Comments (73)

• pete

  Excellent article!

  "Not a bad life, really, especially when you consider the ocean view and the absence of Jim Cramer." LOL
  

  Published: October 20, 2008 8:43 AM

• fundamentalist

  Great response! Thanks!

  Cowen: “Why should the boom be a boom in the first place? The shift toward investment goods, and thus away from consumption goods production, should mean falling real wages, not rising real wages.”

  In addition to Mr. Murphy’s response, doesn’t Cowen ignore the existence of unused resources after a depression and during the initial years of the boom? Unused capital will start the boom, but then businesses will have to consume capital to keep it going.
  

  Published: October 20, 2008 8:48 AM

• Bill

  Perhaps Tyler Cowen should also address the question "Why should the boom be a boom in the first place?" to the venerable Anna Schwartz, godmother of mainstream monetarist theory. In an excellent "must read" piece in the WSJ: http://online.wsj.com/article/SB122428279231046053.html

  "How did we get into this mess in the first place? As in the 1920s, the current "disturbance" started with a "mania." But manias always have a cause. "If you investigate individually the manias that the market has so dubbed over the years, in every case, it was expansive monetary policy that generated the boom in an asset.

  "The particular asset varied from one boom to another. But the basic underlying propagator was too-easy monetary policy and too-low interest rates that induced ordinary people to say, well, it's so cheap to acquire whatever is the object of desire in an asset boom, and go ahead and acquire that object. And then of course if monetary policy tightens, the boom collapses."

  I guess this makes her quite heterodox now and, as Krugman puts it, "as worthy of serious study as the phlogiston theory of fire. Oh well."

  Published: October 20, 2008 9:01 AM

• Michael A. Clem

  Wow. Great example. If Krugman and Cowen can't understand that, I really don't know what to say. But will they read it?

  Published: October 20, 2008 9:09 AM

• Rubén Rivero

  I wish to make a comment on this last paragraph:

  "People in grad school would sometimes ask me why I bothered with an "obsolete" school of thought. I didn't bother citing subjectivism, monetary theory, or even entrepreneurship, though those are all areas where the Austrian school is superior to the neoclassical mainstream. Nope, I would always say, "Their capital theory and business-cycle theory are the best I have found." Our current economic crisis — and the fact that Nobel laureates don't even understand what is happening — shows that I chose wisely."

  I just joined this forum yesterday. To tell you the truth, I didn't even know that the Austrian school existed. On Friday I performed a Google search in order to find a book on the Great Depression and spent the whole weekend reading Murray Rothbard's "America's Great Depression". I agreed with it so much and it reminded me so much of today's world that I became an instant supporter of this school of thought.

  Please forgive my ignorance on the matter, but why is the Austrian school considered obsolete?

  Published: October 20, 2008 10:32 AM

• Chad Rushing

  Mr. Rivero, off the top of my head, it would be my guess that the mainstream considers Austrian economic theory obsolete because:

  (a) It advocates comodity-backed money (usually gold) versus fiat currencies.
  (b) It advocates either full disclosure of bank reserves or no fractional reserve banking whatsoever.
  (c) It advocates the absence of any central banks.
  (d) It advocates the economy being autonomous from the government.
  (e) These policies it advocates will generally lead to monetary deflation and/or appreciation (increased buying power per monetary unit) which is very bad for net debtors.
  (f) It states very clearly that Keynesian economics and socialism are both fatally flawed from the start.

  None of these stances are the least bit popular with those who currently hold either political or economic power in today's world (with very few exceptions), because their current methods have the net result of progressively gaining them more power and wealth (at least in the short run).

  Note that I am fairly new to this, too, so if I misrepresented Austrian economics in any way, anyone should feel free to provide corrections.

  Published: October 20, 2008 10:49 AM

• Niccolo

  Wow... This was simply the best article I've read on this website for months.

  
  The humor helped a lot too. I really enjoyed this one.

  
  I also thought that one of Cowen's main points against ABCT was something like Caplan's, where rational expectations mean that market actors are some how infallible beings from the great beyond.

  
  I respond to that here,

  http://leftlibertarian.org/archives/4967

  and here,

  http://leftlibertarian.org/category/features

  Published: October 20, 2008 10:52 AM

• Niccolo

  Wow... This was simply the best article I've read on this website for months.

  
  The humor helped a lot too. I really enjoyed this one.

  
  I also thought that one of Cowen's main points against ABCT was something like Caplan's, where rational expectations mean that market actors are some how infallible beings from the great beyond.

  
  I respond to that here,

  http://leftlibertarian.org/archives/4967

  and here,

  http://leftlibertarian.org/archives/4937

  Published: October 20, 2008 10:53 AM

• Erik B.

  "why is the Austrian school considered obsolete?"

  I believe the biggest reason for this is public schools... but that is just my humble opinion.

  BTW, the Austrian school is NOT obsolete! In fact, it is the most relevant school of economics you can learn today. I've learned more relevant information about economics on this website than I did in four years of undergraduate education (in economics no less) at a public university!
  

  Published: October 20, 2008 10:57 AM

• Keith

  "People in grad school would sometimes ask me why I bothered with an "obsolete" school of thought. I didn't bother citing subjectivism, monetary theory, or even entrepreneurship, though those are all areas where the Austrian school is superior to the neoclassical mainstream. Nope, I would always say, "Their capital theory and business-cycle theory are the best I have found." Our current economic crisis — and the fact that Nobel laureates don't even understand what is happening — shows that I chose wisely."

  Yeah, but you'll never get on TV or get a job as a politcal advisor.
  

  Published: October 20, 2008 11:00 AM

• fundamentalist

  Rubén Rivero: "...why is the Austrian school considered obsolete?"

  Mainstream economics is variations on Keynesian economics. Keynes claimed that he refuted and made obsolete all economics before him. In reality, he was only resurrecting the mercantile economics that preceded Adam Smith. And Keynes did not refute anything; he simply ignored and distorted the economics of other schools. But because Keynesian econ took over the economics profession, those trained in economics today do not know any of this. They are completely ignorant of Austrian economics. Prof Mankiw of Harvard, for example, has written that he has not read anything on Austrian economics because he thought that everything important in it had been incorporated into mainstream econ. But it hadn’t.

  Actually, mainstream macro economics is what's obsolete. It died in the stagflation of the 1970’s and few people have taken it seriously since then. That’s when people began looking into Austrian economics again. Until Bernanke, no one at the Fed took mainstream macro seriously because it was totally useless.

  A good intro to the differences between Austrian and mainstream econ is “Economics On Trial: Lies, Myths, And Realities” by Mark Skousen.
  

  Published: October 20, 2008 11:56 AM

• Inquisitor

  I see, Austrians are obsolete, but Krugman's way of thinking isn't... it must be some parallel world. :)

  Published: October 20, 2008 12:36 PM

• GVP

  Mr. Murphy,

  Excellent article, it reminded me why I started reading this site to begin with. When it comes to economics the Austrian School is not just superior it is the only tradition actually doing economics. The rest are engaged in jibberish, muddled thinking at best and at worst naked propaganda for self interested insiders.

  Keep up the good work,

  
  George,

  Published: October 20, 2008 12:56 PM

• Bruce Koerber

  Why is Austrian economics considered obsolete?

  Because it does not allow the 'modern economic manipulations' of the progressives and the empiricists!

  Somewhere lost in the early frenzy of the ego-driven interventionists to gain positions of power is the question regarding methodology.

  It is the 'physics envy' of the empiricists that is obsolete since the appropriate methodology of the social sciences is subjectivism. Subjectivism is beautiful and dynamic and in harmony with the human reality which to the empiricist and the progressive is incomprehensible.

  To conclude, in all truthfulness, the propaganda and indoctrination of the empiricists and progressives (who did gain power and institutionalized it during their heyday frenzy) should state that Austrian economics is incomprehensible (since it is to them) rather than obsolete (like their physics envy).

  Published: October 20, 2008 1:11 PM

• Kilmore

  Though this article contains some very interesting insights, the most important question remains unanswered. How exactly does inflation cause disruption of capital structure?

