (like golld), is like real estate agents renting your house out without telling you and collecting the rent himself. They can do this with money since money is homogenous but homogenouity doesnt change the fact that they are the same thing.
There is not transfer of titles of property and banks are safekeepers. But they take the money and lend it out and make good profit from your money. And this is not just theft but it also creates boom bust cycles since it increases the credit stock artificially.
Fiat money system where credit is created out of thin air by a central bank is worse because the creation helps the banks, and hurts the rest of the money holders since purchasing power of their money is lowered as a result of the credit creation.
I would love to give you one billion dollars of credit. Even on a 1% annual rate. I dont have 1 billion dollars worth of savings but that doesnt matter in fiat money. O could just punch in some numbers in a computer and transfer it to you.
But I can't. I am not the fed or central bank of some country.
So you don't need to spend the created money, just the interest is enough.
So when a banks gets a loan with and interst f say 3% from a central bank and gives it out with an interest of 6% and if this operation causes the purchasing power of the currency to drop.
Then this profit that the banks are making are actually theft. They are not making anything productive like lending out the savings of others.
They are stealing the wealth of the rest of the people whoo have to hold cash.
Published: September 12, 2007 2:33 AM
Fundamentalist
Thomas: "The producers of producer's goods then ...produce the amount necessary to fulfill the orders, the producers of consumer goods produce enough to satisfy the orders, and there is no excess..."
Yes, that would work on paper. But you run into the problem of scarcity. Unless the increased investment in basic goods comes from reduced consumption of consumer goods (savings), you'll have basic goods and consumer goods industries competing for scarce resources.
Thomas: "Also, why can't the 'excess funds' be swallowed up in R&D, hopefully creating the discoveries necessary to be able to increase production n-fold so that inflation would not occur?"
Because the funds invested in R&D go to people as wages, who then spend most of their wages on consumer goods. Whether investing in R&D or increased production, the result is greater employment and therefore greater demand for consumer goods. If the new employees are busy with R&D, no one is producing the consumer goods to meet the new demand and prices will rise.
Published: September 12, 2007 7:58 AM
Fundamentalist
Jason: "Mises speaks of stopping the cycle by forbidding credit expansion, but he also at other times argues that the right target for monetary policy is to maintain the exchange value of money as nearly as possible unchanged, in order to avoid falsifying calculation by monetary factors. He does not seem to realize that the two aims are mutually incompatible."
Mises was smarter than you give him credit for being. Credit expansion does depreciate the value of money, but a gold standard, as Mises advocated, would come very close to maintaining the value of money at a constant level because the increase in gold production would match increases in production in general.
Jason: "But the money supply has risen more like 6-7%."
It's closer to 12%.
Jason: "He claims at one point that investments with the shortest lifetimes always have the highest returns, and that longer date investments are only made after all shorter ones are exhausted."
Read it again. Mises does not write that. He shows that when interest rates are lowered artificially, that the shorter term investments earn the highest rate of return. Smart investors and businessmen go for the highest rate. It's very basic math.
Jason: "Nor is there any logical connection between capital intensity and capital life."
Who said there was? Capital intensity increases wages by improving their productivity. That's all.
Jason:"They implicitly treat the *value* of capital available as a fixed result of past savings."
Please read the material again. The changing value of capital due to changing interest rates and changing demand is key to Austrian analysis.
Jason: "But it is the miscalculation and misallocation that is doing the damage."
Are you trying to absolve the Fed of its errors? Who makes the first error? The Fed does by artificially lowering interest rates and pumping money into the economy. If the Fed would stop committing its crimes, the business people would make fewer mistakes.
Jason: "The one who came closest to getting these issues right was Hayek, when it spoke about some sets of future projections or plans, on the part of all the disparate economic actors in a given market situation, sometimes being mutually compatible, and at other times not being so."
You forgot the part where Hayek writes that future plans will be imcompatible because of the Fed's monetary pumping. If new investment came from savings, far fewer projects would become incompatible. The number of incompatible projects increases exponentially because basic industries are competing with consumer goods industries for scarce resources as a result of the Fed's monetary pump.
Jason: "Errors of allocation through time are what IR uncertainties cause, and those errors are the real cause of loss through the cycle."
If investors and businessmen made mistakes on their own, the mistakes and successes would be randomly distributed across time and industries. The volume and size of mistakes would cancel out the volume and size of successes and there would be no business cycle. A business cycle exists because the mistakes aren't randomly distributed, but follow a strong pattern. What causes businessmen to fail and succeed at the same time? Only Austrians have an answer: the Fed sets them up to fail when it artificially lowers interest rates.
Jason: "But zero credit expansion, even could it be achieved without abolishing free markets, would not be choiceworthy, even on his own arguments."
Nonsense. Dr. Reisman demonstrates in "Capitalism" that mild deflation would be better for the nation than mild inflation. Inflation hurts savers and rewards debtors; deflation rewards savings and discourages borrowing. Inflation destroys wages because wages never keep up with inflation; deflation would reward workers; they would never have to ask for a raise.
Creating mild deflation would involve nothing more than limiting the increase in the money supply to a rate lower than the increase in the population and production, or going back to the true gold standard.
Published: September 12, 2007 6:51 PM
Fundamentalist
Jason: "Mises speaks of stopping the cycle by forbidding credit expansion, but he also at other times argues that the right target for monetary policy is to maintain the exchange value of money as nearly as possible unchanged, in order to avoid falsifying calculation by monetary factors. He does not seem to realize that the two aims are mutually incompatible."
Mises was smarter than you give him credit for being. Credit expansion does depreciate the value of money, but a gold standard, as Mises advocated, would come very close to maintaining the value of money at a constant level because the increase in gold production would match increases in production in general.
Jason: "But the money supply has risen more like 6-7%."
It's closer to 12%.
Jason: "He claims at one point that investments with the shortest lifetimes always have the highest returns, and that longer date investments are only made after all shorter ones are exhausted."
Read it again. Mises does not write that. He shows that when interest rates are lowered artificially, that the shorter term investments earn the highest rate of return. Smart investors and businessmen go for the highest rate. It's very basic math.
Jason: "Nor is there any logical connection between capital intensity and capital life."
Who said there was? Capital intensity increases wages by improving their productivity. That's all.
Jason:"They implicitly treat the *value* of capital available as a fixed result of past savings."
Please read the material again. The changing value of capital due to changing interest rates and changing demand is key to Austrian analysis.
Jason: "But it is the miscalculation and misallocation that is doing the damage."
Are you trying to absolve the Fed of its errors? Who makes the first error? The Fed does by artificially lowering interest rates and pumping money into the economy. If the Fed would stop committing its crimes, the business people would make fewer mistakes.
Jason: "The one who came closest to getting these issues right was Hayek, when it spoke about some sets of future projections or plans, on the part of all the disparate economic actors in a given market situation, sometimes being mutually compatible, and at other times not being so."
You forgot the part where Hayek writes that future plans will be imcompatible because of the Fed's monetary pumping. If new investment came from savings, far fewer projects would become incompatible. The number of incompatible projects increases exponentially because basic industries are competing with consumer goods industries for scarce resources as a result of the Fed's monetary pump.
Jason: "Errors of allocation through time are what IR uncertainties cause, and those errors are the real cause of loss through the cycle."
If investors and businessmen made mistakes on their own, the mistakes and successes would be randomly distributed across time and industries. The volume and size of mistakes would cancel out the volume and size of successes and there would be no business cycle. A business cycle exists because the mistakes aren't randomly distributed, but follow a strong pattern. What causes businessmen to fail and succeed at the same time? Only Austrians have an answer: the Fed sets them up to fail when it artificially lowers interest rates.
Jason: "But zero credit expansion, even could it be achieved without abolishing free markets, would not be choiceworthy, even on his own arguments."
Nonsense. Dr. Reisman demonstrates in "Capitalism" that mild deflation would be better for the nation than mild inflation. Inflation hurts savers and rewards debtors; deflation rewards savings and discourages borrowing. Inflation destroys wages because wages never keep up with inflation; deflation would reward workers; they would never have to ask for a raise.
Creating mild deflation would involve nothing more than limiting the increase in the money supply to a rate lower than the increase in the population and production, or going back to the true gold standard.
Published: September 12, 2007 6:51 PM
Yancey Ward
Jason Cawley,
A very nice series of comments.
And Jason is correct, you cannot stop credit expansion without resort to draconian measures of state control. To do so unjustly limits people's right to contract- but we have had that discussion on this site so many times that I have lost count. Libertarians should stand for free money and banking concurrent with the right to failure without access to a national treasury.
Published: September 12, 2007 11:24 PM
Thomas Benjamin
Fundamentalist, Do you believe in 'the limits to growth'? If I understand the definition of scarcity, that is, a good is defined as scarce if and only if when the price of that good is zero, demand exceeds supply; then economic goods are scarce, ceteris paribus i.e. 'other things being equal'. What are these 'other things being equal' that cause a good to be scarce? One thing of course is the cost of transforming the raw material into the desired good (eg. gold and silicon--silicon is supposed to be the most abundant element on this planet, yet the silicon needed for the electronics industry is 'scarce', just like gold...). Another 'thing being equal' is the actual limit of the raw material (like oil, for instance) yet if the price of oil becomes greater than the cost of producing, say, biofuels, hydrogen, solar or other alternative fuels, then those alternative fuels will be chosen. If labor shortages cause inflation (with the money supply increasing), as you suggest, then it is an opportunity for some entrepreneur to develop cheaper alternative labor like robots, for example. The point is (As Ayn Rand correctly pointed out) production is "the application of reason [generally speaking, the human mind--my comment] to the problem of survival", the purpose of which is to reduce the scarcity of economic goods i.e. to make economic goods as 'free' as possible, thus allowing the entrepreneur to have a large amount of exchange opportunities, that is, real wealth. What keeps things ceteris paribus is the limits within the human mind. We should never forget that the ultimate resource is the creative human mind and that the free market alone can unleash the creative human mind to its highest potential. All other systems potentially (and in reality actually) limit it. End of sermon....P.S. Perhaps instead of the notion of 'scarcity' the more general notion of 'value'(value defined as that for which action (conscious or unconscious) is required to achieve and/or maintain it; 'economic' values are defined as that for which conscious action is required to achieve or maintain them) would be more useful for economics. It would at least be more in tune with the 'logic of human action', economics being derived from such a logic....
Published: September 13, 2007 2:02 AM
Fundamentalist
Thomas: "Do you believe in 'the limits to growth'?"
I like your definition of scarcity. Growth isn't limited in the long run because, as you write, we're limited only by our imagination and intelligence. I might add that we're limited by popular socialism, too. Regulation, taxation and inflation are major hindrances to long term growth.
In the short run we are limited. Hayek and Mises have some interested material on the interest rate break on technology implementation. We're limited to the rate of savings and productivity improvements, which have to do with technology.
Published: September 13, 2007 12:28 PM
Jason Cawley
Anthony,
I understand how you took the proposed sight draft money thought experiment. But as I tried to stress and perhaps need to stress more, someone being free to issue a sight draft in no way obligates somebody else to take that sight draft.
If some particular issuer only ever writes new sight drafts and tries to exchange them for (other, non-money) goods, and never performs the reverse operation of accepting sight drafts from others in exchange for his own other, non-money goods, then everyone who knows about it will simply refuse his sight drafts - the same way you refused any bankrupt's promissary notes. He can write all he likes, but taking them is voluntary to his counterparty.
You might then suppose the danger of this is so high that no counterparty will take anyone's sight drafts. But this is not the case. If a merchant of excellent reputation says he will pay you with his bill now, and when his ship comes in you can pay for an equal value of his goods with your own sight draft, there is no reason to prefer another money medium to this arrangement. And if both parties have general enough dealings, the bills of either may circulate as money, without directly crossing. Or they may arrange to clear them by mutual cancelling.
Bills of exchange worked essentially in that way, and were far more efficient than commodity money, from the middle ages to the development of modern deposit banking. It is true they benefitted from an underlying money for clearing, in wider use, whereas the thought experiment involves only sight drafts and various forms of barter.
Of course, if the items being bartered are notes, loans, stock certificates etc on one side of each transaction ("money substitutes"), then most of the gains of avoiding bulk commodity barter are already achieved. The additional qualities of money that make it still more useful are its uniformity and consequent highest liquidity. There may also be a widespread impression that money rather than substitutes involves no risk, but this is a fallacy (money illusion, in fact).
This also illuminates the error, or at least a presumption of it, involved in describing ordinary modern banking as fraud. Leaving aside for a second government stipulations - which are incidentally readily circumvented if people care to, more on that below - there is nothing forcing people to accept the debts of modern banks as money. Any more than the sight drafts of the thought experiment.
If someone does so voluntarily, it is because they in fact benefit by the transaction. They might wish they benefitted even more in some other way, or that other men did not benefit in some way they do, from the practice, but these are "just jawing" - wanting a deal one has already agreed to as profitable to oneself, to have even better terms.