  Creation of new money is merely another form of robbery, it causes devaluation of all existing paper money held by citizens. This stolen wealth is then transfered to government, banking system and those who get their hands on new money first. There is no fundamental difference between this type of expropriation and for example income tax. It is just another transfer, nothing else, therefore simple act of money printing cannot cause business cycle.

  Mises stressed vital importance of precise "point" where new money enter economy. Yet he did not explain why only money injected into financial system should cause cycle. Really there is something wrong with Austrian business cycle theory, it is incomplete and thus cannot convince mainstream economists of its truth.

  Published: October 20, 2008 1:59 PM

• Som

  For some reason, when I see this explanation for capital consumption, I also picture the concept of the broken window fallacy.

  These Peynesian in the ass economists celebrate when a hurricane flips a house (because of all the construction and remodeling jobs made! hooray!) just like it does when an investor flips a house during the housing boom (because, again, of all the construction and remodeling jobs made! hooray!) and later say "What impoverishment? Where? huh?"

  The only difference is that the former was caused by a natural disaster (i.e. hurricane), and the latter was caused by an unnatural disaster (i.e. state)

  Please put this article in Krugman's inbox labeled as "urgent" (I would, if I knew the guy's email address)

  Published: October 20, 2008 2:04 PM

• pussum207

  Excellent article. I thought Krugman's use of the accounting tautology was very telling. In addition to ignoring the effect of time in the adjustment process, he in effect implicitly assumes that national income is fixed - i.e., he uses a model in which there is no business cycle whatsoever to demonstrate that the Austrian model of the business cycle is wrong!

  Pride goes before the fall, I guess.

  Published: October 20, 2008 2:28 PM

• C. Evans

  Kilmore,
  It is my understanding that the introduction of new credit artificially lowers the interest rate, which encourages entrepreneurs to begin more projects than what would have occurred without such interference. This is the boom, which is spurred by malinvestment. But there are no enough real resources available to complete these projects and many must end. This is the bust. I don't know if Mises made this point because I haven't yet read The Theory of Money and Credit. I've been reading Money, Bank Credit, and Economic Cyles, and America's Great Depression. But it seems to me that ABCT is the best explanation we have. I think the real reason Austrians have such a hard time convincing mainstream economists is because Austrians blame government intervention and argue if government would stop intervening, these cycles would cease. Mainstream economists, on the other hand, believe that the free market cannot be trusted and the government must intervene.

  Published: October 20, 2008 2:53 PM

• Eric

  While I can see some economic truths in this article, it uses a model to demonstrate some result and then extrapolates the model to the larger economy. This is what mainstream economics does too often.

  And this modeling can be a dangerous idea at times. It leads modelers to think that if A -> B in the model that A' -> B' in the real world. Here A and A' represent something in the model and something in the real world that are thought to be an analogue.

  Now if these analogues are valid, as for example, a toy model plane may be a good model for a real sized plane, then one can use the model to predict the larger plane's behavior - for example, by using a wind tunnel. But there needs to be a lot of work proving that the analogy holds. Even in Richard Feynman's QED models, which mathematically are quite accurate, even Feynman admits that his rotating arrows (representing cyclical wave like behavior) can't be extrapolated into the larger world of arrows on a axial as though a clock with 1 hand.

  However, I did still like the sushi economy, but I didn't understand what Krugman did with the boat and the motor and how this caused the islanders to change to his proportion of workers in the various jobs.

  In ABCT I thought the stimulus to getting businesses to change (e.g. the fishermen hire more of the maintenance people making them into fishermen) was from the credit that was injected without there being any new savings. The new credit leads the boat owners to hire more fishermen because the new money gets spent on fish leading to these people believing more fishermen are needed. This happens because the new money is always injected somewhere, not evenly as found in some models, such as Friedman's and Bernake's helicopter model of inflation.

  The sushi example has a few assumptions, for simplicity. For example, all the workers are equally trained in all the professions on the island. No time or training is needed to move the workers from one job to the next.

  I guess the new motor was supposed to be the analogy of the dot com or new housing investment tools, but I don't see how new technology leads to an unsustainable boom (meaning a bust must follow) all by itself. In the example, the cluster of errors all follow from Krugman's bad advice, not from any action. For example, there were no creations of counterfeit boats; say made from paper, but good enough to fool people long enough so that they changed jobs. After all, it is not the belief that the overall economy will improve that gets people to change from one job to another, it's a better job, pay, working conditions, etc. that entice workers to move. And this takes time. In addition, workers hate the side effects of changing jobs in most cases. Where is injection that permits the fishermen to hire away the repair crews.

  Anyway, I'm not sure how else to explain ABCT in an easy to understand way - and the author did admit that he was limited in his presentation methods. It is a sad fact, and a partial explanation of our troubles, that most people's eyes glaze over when discussing money and credit. So, while the paper has some problems, it is clearly a good start. I would have liked to see it expand just a bit to include money and credit, since that is the problem with the boom and bust cycle that the author is trying to explain.
  

  Published: October 20, 2008 3:03 PM

• Beta Hater

  Kilmore,

  "How exactly does inflation cause disruption of capital structure? ... [Mises] did not explain why only money injected into financial system should cause cycle."

  You've missed a vital facet of ABCT. Both savings and inflation lead to a lengthening of the structure of production. However, there is an important difference. When savings increases, resources from the early stages (near consumption) are released and allow the new projects in the later stages to be completed. No such "release" of resources occurs when the structure of production is lengthened as a result of inflation. The new projects in the late stages of production cannot be completed. Mises compares this second situation to a builder who believes he has more materials available to him than he actually does. This builder will be unable to finish the project, thereby wasting resources.

  I recommend you read "Money, Bank Credit, and Economic Cycles" by Jesus Huerta De Soto. It is the best treatment of ABCT. In particular, read chapter 5.

  Published: October 20, 2008 3:14 PM

• Maturin

  As always, Dr. Murphy, your arguments are both enlightening and entertaining!

  I especially appreciate the links to Garrison's presentations about Keynes vs Hayek in explaining the business cycles. Those powerpoint-driven explanations are so easy to understand.

  Kilmore-
  I suggest you look at the beautiful and lucid Hayek powerpoint presentation to understand how monetary inflation disrupts the real economic growth and wealth creation. Pay particular attention to the Investment vs Interest graph and the effects of Delta M (fiat monetary expansion, or "inflation") on interest rates and real savings. The fiat money spurs artificial and unsustainable investment (malinvestment) in capital goods (boom) that cannot be used efficiently, so they have to be liquidated/dumped (bust) so that the economy can get back to an equilibrium of sustainable investment and growth. It also drives up consumption at the expense of savings, as we all live high for awhile, not thinking about the future. Why save for the future when the return on a savings account cannot keep up with inflation? This is the shift in time preference for money use that is artificial, created by the inflationary fiat money. Suddenly we all feel poor again as the bust hits, and start saving instead of spending, which allows the curves to get back into equilibrium. But if the Fed keeps pumping in more fiat currency, the curves can never return to equilibrium, and inflation keeps us from saving, because the interest rate signal is distorted toward continued malinvestment rather than real savings. Runaway inflation results.
  

  Published: October 20, 2008 3:16 PM

• Marcus

  As i understand the analogy as follows the motor is the newly created money we have in the real world.
  When the motor runs out of gas and oil he can not longer be used and the boom endet.
  The islanders who invested their time to produce more gas and oil have a malinvestment and this has to be liquidated.

  cu

  marcus

  Published: October 20, 2008 3:37 PM

• Inquisitor

  Kilmore please tell me you are being facetious. Otherwise you are grossly ignorant of Mises's theory. It is an effective price control on the interest rate that causes distortions, not merely the expansion of the money supply. That is how the central banks expand credit. Mises devoted entire books to this. So in this regard, the "mainstream" can only attest to being dishonest or ignorant, or maybe both.

  Published: October 20, 2008 4:15 PM

• Mary Diane Dolan

  Maturin

  Thanks for your comment. It taught me something. Right now real interest rates are about zero, or, possibly, s-l-i-g-h-t-l-y positive. There is not much incentive to save, I wouldn't think--anyway, little incentive involving anything about bank interest rates. People are saving, I am thnking, because otherwise they will not be able to pay their light bill or buy groceries.

  Could you or someone else please tell me how to access Hyeck "powerpoint" presentation? I do not know what "powerpoint" means. If I did, I still would not know how to access it. You will have to tell me a series of what to click on, put into browser, etc. I have subprime computer skills (or had that already occurred to you)? Thank you.

  Published: October 20, 2008 4:31 PM

• Kilmore

  To C.Evans:
  I agree there are more reasons why Austrians cannot convince mainstream economists about their truth (yes, ABCT is certainly better than any other explanation on the table).

  Yet ABCT is not truly "market explanation" at all. First, central bank pumps new money into system and thus lowers interest rate under its natural level. Second, enterpreneurs make mistakes. But precisely because I am Austrian I cannot accept such determinism. People are able to adjust their actions to any change in conditions, therefore enterpreneurs are not bound to fail. They can and they do adapt their actions properly to new distribution of wealth.

  
  To Beta Hater:
  Not even Mises was infallible. He wrote very long and precise descriptions of redistribution caused by inflation. Yet he did not admit this in his business cycle theory. Since inflation is REAL redistribution it must take money from your or my pocket and place them in the pockets of those happy fellows running the banking system. Thus our consumption is diminished whilst their spending is boosted, sources are released somewhere and spent elsewhere, there is no mistake.

  
  To Maturin:
  There is no fundamental difference between financing of banking system via inflation or via another tax (income, VAT, does not matter). In all these cases someone is forced to give certain amount of money to banking system. Thus lower interest rate is not artificial. Some people are really worse off, some better. Ask any one of them whether they consider this transfer to be real or artificial.

  
  Cluster of errors cannot be caused by simple transfer because market is able to handle such disruption. There are many other transfers than inflationary one, yet markets are able to adapt. There is only one explanation of market failure, malfunction of price system. There must be fixed price somewhere to prevent market adjustment. For example too low fixed price of gas can cause both overconsumption and underproduction. We can see "overproduction of investments" and "underproduction of thrift", therefore we should look for some fixed price.

  Published: October 20, 2008 5:06 PM

• Eric

  Rothbard wrote that people generally increase their cash holdings to counter uncertainty. He writes that if there were no uncertainty in future economic conditions then we would not need to hold cash at all. We would know exactly how much of everything we need, and also when and where we could exchange. I think we likely would not even need money at all, as barter in this perfect world of certainty would suffice.

  So, Mary is in agreement with Murray here, since since an important unknown is whether we will have enough to eat tomorrow. Holding cash makes it more likely that we will be able to exchange for food even should we wrong about the future in other respects.

  Marcus:

  I don't see the motor as a good analogy for creating new money, if that is what the article was getting at. I would view the motor as new capital coming in from an external source. True, it's of little use once the fuel runs out, but it's still useful before that occurs. And hey, maybe someone will find a way to turn all that oily fish into motor fuel. Or maybe someone finds a way to make it run on something that is found on the island. Whatever else, the motor is clearly "real" wealth, not money.
  

  Published: October 20, 2008 5:15 PM

• Inquisitor

  "Yet ABCT is not truly "market explanation" at all. "

  It is.

  "But precisely because I am Austrian I cannot accept such determinism. People are able to adjust their actions to any change in conditions, therefore enterpreneurs are not bound to fail. They can and they do adapt their actions properly to new distribution of wealth."

  Yeah, I'm sure entrepreneurs have no problem adapting to an interest rate whose natural tendency they cannot even know in principle due to repeated market distortions. Oh wait, it's just a wealth transfer, nevermind the fact that the Fed explicitly sets a target for the interest rate like any other price control...

  
  "To Beta Hater:
  Not even Mises was infallible. He wrote very long and precise descriptions of redistribution caused by inflation. Yet he did not admit this in his business cycle theory. Since inflation is REAL redistribution it must take money from your or my pocket and place them in the pockets of those happy fellows running the banking system. Thus our consumption is diminished whilst their spending is boosted, sources are released somewhere and spent elsewhere, there is no mistake."

  How about you prove this claim first, that Mises never said it entailed redistribution?

  "To Maturin:
  There is no fundamental difference between financing of banking system via inflation or via another tax (income, VAT, does not matter). In all these cases someone is forced to give certain amount of money to banking system. Thus lower interest rate is not artificial. Some people are really worse off, some better. Ask any one of them whether they consider this transfer to be real or artificial."

  How is it not artificial? Money is created out of thin air by the expansion of credit, artificially lowering the interest rate. This money (or loanable funds, more precisely) does not exist. There is no good reason for the interest rate to go down.

  
  "There must be fixed price somewhere to prevent market adjustment. For example too low fixed price of gas can cause both overconsumption and underproduction. We can see "overproduction of investments" and "underproduction of thrift", therefore we should look for some fixed price. "

  Yes. It's called the interest rate, i.e. the price for loanable funds.

  Published: October 20, 2008 6:06 PM

• Inquisitor

  Edit: no good reason as in, no real reason, hence the fall is artificial.

  Published: October 20, 2008 6:08 PM

• Brent

  To Kilmore,

  Inflation is redistribution, but doesn't that prove ABCT? It is an extremely complex and time lagged redistribution of wealth that entrepreneurs catch on to eventually (prices start rising and people start to adjust), which requires the central bank to make a choice -- should it try to inflate more (to try to keep the charade going) or should it inflate less (which would allow entrepreneurs to liquidate all the inefficient activities)?

  I think you also have to look at the micro decisions that people must make under inflation. It is very unrealistic to expect a business not to "go after" the new money during the boom, even if the entrepreneur knows that the boom will end at some uncertain date in the future.

  Published: October 20, 2008 6:18 PM

• Mary Diane Dolan

  Eric:

  Thanks! I am envisioning that many in USA cannot use credit cards now. --So, if they blow their paycheck as soon as they get it, that means they will not pay light bill, will not buy groceries. This is not uncertainty. This is CERTAINTY.

  In USA, this degree of forbearance--this degree of restraint--in spending all of one's money--now passes for savings. I suppose that technically perhaps it IS savings.

  People have gone from spending more than they have (to put it another way: --from spending in advance of earnings) to spending, simply, what they have, as soon as possible after they get it.

  The point is: Total USA savings may have gone from negative, UP to approximately zero. Anyway, all the financial pundits and others are now trumpeting confidently: "The consumer is now saving" and/or "The consumer must now start to save". If savings are actually zero, it seems a sort of a half-truth.

  And if the savings rate is now approximately zero, what will ever make it increase from there? Not bank interest rates, for they are going down and down. (to match the Fed Funds rate, which is supposed to go down soon).

  Published: October 20, 2008 6:24 PM

• Beta Hater

  Kilmore,

  "Thus our consumption is diminished whilst their spending is boosted, sources are released somewhere and spent elsewhere, there is no mistake."

  Yes, inflation does result in what Rothbard called "The Immediate Redistribution Effect". But this does not result in the "freeing up" or "release" of consumption resources to sustain the new later stage projects. Your argument only implies that different people ("those happy fellows") are doing the consuming. Your argument doesn't imply that inflation and the immediate redistribution effect lead to a fall in consumption, thereby freeing up resources to sustain the new late stage projects.

  In fact, one of Roger Garrison's contentions is that the artificially low interest rate will cause an increase in consumption. In his ABTC diagram, the central bank's new money means the supply of loanable funds curve to shift rightward to SΔM. The interest rate falls. Savers move down their unshifted supply curves, while investors move down their demand curves. In this context, the result of savers moving down their unshifted supply curves is overconsumption. Inflation leads to more consumption and doesn't lead to early stage resources being "freed up" to sustain new late stage projects.

  I recommend Roger Garrison's book "Time and Money" after reading "Money, Bank Credit, and Economic Cycles".
  

  Published: October 20, 2008 6:27 PM

• Mike

  Kilmore:

  There's at least one brilliant Austrian who seems to agree with you: http://mises.org/journals/qjae/pdf/qjae1_4_1.pdf

  These are interesting questions. May I suggest that Kilmore's critics read this article and at least consider that ABCT still has room for improvement.