Someone who honestly believes that using bank money does not benefit him, stress on honestly believes, simply would not do so. The pragmatist Peirce taught us that the evidence of belief is the willingness to stake much on a proposition, not the willingness to verbally deliver glib paradoxes. We can watch what men do, and infer what they really believe, in action.
One might object that government requirements e.g. in payment of taxes, require use of modern bank money. But any group with the slightest organizational ability could readily circumvent this in trivial ways. Just have a lawyerly escrowing service that liquidates real property in whatever form is preferred, as needed, to meet tax obligations and only those. It is not like the banks can make the real property actually held instead of money, become not-valuable.
What is really going on is that some are ideologically opposed to modern banking but nevertheless find it beneficial to themselves and engage in it anyway.
As for the claim that banking is a closed industry, it is absurd. You can go buy bank shares in minutes for as little as $50 and presto you are a partner with the banks. They aren't expensive. As for the claim that one is too ethical to engage in banking, one immediately wonders whether those pretending so have any credit cards or ever write checks. If they do, then they issue gratuitous credit themselves.
Credit is not fraud. If you issue so many IOUs that you can never make them good, go bankrupt, and somehow keep the real assets that flowed to you in return for your paper pledges, then yeah that is fraud. But banks as such do not go bankrupt.
I am well aware that the Austrian charge is that the mere ability to bid for resources without prior savings, itself constitutes a form of fraud, but I utterly deny it. Every entrepeneur does that, whatever form of substitute financing or promises he issues to mobilize resources on his behalf. And when it is successful it is of great public benefit.
Yes it means trading on other people's trust and turning the strength of one's word with other people into a real command of real goods, to which no prior service to anyone by anyone ("saving") corresponds. But that doesn't make it fraud. Bold, sometimes dangerous, occasionally unsound, involving possible loss to the community as a whole as well to oneself, certainly - but not fraud. It is just the underlying phenomena of real credit, and can no more be abolished than property or profit or interest.
In the era of gold standard money of which Mises was thinking when he wrote the Theory of Money, banks that issued lots of gratuitous credit regularly did go bankrupt in crises - their bankruptcy depending essentially on their promise to repay, on demand, and in gold coin, any of their debts. Typically they were illiquid rather than insolvent, and did possess other goods (money substitutes mostly) that could cover their claims in liquidation - and as a result, even in bank failures many of their creditors could be made whole. But some obviously were not, particularly lenders to the least sound.
Hmm, are lenders to unsound enterprises, financial or otherwise, at any risk in other circumstances? Gee, sure. The illusion is that "depositing money in" a bank is supposed to be riskless and that it isn't. But that is because (1) nothing is and (2) the actual operation is lending to the bank, and commodity metal money has been exchanged for a bank debt money substitute. The exchange ratio between them need not remain 1.
Anthony reasonable asks what monetary system I think preferable, credit being necessarily unstable but essential to economic freedom. I think there are several workable systems that acknowledge those facts. I am not a perfectionist. I am not advocating free banking, though I do advocate freedom generally. The scale of credit issuance needs to be prudently controlled, but there are multiple ways of trying to reach prudent control over it, institutionally.
A gold exchange standard with credit allowed but prudentially controlled by leading bankers is a possible system. It will involve crises and bank failures, however. I don't think modern peoples would put up with those, so I don't expect to see them again, but if the banking actually done under that system was prudent enough, and e.g. bank rate was used countercyclically as Bagehot counseled, it was a livable though imperfect system.
I prefer modern banking. I think we have had monetary authorities who are institutionally too loose, and too given to populist and crank-economic notions from time to time, and that is an evil of the present system. It is also just an evil of the present state of opinion, education, etc. The system is potentially better than its performance over the last 50 years or so, particularly the degree to which it might achieve price stability (if less Keynesian in doctrine and direction etc).
I also think present regulation of financial enterprise is quite poor, and that this partially reflects a moral hazard stemming from too much of it being put in the government's lap, and not enough being done by voluntary means, by industry bodies and leading bankers.
An example - I was able to look e.g. the financial statements of New Century Financial, the mortgage lender, 5 years ago, and to tell you on simple Graham-Dodd principles and historical experience that this mode of financing was unsound, "bubble" finance, and that the company would not last the cycle. It was insanely aggressive finance and would earn money while the bubble continued but fail catastrophically as soon as it paused. Now, if I could tell that, so could its lenders, in principle. It might have been cut off ages ago.
I see no easy perfect solutions there. But we need not accept the tendency of modern financiers to think anything acceptable and prudent if it is colorably legal and profitable for a single quarter.
I do not believe there are any magical substitutes for better men as officers of important institutions, both public and private. Men are free to screw things up, and responsible for the messes they make. If we have lousy shortsighted bankers we will get lousy finance and misallocated capital.
It would be good to arrange incentive and selection institutions so they do not remain forever, or so failure has consequences. Frankly they do already, it just takes rather too long and the mistakes have to reach an impressive scale before the stables get cleaned.
Published: September 13, 2007 2:13 PM
Jason Cawley
Though I already addressed some of his points in my previous, I will now speak to Ktibuk's points in reply to my first series.
You are incorrect that banks promised anything about "safe keeping" under banking systems in which they lent out more than is deposited with them. You are free to get a safe deposit box at a bank and to stuff it with Federal Reserve Notes, or with gold bullion if you prefer, and the bank won't touch them.
If all you want is safekeeping, you contract with the bank for safekeeping only, not a deposit, and that is what you get. You won't get interest, you won't get checking ability against your deposited assets, you won't get clearing vs. other parties by order entry - but you won't get those things because you haven't lent to the bank.
If instead you lend to a bank, you are accepting its debt in return for your money. Now, under old commodity standards, one reason you might be inclined to do so is the bank might offer to exchange its debt back for gold coin on demand, and you might *credit* the bank with an actual ability to perform this. Which it might actually have, and all it well, or might not have, and you have made an error in the estimate of the ability of a borrower to repay you, on contracted terms. He might still be able to repay you in some workout, but without being able to pay as contracted - and that is what typically actually happened in bank failures past. Nevertheless, plenty of banks went through the toughest times and did not fail.
Under fiat money, you aren't contracting that. If you lend to a bank today, it promises only that you can get federal reserve notes on demand. It promises nothing about the purchasing power those might or might not retain. In practice, interest and the fall in the purchasing power of FRBs have essentially kept pace, though with some temporal variation.