  If inflation is recognized by market participants, credit expansion need not lower interest rates. Entrepreneurs, in anticipation of higher selling prices, can bid interest rates up to their natural levels preventing the initiation of unsustainable business projects (i.e. the demand curve for loanable funds can shift rightward). This explains why increases in the gold stock (in a free market) need not initiate a business cycle.

  In order to explain why artificial credit expansion may lead entrepreneurs en masse to make investment errors, we need to explain how the government prevents market participants from adequately anticipating the inflation.

  Also, I don't think you can separate traditional ABCT from the problem of moral hazard. With the ever present promise of central bank bailouts, it becomes rational to initiate risky investments and the "wrong" projects can outcompete sustainable projects for capital. Bailouts also short-circuit the market's natural selection process and capital is allowed to remain in the hands of entrepreneurs who do not excel at perceiving the effects of inflation.

  Published: October 20, 2008 6:44 PM

• Kilmore

  To Inquisitor:

  Your reaction is too hostile for my taste. Thus I wish to react only to that part about interest rate being fixed price because it is an argument ad rem, not ad hominem. Interest rate is not fixed, it is only lowered, market forces are still able to change it. Gas price can be lowered the same way and yet it cannot cause over/under consumption and production problem.

  Interest rate is lowered by inflationary theft, this change is real, not artificial. I do not wish to discuss reasons of such interference, I am only interested in its effects. Since they are truly real, there is no mistake hidden here, no cause of business cycle.

  
  To Brent:
  Any taxation is very complex and time lagged. Where is the difference?

  Certainly enterpreneurs must "go after" new money because they must serve consumers. Inflationary transfer changes wealth distribution hence enterpreneurs have to change production schemes. Otherwise there would be serious market failure.

  
  To Beta Hater:

  I just don't see it. Some people have to cut their spending because certain portion of their wealth has been stolen.

  Yet we see boom periods are accompanied both by increased consumption and spending on capital goods. How is that possible? I think it is a bad idea to concentrate on inflation per se, because inflation alone cannot cause such double mistake. I still look for that fixed price somewhere and I see one. Certainly some banks have made better investments than others, some are almost bankrupt, some are well managed (or at least not that bad as others). Hence various market value of such deposits. Yet we see the same nominal value! Fixed price par excellance.

  Published: October 20, 2008 7:18 PM

• Inquisitor

  "Your reaction is too hostile for my taste."

  I suggest you harden up then.

  "Thus I wish to react only to that part about interest rate being fixed price because it is an argument ad rem, not ad hominem. Interest rate is not fixed, it is only lowered, market forces are still able to change it. Gas price can be lowered the same way and yet it cannot cause over/under consumption and production problem."

  None of my arguments were "ad hominem". Is asking you to prove something "ad hominem?" Ok, now tell me how much to lower it and at what pace. How exactly does one attain this knowledge. Since you know, go on and tell us. Because that is what you'd need to do to just say entrepreneurs can figure out the right rate. Since they can't, they're stuck malinvesting with what is for all purposes a de facto price control...

  "Since they are truly real, there is no mistake hidden here, no cause of business cycle."

  Ipse dixit.

  Published: October 20, 2008 7:24 PM

• Mary Diane Dolan

  Eric:

  Thanks! I am envisioning that many in USA cannot use credit cards now. --So, if they blow their paycheck as soon as they get it, that means they will not pay light bill, will not buy groceries. This is not uncertainty. This is CERTAINTY.

  In USA, this degree of forbearance--this degree of restraint--in spending all of one's money--now passes for savings. I suppose that technically perhaps it IS savings.

  People have gone from spending more than they have (to put it another way: --from spending in advance of earnings) to spending, simply, what they have, as soon as possible after they get it.

  The point is: Total USA savings may have gone from negative, UP to approximately zero. Anyway, all the financial pundits and others are now trumpeting confidently: "The consumer is now saving" and/or "The consumer must now start to save". If savings are actually zero, it seems a sort of a half-truth.

  And if the savings rate is now approximately zero, what will ever make it increase from there? Not bank interest rates, for they are going down and down. (to match the Fed Funds rate, which is supposed to go down soon).

  Published: October 20, 2008 7:35 PM

• Eric

  Mike:

  Even if entrepreneurs anticipate the inflation, they are still faced with tough decisions since "everyone else" is going along with the mistake, this can force the knowing entrepreneurs to "go along" too.

  One reason is that you might know the inflation is happening, but you don't know when it will end. If your competition is fooled into creating some business environment that will attract more customers, then you might have to go along or lose all your sales - and go belly up.

  It makes little difference that these mistakes will someday (but we don't know when) be uncovered for what they were and these people then have to cut back. Long before that time, you might be gone if you didn't go along.

  If you think your competition is simply being fooled into expanding, will your employees also think this and not leave the job when a higher paying offer arrives? You might not be able to risk losing workers given the costs of training and recruiting.

  And it's quite difficult to predict the future; while many Austrians did talk about the problems of savings, until the "subprime" crisis became everyday news, I didn't read anything that said on such and such a day, the following will happen. Mostly, I recall reading that there was something fishy going on with the pool of real savings (Frank Shostak) and that something had to give. But when I was reading this (for years it seems) I recall no specific predictions with accurate dates. In other words, it has taken a long time before I could tell my friends, "Remember when I told you this was coming".

  If they keep spiking the punchbowl, the party can go on for quite some time. We have a lot of seed corn we can consume, especially when few know they are doing so.

  
  

  Published: October 20, 2008 7:49 PM

• Kilmore

  To Inquisitor:

  There is of course an other way than "harden up". I suggest you to soften down.

  You asked me to prove something that cannot be proven. I have read almost all of books written by Mises, therefore I am familiar with his thoughts he had put down on paper. You may prove me wrong by some citation but I cannot prove myself right by throwing all his papers at you. Or are you prepared to do lots of reading to prove ME right? I do not think so.

  I have never suggested any knowledge about right rate of interest. It is market phenomenon, therefore it must be set there. I merely say that enterpreneurs are able to make proper decisions based on market data even though the data are distorted by central bank intervention. This example might throw some light on the issue. If government was to subsidize gas producers gas price would be lowered. Yet it would still be functional market, market participants would be able to make right decisions based upon current state, free market price + intervention. The same holds for interest rate. It is very different from fixed gas price or fixed interest rates.

  To Mike: I know this article, it is very interesting, he shows weak spots of standard theory. Yet his abstract style of thinking may not convince many.

  Published: October 20, 2008 8:06 PM

• Bob Roddis

  My own response to Krugman and all of the other fiat money supporters is to demand that they explain how a transfer of wealth will not occur with the issuance of new fiat money. Money is a claim upon resources. Those getting the new money first will have claims upon resources that are reflected in the dilution of the value of the existing money stock held by others. Issuance of the fiat money starts a game of financial musical chairs where everyone is trying to find a store of value in lieu of the diluted money stock. The malinvestments appear to be a good idea, but they are not. The price system is effectively destroyed and capital investment in appropriate lines of production does not take place. The boom ends because there are not enough real savings to support the malinvestments. The bust should be allowed to liquidate those investments which cannot be sustained. Otherwise, it will be impossible to know what are the appropriate lines of production for the future.

  Published: October 20, 2008 8:19 PM

• Inquisitor

  "There is of course an other way than "harden up". I suggest you to soften down. "

  Not going to happen.

  "Or are you prepared to do lots of reading to prove ME right?"

  No, simply using the search function can do miracles.

  Mises in Ch, XXXI of HA, when delving into an explanation of credit expansion (the centrepiece of his business cycle theory):

  "The objective of credit expansion is to favor the interests of some groups of the population at the expense of others. This is, of course, the best that interventionism can attain when it does not hurt the interests of all groups. But while making the whole community poorer, it may still enrich some strata. Which groups belong to the latter class depends on the special data of each case."

  http://mises.org/humanaction/chap31sec5.asp

  Now, why would he state this if he did not account for it?