But the reason people use bank debt as money is its liquidity conveniences, not its ability to store value through extended periods of time. Portfolio investment or real productive assets are clearly superior at the latter task, and is what people with anything much to transmit through time actually use.
As for the statement that it "increases the credit stock artifically", it certainly increases credit outstanding. But what is artificial about it? Or, otherwise put, what is natural about any other form of pure credit? Yes there are credit transactions that are not pure credit, but e.g. buying consumer goods on an installment plan, or paying for anything with a credit card, or funding a business by issuing promissary notes, are actions of precisely the same character. The only difference is that the credit of banks generally stands so high they have less fear of their debts flowing back to them rapidly for repayment. But ask e.g. Countrywide Financial whether debts ever do flow back in that manner.
Mises makes numerous comments about what is possible for all banks as a group if following a uniform and cooperative policy. Yes, gratuitous credit can go a lot farther if those with the most real economic credit uniformly and cooperatively abuse that trust as egregiously as possible, and especially so if that continues for ages without that trust being removed. But this need not happen and in practice does not happen. It is approximated by rather loose central banks as a group, all practicing Keynesian policies, say. But it is not forced by the nature of banking as such.
Again, all credit is created out of thin air, that is what credit is. Yes, rapid credit creation, if more rapid than the increase in real wealth, harms static holders of money balances, particularly if unexpected (since otherwise it is typically compensated by earned interest). If credit creation occurs but is slower than the increase in real wealth it gratuitously benefits holders of static money balances, since over and above any interest they may receive, the exchange value of what they hold also rises.
But the same is true of absolutely every other commodity whose real value changes over time, as the market evolves. If you hold commodity X, you benefit if its real exchange value rises and are harmed if it falls. Money is just another commodity in that respect. We do not call every economic action of anyone anywhere, that changes the exchange value of any other asset of anyone else, theft of that asset. If my invention of a new machine makes your stock in an old company that used a now obsolete process, go down, this does not mean I have committed fraud or stolen your stock.
You have zero a priori right to the present purchasing power of whatever commodities you freely choose to hold. You and only you are fully responsible for any risk and any potential gain that may fall to you through changes in the real value of the commodities you hold, to everyone else.
This is equally true of changes to other economically vital variables, and other factor influences. If another man starts working in your field and lowers the average wage for those with your skill, this does not mean he has robbed you - because you do not own the present exchange value of your skill projected unchanged (or changed only upward like a ratchet) forever. You only deserve the real value of the real usefulness of your services to others.
And the same is true of the commodities you hold. Their real usefulness to others can and does change. You have no a priori right to stipulate that their real value to everyone else shall remain unchanged henceforth forever. You are not being robbed if their real value does change. The government does not merit being enlisted to go chasing after everyone whose actions you think may impair the value of some asset of yours, forbidding their free actions just to save the present exchange value of some commodity you own.
If you don't like the expected future changes in the exchange value of money, don't hold great whopping balances in money. You can put all your assets in bank stock and write checks against the brokerage account that holds them for specific transactions, if you like. Then you aren't being exploited by any imaginary bugbear financiers, you can have the supposed benefits yourself. If you dislike not the side of the transaction you think you are forced into (but in fact are not, as the above amply demonstrates), then you can substitute whatever other line of business you consider promising. Or you can hold commodities and get a futures broker to give you credit against your warehouse receipts.
The average person does not do these things for transactions balances because any loss from inflation exceeding interest for the small amounts he leaves for those, is utterly swamped by the value of the great convenience of using money forms that everyone else uses. They voluntarily prefer the set, gradually devaluing but highly liquid money, for modest balances, to having everything in less liquid forms.
They are therefore *not* wronged by the existence of such transactions. They judge themselves to be benefitted by them.
"I would love to give you one billion dollars of credit. Even on a 1% annual rate."
Decrying the fact that others possess a real economic credit that you do not, such that their debts are accepted as money and yours are not, is not more defensible than any communist's screams against earnings from owning property, or any medieval borrowers screams against paying interest.
Credit is as real an economic fact as interest or profit, and pretending that it is illegitimate is as indefensible as assailing either of those. If a man or a company earns something because he has better credit than you do, then you can seek to improve your credit to his level, or you can join or share in his enterprise, or you can leave his gains to him as his own source of fortune.
If you won't take both sides of a transaction at some price or reward, you are in no position to denounce terms offered as another as unjust. Someone who plans only ever to sell commodity A can scream that it is unjust that its price isn't twice what the rest of the world decides it should be. But until he "makes a market" by offering to buy it too, his ideas about the fair price can be dismissed as "just jawing".
There is some degree of economic reward to engaging in credit operations, that suffices to attract capital and talent to those operations, sufficient to supply such services on a scale beneficial to the rest of society. If you claim the rewards to supplying credit services are too high to be morally justified, then by honesty as well as interest, you are obligated to go provide them, risking your own capital. If you are unwilling to do so at present market terms of risk and reward, then you are demanding that the rewards others reap for running risks you will not run, be reduced. Which is unjust.
Either bankers have the easiest job in the world that effortlessly gives them a license to steal, or you are slandering them. If the former, then you are fool to carry bank deposits instead of bank stock. But you cannot twist it any way to being forcefully wronged by them, since you are free to pick which side of the transaction you wish to be on. If it were illegal for you to own bank stock, if the state reserved it to a hereditary nobility as a privilege, then you might conceivably have a legitimate grievance if you were right about the economics involved. Since they don't, you don't have a legitimate grievance even if you are right about the economics involved. Your calling them thieves is therefore slander pure and simple, of exactly the same form as the property denunciations of Proudhon or Marx.
Your last line claimed that others "have to hold cash". They are under no such compulsion. No banker puts a gun to anyone's head and says "if you don't hold cash for me to tax through inflation, I'll kill you". Holding cash is purely voluntary, and people do it because it confers what they themselves judge to be benefits. Just as no worker "has to" work for money wages from an imaginary exploiter capitalist, and no borrower "has to" borrow from an imaginary exploiter ususer. Voluntary transactions are voluntary, and claiming those providing you a real benefit are antisocial criminals, is itself an antisocial and unjust attidue.
Published: September 13, 2007 3:16 PM
Jason Cawley
A further point on Ktibuk's unjustified opinion that only central bank authorities have credit, and his hypothetical wish to issue $1 billion himself, for my benefit, at 1%. I can illustrate the actual constraint and real economic ability involved by taking this literally.