  "I have never suggested any knowledge about right rate of interest. It is market phenomenon, therefore it must be set there. I merely say that enterpreneurs are able to make proper decisions based on market data even though the data are distorted by central bank intervention. This example might throw some light on the issue. If government was to subsidize gas producers gas price would be lowered. Yet it would still be functional market, market participants would be able to make right decisions based upon current state, free market price + intervention. The same holds for interest rate. It is very different from fixed gas price or fixed interest rates."

  And how are they to do this when the government is constantly intervening? How are they to know when the interest rate reaches the level at which borrowing is justified? This is not a one-off intervention. The Fed is very active in setting its interest rate targets. So far I see no indication as to how entrepreneurs are meant to overcome this knowledge problem.

  Published: October 20, 2008 8:33 PM

• iya

  "If government was to subsidize gas producers gas price would be lowered. Yet it would still be functional market, market participants would be able to make right decisions based upon current state, free market price + intervention. The same holds for interest rate. It is very different from fixed gas price or fixed interest rates."

  This depends on your definition of "right decisions". The market is functional in sofar as supply and demand will meet, but the structure can become very different from an unaltered market (higher, when subsidized and lower, when taxed).

  Since the central bank has an unlimited supply of credit, it can keep the interest rate at the low levels it set. (It doesn't not force the banks to take it, so it can still result in an illiquid credit market.)

  But the point is that peoples consumption and investment decisions will definitely be altered in a subsidized credit market.
  

  Published: October 20, 2008 9:49 PM

• Beta Hater

  Kilmore,

  "Some people have to cut their spending because certain portion of their wealth has been stolen."

  Yes, but those people who lose their wealth must lose it to somebody. The counterfeiters and early receivers receive the wealth, and they will do the consuming.

  A simple example: If a thief steals 20 dollars from me, my consumption will fall. But wont the thief's consumption increase? The fact that I can't spend the 20 dollars doesn't mean that 20 dollars has been released into the later stages. In fact, the thief likely stole my money precisely because he wants to consume it immediately.

  "Yet we see boom periods are accompanied both by increased consumption and spending on capital goods. How is that possible?"

  It's possible because of capital consumption. That's the heart of the ABCT. Cheers.

  Published: October 20, 2008 9:49 PM

• Greg Ransom

  Great article.

  I hammered Cowen on the capital consumption point a few days ago in the comment section of his blog.

  I'm convinced Cowen has read very little Hayek.

  Really.

  He doesn't know it.

  Published: October 21, 2008 12:10 AM

• Francisco Torres

  I have never suggested any knowledge about right rate of interest. It is market phenomenon, therefore it must be set there. I merely say that entrepreneurs are able to make proper decisions based on market data even though the data are distorted by central bank intervention.

  If the data is distorted, they would have nowhere to start to see the distortion. The pervasiveness of the intervention makes it impossible for investors to know the reality, since the measuring stick keeps changing on them artificially. It is true that inflation by itself does not fuel the business boom (inflation is only the tool); it is the price fixing which is what setting the interest rate is after all which entices investors to malinvest. Investors use the interest rate to "rate" their investments, and since they can only rely on the interest rate as immaculated conceived by the Fed, they are doomed to be fooled.

  Let us say you have an entrepreneur and savvy investor fully versed on Austrian economics. He knows the interest rate is manipulated, but to what extent? By how much? Cannot be known. Also, his competitors will take advantage of the short-run investment opportunities and eat his market if he does not act. So he would have to risk and investment and try to reap the rewards before the coming disaster - and liquidate afterward. Or, he could ride it out, save his holdings, but this would simply take capital out of the market, and his productive ideas out of reach of consumers. It is a perverse system.

  Published: October 21, 2008 12:36 AM

• Félix M

  Well done Mr. Murphy!

  I'll have to buy another few copies of your book to hand out to friends.
  Thank you very much for your efforts.

  Published: October 21, 2008 12:48 AM

• Kilmore

  To Inquisitor:
  I don't pretend to understand Mises' motives, I can only guess. Mises (and many other Austrians then) was an adherent of full reserve banking. Therefore he had to condemn any inflation without much analysis. Moreover historical examples show clear relation between inflation and business cycle. It is natural to leap from this finding to conclusion.

  Contrary to Mises I cannot condemn inflation so easily because I am an advocate of free banking. Under such regime it is perfectly plausible to run on fractional reserves, to print new notes upon nonexistent bullion if depositors are willing to accept extra risk (this is crucial condition of course). Thus free banking is clearly incompatible with ABCT. However truly Austrian attitude, at least I see it this way, is to advocate banking system allowing anyone to enter any contract, even "fractional" one. If ABCT is true, then market fails to run banks properly.

  Contrary to this view, enterpreneurs are perfectly able to adjust their behavior to inflation. If free bank issues too much notes they must assess them lower, their price have to be decreased. The same thing happens when new paper is printed by central bank, money value is diminished. Those who hold such notes face reduction of their wealth. This reduction may continue indefinitely as bank goes on printing. Again, enterpreneurs are perfectly able to handle it. Why should not they?

  
  To Iya:

  Certainly unhampered market would be different from regulated one, but it was not doubted here. Since inflation is redistribution, it must really re-distribute wealth. However enterpreneurs would be able to adjust themselves to new conditions and to serve new customers as well as to former ones. This is the meaning of "functional" market. Contrary to this our financial markets are not functional. Depositors, creditors and managers, they all made very bad decisions in past few years. Simple inflationary redistribution cannot explain it.

  
  To Beta Haters:

  Exactly, counterfeiters do consuming. Why then should there be overall boom? Some people consume more, others consume less. It is not much different from any other tax. Certainly there is no capital consumption caused by such redistribution though capital structure may change to meet altered demand (counterfeiters may have another taste).

  
  To F.Torres:

  The distortion is reality, there is no need to reveal "true" one. Interest rate is really lowered, some people suffer losses, their money are pumped to financial system. Therefore interest rate is right one, it reflects both voluntary saving and forced (inflationary) saving.

  Published: October 21, 2008 4:23 AM

• Current

  The difference between taxation and central bank money creation is quite easy to understand.

  Let's say the US President increases taxes. Every persons income tax increases by 1%. He gives the the gains which are 300 billion dollars to me. It is easy for businesses to plan around this, they can see the change caused by the tax.

  Let's say the US Federal Reserve chairman has 300 billion dollars printed. He gives them to me. This is a vast amount of money and makes me the richest person on earth. This situation is different. Until I begin spending my money nobody understands that they are poorer. Tax gives a signal, money printing gives no similar signal. The money I spend will gradually filter through different sectors of the economy in unpredictable ways, at this stage others will realise that they are poorer than they thought they were. There is asymmetric information.

  This problem doesn't affect free banking systems in the same way. A commercial bank cannot issue new money in the same way the Fed can. If it issues more than it has in reserves then it runs the risk of being bankrupted. This is exactly what happened in the times of free banking. When a bank over issued its competitors would gather up its notes. They would then present them to the bank all on the same day and request them to be exchanged for gold. With no central bank to go to the bank in question was bankrupt.

  The only way a commercial bank can safely expand its money issue beyond its reserves is if its major trading partners know about it. There are still asymmetric information but to a smaller degree.
  

  Published: October 21, 2008 8:33 AM

• PR

  Creation of new money is merely another form of robbery [...] It is just another transfer, nothing else, therefore simple act of money printing cannot cause business cycle.

  Not exactly. The victim of a robbery knows right away that he has been robbed. He will reduce his consumption by that amount immediately because it is obvious that he no longer has it. Inflation is different. The victims do not know to what extent they have been "robbed" for quite some time. Yes, eventually this knowledge will make its way through the economy, but it will do so unevenly just like the newly printed money itself.

  To expect that, say, all wages and prices will simultaneously increase by 0.1% because that much new money has been created is to demand a level of coordination that simply does not exist in human society.

  Published: October 21, 2008 9:14 AM

• Inquisitor

  "Thus free banking is clearly incompatible with ABCT."

  Tell George Selgin that.

  "However truly Austrian attitude, at least I see it this way, is to advocate banking system allowing anyone to enter any contract, even "fractional" one. If ABCT is true, then market fails to run banks properly."

  And why would that be? It applies strictly to a system imposed by force over an entire population. Without bailouts, banks that overissue notes would collapse from bank runs. To me it seems like the market works just fine. Rather, it's the Fed and its associated fraudsters that are the problem. Even if that were so though, the market "fails" at nothing. Instead, it is free banking that would fail at being a viable practice.

  "Contrary to this view, enterpreneurs are perfectly able to adjust their behavior to inflation."

  Why are you comparing banks on a free market to ones backed by force of a monopoly?

  You seem unable to comprehend a very simple principle: this is not analogous to taxation. Money is expanded by multiples, it is not merely transferred. In the process a price, the interest rate, is constantly distorted. Until capital consumption sets in, the process can go on smoothly. And it is bizarre that you insist the artificial interest rate is the real one. This seems more like a thinly veiled agenda in favour of free banking than a problem with the ABCT.

  Published: October 21, 2008 9:35 AM

• Doug

  Just a quick hit - wanted to say that I thought this was a great article.

  Published: October 21, 2008 11:14 AM

• Yancey Ward

  Some have questioned the appropriateness of the analogy drawn between the boat with the outboard motor and credit inflation. I think you are missing the true analogy that Dr. Murphy is drawing. The analogy to credit inflation is the advice of Dr. Krugman- the islanders are led to believe that they can increase sushi production with no actual increase in real savings to back it up (like more labor hours spent maintaining the boats rather than on leisure).

  The boat with the outboard motor is an additional capital item, but it only provides enough sushi to feed Krugman, and he has cleverly fooled the islanders into feeding him rather than fish, pick rice, or maintain boats himself.

  Published: October 21, 2008 3:49 PM

• Som

  Killmore,

  In Hans Herman Hoppe's paper "the economics of taxation" he outlines what taxation does regarding the "wealth effect". He says taxation actually distorts the time preference of the population to higher time preferences. Credit injections and monetary inflation distort the signals of the actual time preference of the population, making it seem lower than it actually is. The inflation "robbery" happens in the long run, once the money runs it's course. Think of the difference of the preferences and desires you encounter right after when someone puts a gun on you and asks for your money, versus someone giving you counterfeit money that you couldn't tell was fake. You know you're robbed right away so feel poorer in the former, but you feel rich until you realized you're money is no good and got ripped off in the latter. Think about what happens when entire populations get robbed (taxes) or conned (inflation) and the differences become clear, even though the end result is the same (impoverishment) the process is different in each case.

  Published: October 21, 2008 5:52 PM

• MIchael A. Clem

  What if it's a race? The lowered interest rates are used to inject new money into the economy, and this new money is used to bid up prices of capital goods because capital goods haven't increased to match the increase in money. Even if entrepreneurs know exactly what's happening, they will try to get as much of the capital goods as they can before they run out, instead of letting others get them and leave them in the cold. I suppose the smart entreprenuer could create a scalable project, one that could be scaled back once they realize that more capital isn't available. Not an easy thing to do, though. Even then, that's no guarantee that consumers will support the end products of these projects, since they didn't save for them--and capital redistribution has already occurred when businesses were busy bidding up the prices of capital goods.

  Published: October 21, 2008 6:44 PM

• Dave

  Cowen's objection is that he thinks ABCT implies that real income/consumption is countercyclical - less consumption during the boom, more during the bust. No one has really addressed this. At least I think that's it - my big problem with this whole controversy is I am not sure what he is saying. Where is this coming from?

  Published: October 21, 2008 8:56 PM

• daneli

  Funny, my expectation would be that credit expansion by the government would have more or less the exact opposite effect Murphy claims. That is, I would expect it to cause production to shift away from current goods and towards future goods.

  Published: October 22, 2008 12:41 AM

• Kevin B

  daneli: I think the idea is that the government's credit expansion encourages production of both current goods and future goods, rather than one at the expense of the other.

  Published: October 22, 2008 2:51 AM

• Kilmore

  To Current and Som:

  Some mainstream economist could point out the fact that price system is unable to transmit information about inflation without delay. This time lag, as it seems, is core of your argument. Consumer has been robbed of his money and yet he goes on spending without knowledge about his diminished wealth. But this is very strange notion I cannot comprehend. Logic of this robbery necessitates change of structure of production. Without such change thieves could not profit from their foul deeds, only if enterpreneurs serve them instead of former customers then their immoral goals are accomplished. Thus there can be no merry meantime when everybody can spend, when both robber and his victim do the consuming. Either production is redirected or not, either robbery took place or not.

  Following example should throw more light on this problem. Lets say there are two groups, plum consumers and apple consumers. If one thousand former apple consumers shifted to plums, then increased demand for plums would have to raise their price (at least in short run). Vice versa, apples would be cheaper. No, says mainstream economist, prices are sticky (market imperfection is their favourite topic), therefore plum and apple prices cannot change fast enough. But this means that new plum consumers cannot get any plums while some apples are left to rot. Production scheme has not been altered at all because prices remain intact. Only through change in prices market can restore equilibrium, apple consumers must get their apples at lower price while plum consumers must pay more. This means loss for apple producers and gains for plum producers. It is very reason why some apple producers shift their production to plums.

  Since there can be no change of production schemes without prior change of prices then there can be no time lag between robbery (inflation) and adjustment of consumer spending because the very act of robbery necessitates price changes.

  Published: October 22, 2008 3:23 AM

• Luis Enrique

  So in your sushi model, the islanders decide to devote 5 people to motor maintenance, but the marginal product of using the motor is only 6 rolls of sushi (the increasing in output coming mainly from reallocation from boat and net maintenance to production). Why would they do that? What makes you think Krugman would ever advise making an investment with such a low marginal product, when the cost is allowing depreciation-replacing capital investment (net and boat maintenance) to fall below break-even? It's not a very convincing argument - people do something stupid, and end up suffering - hence, er ... what?. You have to show why traditional economic theory would ever suppose that the production process would be optimised by doing what Krugman advises in your story. [it wouldn't]

  Published: October 22, 2008 5:03 AM

• Current

  Kilmore: "Some mainstream economist could point out the fact that price system is unable to transmit information about inflation without delay. This time lag, as it seems, is core of your argument. Consumer has been robbed of his money and yet he goes on spending without knowledge about his diminished wealth."

  That's right. It is not just an argument of mainstream economists, but one of Austrian economists too.

  Kilmore: "But this is very strange notion I cannot comprehend. Logic of this robbery necessitates change of structure of production."
  Exactly.

  Kilmore: "Without such change thieves could not profit from their foul deeds"
  No. No major changes in the structure of production are needed to suit them. Assuming they have similar tastes to others of course, which is not unlikely. What changes by theivery and redistribution is the direction to which production is put. Inflation though changes both where production is directed and the structure of production.

  Kilmore: "only if enterpreneurs serve them instead of former customers then their immoral goals are accomplished."
  Yes.

  Kilmore: "Thus there can be no merry meantime when everybody can spend, when both robber and his victim do the consuming."
  Yes there can be capital consumption gives the answer.

  Kilmore: "Either production is redirected or not, either robbery took place or not."
  Production is redirected and the structure of production changes.

  Kilmore: "Following example should throw more light on this problem. Lets say there are two groups, plum consumers and apple consumers. If one thousand former apple consumers shifted to plums, then increased demand for plums would have to raise their price (at least in short run). Vice versa, apples would be cheaper. No, says mainstream economist, prices are sticky (market imperfection is their favourite topic), therefore plum and apple prices cannot change fast enough. But this means that new plum consumers cannot get any plums while some apples are left to rot. Production scheme has not been altered at all because prices remain intact. Only through change in prices market can restore equilibrium, apple consumers must get their apples at lower price while plum consumers must pay more. This means loss for apple producers and gains for plum producers. It is very reason why some apple producers shift their production to plums."
  Your example economy has no capital goods, which is what is at question here.

  Kilmore:"Since there can be no change of production schemes without prior change of prices then there can be no time lag between robbery (inflation) and adjustment of consumer spending because the very act of robbery necessitates price changes."
  No. The nature of capital means that changes are real.

  To give an example. Let's say we have two groups of people. Group A and group B.

  Group B embezzle wealth from group A. They do this by persuading a central bank to issue money to them.