He can present a convincing business plan to the capital markets and issue 100 million shares of stock at $10 each, and take the proceeds and lend them to me at 1% interest. Unfortunately, when I repay him only $10 million in the first year as agreed, his stockholder will get rather upset at the wasteful misuse of their $1 billion, and the value of the shares will not remain where he issued them.
Instead it will fall, if he is lucky stopping between $1 and $2 on the strength of my actually paying the interest. But more likely, further still, based on a justified opinion that he has had my interests in mind and not his new stockholders' interests, throughout the entire transaction. He will emphatically not be able to issue anything more after such a performance. The slightest hint that it was the original intention would prevent the entire affair from ever getting off the ground.
Why does this happen? Because credit issuance justifies itself by the use of the capital so deployed being really justified economically. If it isn't, real value is destroyed. If it is but fraud is actually practiced on the creditors involved, then real assets are moved (from purchasers of the stock to me in the above example, from bank despositers to lendees, potentially, in interested bank mislending). But the mere raising of the capital one promises is not fraud, and it is open to anybody to try it.
Banks are marked by their superior ability to market their debts, because those are so trusted they act as money. But that trust is a real economic fact, with real economic antecedents, and it is a creature of the bank's continuing to act in ways that merit that original trust. Including allocating loans sensibly, not senselessly, and increasing its outstanding debts sensibly and sustainably, not as some ponzi scheme.
Published: September 13, 2007 4:19 PM
Jason Cawley
Now to reply to Fundamentalist, my most learned critic.
"Mises was smarter than you give him credit for being."
You have no clue where I rate Mises intellectually. He not only makes recommendations about gold, he also analyzes how fiat money functions. Since we actually live with the latter, his remarks on it are decidedly more important. He regards any issuance of fiduciary media as dangerous, and a fiat money system that issues no new fiduciary media (leaving it fixed) is necessarily committed not to price stability but to deflation - and not a gradual deflation I might add. It is in fact tighter than a gold standard. Since he admits that price stability is better than a continually changing exchange value of money, he is stuck with simultaneous mutually incompatible recommendations. That they are incompatible should be a clue that his analysis of the supposedly horrible effects of any issue of new fiduciary media are overblown, and actually arise only from overissue, sufficient to cause inflation.
As for rates of money growth, obviously it depends on the measure used and on the time period. The lower figure I gave is correct for M2 - 6.87% from 1959 to now, 5.65% from 1982 to now, 6.16% from 2000 to now, etc.
"He claims at one point that investments with the shortest lifetimes always have the highest returns, and that longer date investments are only made after all shorter ones are exhausted."
"Read it again.Mises does not write that."
I've read in n times, and it says exactly what I claim it says. It is flat wrong, it is downright silly, but it is right there in black and white and von Mises wrote it. It is a scandal, but it is what he said. Worse, Hayek who definitely knew better repeated the error in correspondance with Keynes, when pressed to explain the precise mechanism whereby misallocation was supposed to result in real value loss. Misallocation does result in real value loss. But the Keynesians may be forgiven for not having believed the Austrians on the point, because the latter argued their case with an utterly worthless argument. The right cause and the good argument do not always coincide, and here they emphatically did not.
"He shows that when interest rates are lowered artificially, that the shorter term investments earn the highest rate of return."
Except this is utter nonsense, nothing of the kind happens. In fact, when rates fall below levels that are sustainable, and while they are below their equilibrium level, it is precisely the assets with the longest income streams most heavily weighted to distant future cash flows, that rise the most in present value terms. A 30 year zero coupon cash flow will rise 120 times as much as a single quarter bill. The same is true of any business with cash flows so structured, if the new low rates are believed. It is in reality precisely the (eventually) unjustified scramble into long dated assets during the boom, that constitutes the capital misallocation. The whole society trades more present income for future income, than actual time preferences would support. It overinvests, and some of the overinvestment will end up worth less than what was sacrificed to make create it.
The schedule used to decide on investments is return and not period, but when rates are forecast to be lower, the returns for investment that pay over long periods of time look higher, than they look when forecast rates are lower.
Mises and repeating him Hayek both claimed that investment in capital goods proceeds from short term to long term, as a way of trying to mix together their idea of a wage-fund style limit to total investment, with their correct appreciation that too much goes to long dated assets in the boom. They therefore conflated the quantity of total investment with its composition.
To get them to move in direct relation, they argued, quite falsely, that returns on investment are highest in the shortest lived assets, so that the whole society only invests in 10 year long items after it has exhausted the more profitable 9 year long ones, and so forth. They wanted to equate the extension in average capital life that an increased total value of capital stock involves, with the process of picking down through possible investments from highest returns to lowest, which is the real schedule of investment priorities.
But this is a flat error. It is utterly false that the shortest investments give the highest returns, either simply, or when rates move lower than their free market equilibrium level. Some short investments have high returns and will be done earlier in the process of societal capital accumulation (gather food), others very late (make iced lattes). Some long dated investments will be made early (create elementary shelter, build basic tools), others very late (launch satellites).
In addition, they argued from a too mechanical assumption about investment being undertaken and the value of invested capital rising. In fact the value of installed capital fluctuates with every change in the market. If capital gains from revaluation of assets are considered income, then one can say savings passively occur whenever long dated claims rise in present value through rate decreases. Just lowering rates will raise the present value of identical future cash flows by huge amounts, generating "savings" of out thin air by generating "capital income" out of thin air.
But the problem then is not that investment is made without savings to match (because if those gains are included, they will and to spare), but that later, when unsustainable rates reverse themselves and rise, income plummets through capital losses to long dated assets. Notice that this form of the cycle would occur even if there were no fiduciary anything involved, even if savings and investment matched each other exactly throughout, etc. All that is necessary is that interest rates move, because by definition a rate that moves is not permanently at a sustainable level.
If instead one excludes the capital account fluctuations occasioned directly by rate changes affecting present values of unchanged future cash flows, from income, then the theoretical (explanatory) cost is that no direct relation need remain between savings and changes in the value of the capital stock. Because the first derivative of the value of capital is not dominated by new savings inputs, but by changes to the value of existing assets as conditions shift, rendering them better or worst adapted to the new state of the market (including both rates and demand etc).
And in that case, if a new issuance of gratuitous credit shifts existing capital assets to uses that wind up working out and thus creating capital gains, that issuance will justify itself, without need for prior savings. If not, then it won't justify itself. But this is the relation automatically present whenever capital is deployed. If the use is sensible, it remains "capital". If the use is senseless, the *value* (not the plant etc) evaporates.