  So, on day 0 each member of group A has £30000 and each member of groups B has £30000. The price level is stable.

  On day 1 the central bank print the money and give it to group B. At this stage group A have £30000 and group B have £40000 each. Note no extra wealth has being produced.

  On day 2 group B start spending their money. The price level begins to rise. Both groups have judged their future spending plans on the basis of the price level on day 0, making appropriate provisions for what likely future price increase. Long term spending, such as on capital equipment will be judged on this basis.

  Only by day 150 does this work itself out. By this time the members of group B have spent most of their extra money. However the plans of both groups were based of thinking that they were richer than they actually were. As a result distortion of the structure of production occurred.

  Once prices begin to increase people's planning is shown to be incorrect. At this stage the recession begins.

  
  

  Published: October 22, 2008 7:29 AM

• Michael A. Clem

  Kilmore, the problem is that there are not enough capital goods to match the increase in money. Prices are bid up for capital goods, and the people that got the newly created money are able to redirect those capital goods to some degree, before prices correct and people realize that there aren't enough capital goods.
  
  Even if the new money went to everybody simultaneously, instead of to just some people, it would still take some time for the prices to be bid up. Since it does only go to some people and not everybody, those people are getting an advantage over others until the price corrections occur.

  Published: October 22, 2008 8:58 AM

• Stanley Pinchak

  Luis Enrique,
  are you suggesting that monetary inflation and interest rate manipulation does not cause capital consumption? You bring up depreciation. I suggest you read Reisman for a background on the effects of inflation and taxes on capital gains and the detrimental effect that these combined have on the capital stock under a fixed depreciation schedule. Traditional economic theory has a very limited understanding of the time structure of production. When you ignore the fact that production takes time, you can not account for the overconsumption which takes place when scarce resources are bid towards both consumption and capital goods as directed by the false price signal in the manipulated supply of loanable funds. It is quite obvious looking at historical business cycles that resources were misallocated, capital was consumed, and overconsumption did take place. If you have a problem with the reorganization as specified by Robert Murphy, it must be of degree and not of kind. Theory and History are against you on this argument.

  Published: October 22, 2008 10:38 AM

• Scott Fox

  A good article, although I had a hard time following the intro and the explanations of Krugman's and Cowen's views. The island sushi example and end-of-article conclusions were fantastic, however.

  From a writing standpoint, I might suggest putting a a little more of your substantive argument nearer the beginning of the article. This will make your viewpoints much easier follow for readers not entirely familiar with the economic language of the various 'schools'.

  I am new to the Austrian school (~6 months), however I do have some insight into written communication.

  Published: October 22, 2008 10:48 AM

• Kilmore

  To Current:

  Even if thieves had the very same taste as their victims the need of price adjustment would not be undone. There is new demand if nothing else. Once prices are readjusted (and that must take place instantly after attempt to spend new money) all victims are aware of inflationary robbery because they cannot buy expected amount of goods and services. Why then should victims go on according to yesterday plans? They face impoverishment, therefore they must act upon new data, not to continue now inappropriate projects.

  Of course some past projects are revealed to be unprofitable under new circumstances, thus they are abandoned. Consequently there is some "capital spending", something is wasted during the transition period. But as soon as the inflationary scheme is firmly established, then new capital structure mirrors new consumer demand (altered original one). This means that central bank should not try to "tune" anything because any change of their policy is very costly, Friedman was right about this. However this is not business cycle, inflation alone cannot fool people. Yes, somebody might err for certain time, but such mistakes are always present, they would be present even under deflation. Yet we see error everywhere during boom periods. How is that possible? My attempt for explanation (I have already described it above) is somewhat different.

  If you lent some money to your friend for next six months your consequent actions would be based upon some estimate of his trustworthiness. Lets consider following two cases, absolute certainty and only half certainty of pay off. If you are absolutely sure then you may plan to buy rare vintage car in six months + 1 day, you may even sign contract with its current owner. You would not sign it if you were only half certain about your friend's trustworthiness. This simple example explains crucial role of risk assessment.

  Now we have got lots of fractional reserve banks here and great part of money supply consists of demand deposits or another contracts. These banks are your friend from example above. During the boom period everyone is absolute certain about their trustworthiness, everyone acts as if there were no doubt about them (I mean every depositor). This means that many people based many decisions upon mere illusion, they plan to buy cars, houses, jewelry and so on on in "six month+1 day". How can be they so sure? Because we all trust banking system, because there are printing presses running behind it, there is compulsory deposit insurance and there is of course government promising to bail-out every big enough bank.

  This is the reason why consumer demand is too high during boom. We all think of our contracts with banks as of absolute certain ones. It is delusion, because bankers make many very risky investments. Why? Because risk is socialized. Each bank is induced to lend as much as possible because it can eat profits and throw risk on the whole system, thus bear only small part of it. It is well known tragedy of commons, every shepherd aims to exploit as much as possible without regard to capacity of "pasture". These risky investments explain enthusiasm of enterpreneurs. To them it is fulfillment of all their wishes, consumer demand is high and interest rate low simultaneously.

  Risk demands creation of pool of reserves, uncertainty must be met by redundant capacity (machinery, storage, more employees, unsold product, cash holdings and so on). Exhaustion of reserve reservoir brings abrupt end of boom. Consumers try to cut their excess spending, to recover their cash holdings, enterpreneurs must stop their business, everyone is forced to pay except bankers. They simply wait for goverment to pour money into their failing companies.

  Thus business cycle is obviously hidden in very nature of our banking system, while inflation is merely convenient method of its funding. This system would run smoothly on any money, not only newly printed inflationary greenbacks. Moreover inflation is not the only scheme employed. Law prevents true competition and enforces compulsory deposit insurance while government is ready to fund banks directly if necessary.

  Published: October 22, 2008 11:23 AM

• Maturin

  This thread has gotten too long to follow logically.

  Let me respond to the conflict between Kilmore and Inquisitor: I believe we have a semantic problem.

  Kilmore said interest rates forced lower by the Fed are not artificial, because they are the real rate offered in the market. But they are also not natural as determined by free market forces, which is the price signal in Hayek's model which leads entrepreneurs to decide how wise it is to borrow and build capital goods.

  While the Federal Funds Rate is the real interest rate for its select market, it is a distortion of the true natural rate in a non-coerced market, and the driving force behind inflation and malinvestment. This govt-determined lowered interest rate sends the wrong signal to the business community, telling them it will likely be profitable to borrow money to expand their business, because the demand curve has shifted in their favor. In reality, it was not the demand curve that shifted, but the supply curve, because the Fed increased the supply. You have to look at Garrison's powerpoint explanations of this model to see this. While the interest rate is real, the "signal" it sends to the market is artificial, distorted by govt intervention.

  Also, this distorted signal to lenders, meaning those of us who put money into savings accounts, says it is not in our interest or profitable to save money in the bank. It changes out "time preference" for how we use our money, more toward consumption. So consumption goes up, which reinforces the artificial signal sent by the lowered interest rate, telling the markets that they are doing better than they are, and that they should expand, that businesses should borrow more money and build more factories to meet this demand.

  It becomes a vicious cycle, with a lag in it as the capital goods get produced. Understanding this lag is key to understanding the Hayek model. By the time businesses realize that they were mistaken in their predictions of the future, they have borrowed and spent, and have to struggle to avoid bankruptcy (as the financial sector is doing now). Suddenly, businesses realize the true demand for what they hoped to produce does not match the signals sent earlier, and the market has to shrink to match reality. But the Fed and now Congress (via bailouts) do not want that to happen, so they continue distorting the signal by pumping in more money at an interest rate below the natural free market rate. Bubble, bubble, bubble..... Ohmygod POP!

  Now who benefited from the artificial signal created by Fed manipulating the interest rate? Initially everyone did, because business was booming. But eventually, the ones who benefit the most, as we have seen in the past few months, are those who control the Fed, who get first crack at the new money as it gets pumped into the system, and thus get the biggest profits from it, and can better predict what will happen and when the bust will come (Goldman Sachs, whose chief economists predicted it a year ago when the Dow was peaking, and the other players at Jekyll Island), and then they can turn to the Fed and demand another infusion when they start feeling anemic. It is a too easily corrupted system, and Jefferson said so two centuries ago, in his struggle with Hamilton (see today's Mises.org article).