So we are left with the true cause of the cycle, partially diagnosed by the Austrians but explained with a mixture of true and falsehood - that misallocation of capital through poor investment decisions, spurred by miscalculations that any false price signal can create, but that are particularly potent when it is a matter of interest rate forecast error, because that effects all long dated assets and does so in large ways.
Has the Fed made errors? Sure. So have private bankers, traders, and merchants. Without regulated restraint of the money supply, they would undoubtedly make even larger ones. They did in the past, long before the Fed existed. They would again even if it did not. The largest error the Fed ever made was not its period of greatest looseness but that of its greatest tightness, when it let the money supply drop 30% in the face of collapsing world trade etc.
It has made errors in both directions since then, but definitely more often on the side of looseness. Very often it has been too complacent about credit growth because items it was regulating or tracking closely were well behaved, while new money substitutes found by creative finance were burgeoning and barging without restraint. As for who made the *first* error, the canonical answer is Eve, as I recall. But economic life does not have an original sin. Instead it has lots of fallible actors each responsible for their own actions, every one of whom can and does frequently screw the pooch, royally. In part because the economy simply has a difficult allocation problem to solve, and in part because men can be short sighted, vain, pig ignorant, etc.
And I am not forgeting what Hayek traced incompatible future plans, to. But the notion widely peddled by libertarians that only government officials make mistakes is laughable on its face, as is the idea that only they have sufficient power to mess things up on a large scale, or the idea that they should be held to a perfectionist standard - that is all nonsense and always has been. Hayek got it right when he instead argued that freedom is superior to planning for the information it mobilizes, but further that we accept the costs of error and the insecurities in brings for the sake of freedom and the higher values freedom brings in its train, and not because of any imaginary perfection in market outcomes.
And I am sorry, but even if new investment comes from savings, plenty of projects can and do become incompatible. There is no substitute for good finance, and good finance is not a morality tale in which never going into debt is the saintly high road to perfection. As for the difficulties occasioned by competing for scarce resources, inflation is the signal of that getting out of hand. And business and sectors always compete for scarce resources; we depend on it to allocated capital rationally. None of that is the problem. The problem is the wrong investments being made, because the long dated ones look like they can't miss when rates are falling, and this lets poor investments through."
"If investors and businessmen made mistakes on their own, the mistakes and successes would be randomly distributed across time and industries."
Sorry, that is pure ipse dixit. You say it so it must be so. It is false empirically. Not only under Fed governership but in general. It is also belied by any close analysis of the interconnectedness of the economic system. Trend following is popular because it can work for short enough periods and drastically reduces the cleverness required to deploy capital. Fads exist. Market psychology exists. Overvaluation of stocks allows overfunding of dubious ventures. Easy money is freely spent, and seeking to sop up free spending positions other supplies right where the demand is likely to prove the most ephemeral.
The economic system contains restoring forces, yes, and can correct its errors eventually. It offers sizable rewards to those who correct widespread errors, if they are brave enough, right enough about the timing, and have the wherewithal to remain solvent longer than the market remains wrong. But it has none of the inherent stability of a pure Gaussian independent randomness. It is shot through with feedbacks and autocorrelation. In shorthand we simple say, "the credit system is inherently unstable". So we get booms and busts - we got them before modern banking and they are not going to disappear. We may manage them better, we might moderate their amplitude, etc. But they are not the readily correctable byproduct of a simply stupid policy or institutions. That is as crank an idea as the contrary inflationist fallacy, that we could all be rich if we could just counterfeit enough.
Beware of men who argue that economic realities have been demonstrated in the books of their school, especially when worded in the subjunctive. That is called ipse dixit reasoning, or it is advocacy. Economic realities are demonstrated, or better evidence is found for them, in the real world. In the real world, mild inflation has generally proved better for economies than mild deflation (ask the Japanese), though there have been successful periods of either. Both have proven better than unmild versions of either. Unmild versions of deflation are easily the greatest catastrophes on economic record.
Inflation hurts savers if savers save in money or fixed denomination debt. Even this can be overstated because rates soon compensate, though not without some loss, especially to those lending long before the inflation was expected. Deflation hurts debtors absolutely. There is no doubt whatever that debtors being numerically larger than lenders, plus democratic governments, are the prime reason that inflation is more popular and common in practice, than deflation. The diagnosed cause also puts paid any schemes for simply reversing this by publishing a tract exclaiming the supposed virtues of deliberately supporting the financial fortunes of the less numerous and wealthier group. When pigs fly. Mises was enough of a realist to acknowledge that the cause of present monetary policies are political and not simply wonk-policy issues.
Price stability is a better target, is better justified economically as Mises himself showed, and is much more feasible, politically and institutionally.
Published: September 13, 2007 6:33 PM
Anthony
Jason, thanks for your further comments. I agree with your points on voluntarily-driven market regulation.
Published: September 13, 2007 6:34 PM
scott t
" Gold was the monetary standard in most countries until 1914, or even until the 1930s. Furthermore, gold was the standard when the U.S. government in 1933 confiscated the gold of all American citizens and abandoned gold redeemability of the dollar, supposedly only for the duration of the depression emergency."
http://mises.org/daily/1503
this doesnt sound like voluntary-driven market regulation.
"The economic system contains restoring forces, yes, and can correct its errors eventually"
well..yeah, of course - life goes on. but why did the us government confiscate gold in teh first place?
"So we get booms and busts - we got them before modern banking and they are not going to disappear."
weren't the previous booms and busts simply using earlier versions of modern banking techniques?
except if say, spain had to invest in mining equipment exploration and instead of slaughtering natives and shuttling gold back to europe - would the same level of inflation (boom/bust) have taken place?
Published: September 13, 2007 7:20 PM
Jason Cawley
I promise to address Scott's questions in a moment, but first I have one piece of unfinished business with Fundamentalist. I have to substantiate my claim that Mises made the mistake of conflating the allocation of capital down through the scale of potential returns, with the allocation of capital across uses with different terms.
My source if the Theory of Money and Credit, liberty classics edition, page 399-400. If your pagination is different, the chapter is the one of Money, Credit, and Interest and the subsection is the 4th, the influence of the interest policy of the credit issuing banks on production.
Immediately preceeding the critical passage, Mises puts forth a version of the wages fund theory, citing Bohm Bawerk on an important subsidiary point (that if workers are not provided for through the whole period of production, and "the consequence would be an urgent offer of the unemployment (sic) economic factors").
He then proceeds to explain that and why the entrepeneurs can only extend total investment by entering on more roundabout processes of production. (Hence my earlier reference to capital intensity, as an aside). And writes, first -
"It is true that longer roundabout processes of production may yield an absolutely greater return than shorter processes; but the return from them is relatively smaller, since although continual lengthening of the capitalistic process of production does lead to continually increasing returns, after a certain point is reached the increments themselves are of decreasing amount."
Here the overall quantity (with physical or by value left horribly unspecified) of capital being employed is clearly regarded as proceeding down a marginal series. The increments are to total capital and there are decreasing marginal returns. But he has already conflated the total quantity, through the wage fund idea, to an average total length of production. He is therefore already dangerously close to claiming that shorter means higher marginal return.
He continues -
"Every new roundabout process of production that is started must be more roundabout that those already started; new roundabout processes that are shorter than those already started are not available, for capital is of course always invested in the shortest available roundabout processes of production, because they yield the greatest returns. It is only when all the short roundabout processes of production have been appropriated that capital is employed in longer ones."
One scarcely recognizes an economist of the stature of von Mises in these passages. The wage funds theory morass has simply swallowed him, and transformed the sensible expected yield schedule of possible capital investments, into a schedule rigorously arranged from short investments to longer ones, such that all the shorter ones have higher marginal returns than any longer one, and therefore no longer ones are entered on until all shorter ones are exhausted.
Nor is this a simple oversight and readily removable. Without it, the entire wages fund argument collapses. As soon as it is admitted that some of the new investments that might be made possible by a lower than clearing rate of interest, might actually be shorter than the present average length of production, it ceases to be necessary that an increase in the quantity of capital employed, corresponds to a longer schedule of real arrival of the stream of goods.
Capital intensity is distinct from capital duration. And there is no time of arrival ordering of the schedule of investments.
More, the underlying fallacy can be easily spotted. The average period of production is an arithmetical artifact of a whole sum of individual valuations of a whole series of processes. The items being summed are not quantities but momentary valuations at one set of prices, and moreover valuations created by discounting projected future flows at some momentary rate of interest (or curve).
Additional capital value can be invested in ways that will arrive in 30 days or in ways that arrive in 40 years, or anything in between. It has many internal degrees of freedom, and is not determined by the total value of invested capital.
The divisor that is supposed to reduce this diverse set of cash flows to a single number and that with the units of a time, is supposed to be the cost of employing the workers per unit time. This is the wage fund theory in all its ... well, you pick a word. But if this is a value, not a physical quantity, why is this expected to be fixed? See the Bohm Bawerk citation above, where a possible change showing one is not at equilibrium is just dropped.
Later he shows that he understands the wages fund theory in a physical sense - he speaks of a possible peril to human existence, as though while everyone was trying to build the tower of Babel, the food runs out and everyone starves to death. He admits that price changes will save the day and keep it from being that drastic. The change he has in mind is the price of consumer goods rising - that the wages of the workers might fall in real terms is not mentioned as a possibility.
Then at the end of page 401, we get a further whopper. After describing the countermovement as demand for consumer goods rises and that for producer goods falls, he say "that is, the rate of interest on loans rises again". Here we have a clear conflation of relative prices of consumer goods and production goods, with the rate of interest. As though the interest rate were the ratio of the PPI and CPI series.
The Austrians were right to diagnose the cause of loss in the cycle as misallocation of capital, and to see that this misallocation becomes real during the boom and not in the slump, that the slump is repairing past errors and acknowledging and adjusting to their cost, that permanent "goosed" boom is impossible, and that keeping the rate of interest below its equilibrium level causes capital misallocation and if sustained long enough, inflation. But they were quite wrong about the transmission mechanism and the specific constraints involved, which are not of this mechanical nature.
Misallocated capital does its damage by failing to produce the returns expected of it, because it is misaligned with people's actual schedule of demand. That reduces the real income of the whole community below what it could have been with proper application of the capital. The problem is not that everything will run out and everyone will starve if too much is invested. It is that what is being invested is being aimed quite poorly.
Note that Hayek repeated many of these errors in his correspondance with Keynes in the 30s. I think Hayek knew better later on, and his discussions of the importance of information and plan compatibility is a sounder analysis of the real forces making for loss in the cycle, than the wages fund theory.
I hope this is interesting, at least to some. At any rate, the above shows, I believe, where Mises can be found baldly stating that shorter investments are always more profitable than longer ones and are always filled first. His "all"s are unambiguous. Homer nods, and a cat can look at a king - I am not claiming any general superiority to a great economist. He is certainly not alone in this - you can find worse in Keynes on every other page. But there it is - on an absolutely vital point, the man just wrote nonsense.
Published: September 13, 2007 9:25 PM
Jason Cawley
"this doesnt sound like voluntary-driven market regulation"
Straw man. The prior comment referred to my preferences to regulating modern fiat banking. You might as readily pretend that anyone who says you should vote in the next US election is advocating war with Great Britain.
As for why the US went off gold in the first place, I thought that was tolerably well known. We had a gold standard. It was managed very badly after WW I, becoming a gold exchange standard and then falling apart as leading states tore into each other. There are plenty of bloody preliminaries in Mises and more in Kindleberger (my personal favorite is the French government demanding Austria renounce the customs union with Germany as a condition for saving its banking system, and the height of the run on central Europe).
The legal side of it was rigid enough that the Fed reduced the money supply 30% in less than 2 years in response to foreign withdrawals of gold, because the rules of the system said it had to keep a definite mechanical relationship between total bank deposits and gold in its vaults. That nearly destroyed capitalism and with it freedom in the modern world. France stayed on gold, everyone else left it.
It would have been better to have left gold legal even after convertibility to it was removed. Obviously the reason it wasn't is the government feared the new monetary regime might not take, and the banks might instead lose the ability to market their debts, which would sink the money supply down to the coins in country, or oh about another factor of 3 or 4, say. Might have managed to get the unemployment rate clear up to 50% that way, wouldn't that be great?
But it was a frankly coercive and emergency measure, dubious even at the time, clearly unjust and unnecessary by ten years later etc. So what? Anybody can own gold now and lots do, it has a nice rate against FRBs. But it isn't money. Bank debt is. You don't need to like it for it to be so.
As for earlier booms and busts, see Kindleberger for chapter and verse. There are two constants - one, speculation can focus on anything and get as absurd as you please. And two, financiers will play with what counts as money, always have always will, states will play too but are not essential to any of it.
You can find hyperinflations with pure metallic money (Rome had one), you can find paper towers before there were banks (through chains of bills of exchange), you can find whole bubbles financed with nothing more than post dated checks. Rome didn't have to do anything more, when it wanted to inflate, that debase the currency by alloying - the silver content of the denarius fell by a factor of 45 over 200 years.
If you find yourself in a country or time with a money that does not preserve value through time, do not hold savings in money. Put your wealth instead in productive enterprise and real property. This isn't rocket science, every decent merchant has known it throughout history.
Yes we can demand better finance, but we need not pretend we are helpless. It is false as well as degrading. You don't have to stand around waiting for somebody else's permission to handle wealth soundly. Practical action as financiers ourselves is more useful. If you think modern banks have an outrageously great deal, fine, there they are, go invest in them, instead of lending to them.
Published: September 13, 2007 9:53 PM
TLWP Sam
Wow your last post was perhaps the best one I have read yet on this site Jason Cawley!
Published: September 14, 2007 12:32 AM
scott t
ipse dixit?
"Anybody can own gold now and lots do, it has a nice rate against FRBs. But it isn't money."
so if i give gold to someone and they give me somethig in return - would it be money then?
Published: September 14, 2007 1:38 AM
Fundamentalist
Jason,
One of us doesn't understand Hayek and Mises at all. I'll leave it to others to decide which.
Published: September 14, 2007 8:03 AM
Thomas Benjamin
Jason, You have made many, many interesting points in your recent comments. Thank you. I do, however question the claim that credit is always created out of 'nothing'. If one takes this very general definition of 'credit', i.e. that credit is the exchange (exchange in the Misean sense) of present 'X' for future 'Y', 'X' and 'Y' being 'somethings' (if one assumes that either 'X' or 'Y' is 'nothing', then its counterpart is a free gift, but I think it is safe to assume that all giving is value-for- value exchange of some sort so that if the gift appears free, you should look for the actual value it is exchanged for) agreed upon by the parties involved and that all debt is actually collateralized debt, collateralized by either personal property, real property, or future production (think of the last personal loan you took out--think of the information you provided on the application--If you had no way in the future to return the present goods given, do you think those who would loan you the present goods actually loan them to you?). If this is a good (and correct) definition of credit then credit is not created out of 'nothing' but out of an exchange of a present 'X' for a future 'Y', whatever the 'X' and 'Y' might be. A better question, I think, ktibuk should have asked, is if, in a completely free market, banks might not be superfluous. Since all it takes to create credit is the exchange of present value for future value by agreement of the parties involved, the written exchange agreement made negotiable (ah, but this is just the 'bill of exchange', yes?) one could (and historically did, as you and Fundamentalist correctly pointed out) use these bills of exchange as fiduciary money (though the better way, in my opinion is, if one agrees with the notion that all debts are collateralized by something, is to issue security interest certificates based on the appraised value of the collateral and use that as 'money'...). It would be up to the commercial enterprise known as a 'bank' to show to the market participants that it was superior to the other market participants in ascertaining risk of nonpayment, marketing either the bills of exchange or the security interest certificates, etc. If it could not, then of course no one would patronize that particular enterprise. The 'fraud' that ktibuk is reaching for, I think, is illusion that banks are absolutely necessary to the process of credit creation when in fact they are not. In fact, banks are only necessary when warehousing a medium of exchange (historically, commodity money). That is where, at least I understand the Austrian School to say, all the problems begin....
Published: September 14, 2007 9:59 PM
ktibuk
You can not lend out what you dont have and credit can not be given to anybody without saving it first.
If anybody thinks credit can be created out of thin air, without saving it first, either they live in a dream world or they are frauds.
Economy is economy even without the money, all the rules of production, trade, valuation are the same.
What Jason thinks happens can not happen in a barter economy, and if it can be done in a money economy this means money has magical powers besides being a medium of exchange.
And if there is something as overwhelming your opponent with ignorance and absurdity it is this.
Very very long, incoherent posts riddled with absurdities only possible in imaginary fairylands.
Published: September 15, 2007 6:39 AM
Fundamentalist
ktibuk: "it can be done in a money economy this means money has magical powers besides being a medium of exchange."
Very good point! If people would consider how a theory would work in barter it would stop a lot of dumb theories in their tracks.
Published: September 15, 2007 9:48 AM
Fundamentalist
Jason: "One scarcely recognizes an economist of the stature of von Mises in these passages. The wage funds theory morass has simply swallowed him, and transformed the sensible expected yield schedule of possible capital investments, into a schedule rigorously arranged from short investments to longer ones, such that all the shorter ones have higher marginal returns than any longer one, and therefore no longer ones are entered on until all shorter ones are exhausted."
For anyone interested, the "offending" passages to which Jason refers are online at http://mises.org/books/Theory_Money_Credit/Part3_Ch19.aspx.
Mises is writing about the "roundaboutness" of production processes, which refers to production processes that take a greater amount of time from input to output, but at the same time produce a greater output.
In the passage Mises is describing why business people must choose more "roundabout", or longer processes of production, when the interest rate falls. Mises writes "But every new roundabout process of production that is started must be more roundabout than those already started; new roundabout processes that are shorter than those already started are not available, for capital is of course always invested in the shortest available roundabout processes of production, because they yield the greatest returns."
Why would shorter production processes yield greater returns than longer ones at the same interest rate? Say two people invest $100 with a promise of an absolute return of $10 at the end of the production process. A's process takes six months and B's takes a year. What is the rate of return on each? B earns 10% on his investment for one year, but A earns 20%, because his took half the time to complete. Now if the prevailing interest rate is 15%, which businessman will make a profit, assuming all the money was borrowed. That's really all Mises is saying.
Jason: "Here we have a clear conflation of relative prices of consumer goods and production goods, with the rate of interest."
Mises explains it himself in the next paragraph: "At first the banks may try to oppose these two tendencies that counteract their interest policy by continually reducing the rate of interest charged for loans and forcing fresh quantities of fiduciary media into circulation. But the more they thus increase the stock of money in the broader sense, the more quickly does the value of money fall, and the stronger is its countereffect on the rate of interest. However much the banks may endeavor to extend their credit circulation, they cannot stop the rise in the rate of interest. Even if they were prepared to go on increasing the quantity of fiduciary media until further increase was no longer possible..."
Jason doesn't seem to understand that price inflation and interest rates are related. "Rising prices" is the flip side of "devalued money". When the value of money falls, banks must raise their interest rates or see their real income fall. Mises never has "conflated" interest rates with the prices of goods, but merely explains that rising prices eventually cause interest rates to rise.
Mises's writing style can be difficult to navigate sometimes, but it seems to have drowned Jason. Anyone who wants to bother can read the passages for themselves and see that Jason simply doesn't get it.
Published: September 15, 2007 11:18 AM