  Ron Paul predicted what is happening five years ago, based on his understanding of ABCT. The model is elegant, and has strong explanatory power, and does not rely on animal spirits to explain rational human action in the marketplace.

  Published: October 22, 2008 12:32 PM

• Brian N.

  Mr. Murphy, you've done good. Real good.

  Published: October 22, 2008 8:28 PM

• Jeremy

  Kilmore - "Once prices are readjusted (and that must take place instantly after attempt to spend new money) all victims are aware of inflationary robbery because they cannot buy expected amount of goods and services."

  In what magical world do you live in that all new money is instantly spent? The only way that prices would immediately adjust is if new money lent out was immediately spent by its first recipients, then immediately spent by its second, then third, then fourth, and so on until prices reached a new equilibrium based on preferences of all rational actors in the market. (Note: I don't believe in price equilibrium, but you seem to, so...)

  And you're saying that takes place instantaneously? Are you deliberately ignoring reality? Using a broken model is worse than using none at all.

  The point is this: Prices don't adjust immediately, and even if they did (which they don't) you'd still have to deal with the fact that people don't realize that their incomes have gone down as much as they have immediately. The reason why is because many people are fooled by nominal income increases for a short period of time as they adjust to the new pricing reality. People don't spend money equal on all things at all times or spend all day checking changing prices of all of the goods they will ever consumer, so there is no way for them to become completely aware of all price changes that will affect them in an economy instantaneously as you claim.

  Instead, most people feel 'richer' with higher nominal incomes, and spend more.

  So borrowers and other recipients of new money are spending it to bid up the price of capital goods and consume more consumption goods at the same time - they do this by decreasing their savings (ie through capital consumption).

  If you insist on using assumptions that don't at all fit reality you should be prepared to have your arguments attacked repeatedly.

  Published: October 22, 2008 11:29 PM

• Current

  Kilmore: "Even if thieves had the very same taste as their victims the need of price adjustment would not be undone. There is new demand if nothing else. Once prices are readjusted (and that must take place instantly after attempt to spend new money)"

  Jeremy has dealt with this point. I agree with everything he has said. Prices do no adjust instantly.

  Kilmore: "Yes, somebody might err for certain time, but such mistakes are always present, they would be present even under deflation."
  The errors though would not be systematic. Cental bank money issue causes systematic errors.

  Kilmore:"This is the reason why consumer demand is too high during boom. We all think of our contracts with banks as of absolute certain ones. It is delusion, because bankers make many very risky investments. Why? Because risk is socialized. Each bank is induced to lend as much as possible because it can eat profits and throw risk on the whole system, thus bear only small part of it. It is well known tragedy of commons, every shepherd aims to exploit as much as possible without regard to capacity of "pasture". These risky investments explain enthusiasm of enterpreneurs. To them it is fulfillment of all their wishes, consumer demand is high and interest rate low simultaneously.

  Risk demands creation of pool of reserves, uncertainty must be met by redundant capacity (machinery, storage, more employees, unsold product, cash holdings and so on). Exhaustion of reserve reservoir brings abrupt end of boom. Consumers try to cut their excess spending, to recover their cash holdings, enterpreneurs must stop their business, everyone is forced to pay except bankers. They simply wait for goverment to pour money into their failing companies.

  Thus business cycle is obviously hidden in very nature of our banking system, while inflation is merely convenient method of its funding. This system would run smoothly on any money, not only newly printed inflationary greenbacks. Moreover inflation is not the only scheme employed. Law prevents true competition and enforces compulsory deposit insurance while government is ready to fund banks directly if necessary. "

  No, you are misunderstanding the problem. To give an example, in my home country of Britain the banks once used the gold standard. They also had a central bank that acted as lender of last resort, The Bank of England.

  In that banking system there were socialized losses but no inflationary money issue. It's problems were quite different. There could be no money printing boom that to make people feel richer. However, there was still a cartel of lenders.

  The presence of this cartel didn't mean that risk was particularly high. More that banks had an advantage over other organizations.

  You say: "Each bank is induced to lend as much as possible because it can eat profits and throw risk on the whole system, thus bear only small part of it"

  In the past a bank that lost on high risks would be bailed out, but would not be able to make profits because of the high cost of the bailout. So, each bank did not bear only a small part of the risk, they bore most of it. So, each bank had an interest in lending responsibly even though it was not as strong as it should have been.

  The problem though was that the central bank gave them a special privelege in acting as lender of last resort. It was not like the tragedy of commons, but rather more like a welfare system and had similar issues.

  Things are fundamentally different when the government control the interest rate and influence the money supply.
  

  Published: October 23, 2008 6:15 AM

• fundamentalist

  Rubén Rivero: "...why is the Austrian school considered obsolete?"

  If you want to see an example of how badly off mainstream macro is, visit Arnold Klings comments today over at econlib.org under the heading "A Pat on the Back for Macro."

  Published: October 23, 2008 11:52 AM

• Kilmore

  To Jeremy:

  The very act of inflationary theft requires price change. Without such adjusments production structure would not change a bit and therefore thieves would not get their desired goods and services because enterpreneurs would still serve to original customers. Thus it is impossible to separe price adjustment from inflationary theft, they occur in the very same moment, there is no time lag between them, the word instantly was not misplaced. Moreover price adjustments are prior to production adjustments (because prices govern production and not the other way around). Thus thieves must FIRST announce their robbery to get what they wish.

  
  To Current:

  I just cannot agree. If central banks did nothing else than printing of new paper (I mean really printing) then there would be no business cycle at all. Similarly gold mining does not cause business cycle. The reason is not as some suggest relatively small amount of mined out metal. Even swift inflow of gold into economy would not cause any cluster of errors.

  One serious problem of your example (Britain under gold standard) is the fact that it supports my position, not yours :) Though it was impossible to create money per se, for it was impossible to print gold, business cycle was present. This is exactly what I say. Socialized banking system must always cause boom-bust, inflation is only easy way to finance it. Interestingly some Englishmen recognized the problem and its link to banking system, see currency school. Mises was inspired greatly by their views.

  If government imposed tax on tax holdings, for example three percents, and then gave this huge sum to central bank thus enabling it to lower interest rate what would be the difference between such scheme and inflation? None. Yet you would be rather unwilling to relate taxation with business cycle.
  That's it. Inflation is just another tax while structure of our banking system is real menace causing cycle.

  This stance has got many many advantages. I have already mentioned its compatibility with free banking some few posts above. If mere printing of money cannot cause business cycle then there is no reason to enforce full reserves. Thus there is no need to supress any forms of contracts, not even fractional reserve ones. Another advantage has been mentioned in this post, there is no problem with gold mining, it cannot cause no matter how successfull it might be. Moreover there is no need to be "golden bug", to fight for restoration of that "barbarous relic" as mainstream economists view it. We could finally convince mainstream if we were for free banking and not for gold. (of course it is disguise, free banking would re-introduce gold)
  

  Published: October 24, 2008 2:49 PM

• Jeremy

  "The very act of inflationary theft requires price change. Without such adjustments production structure would not change a bit and therefore thieves would not get their desired goods and services because enterpreneurs would still serve to original customers. Thus it is impossible to separe price adjustment from inflationary theft, they occur in the very same moment, there is no time lag between them, the word instantly was not misplaced. Moreover price adjustments are prior to production adjustments (because prices govern production and not the other way around). Thus thieves must FIRST announce their robbery to get what they wish."

  Sure prices adjust after new money is spent - the point is that this process is gradual, as that money is not spent once but many times.

  The other thing is it is impossible for most people to distinguish between regular price fluctuations and changes due to new money being spent by the recipients of new money.

  "Even swift inflow of gold into economy would not cause any cluster of errors. "

  You're wrong about this - there have been business cycles that were entirely due to influxes of new sources of gold & silver (I don't remember the name of the book but it's somewhere here on Mises.org). The difference being, of course, that such influxes are rare and non-continuous. Printing of money and spending it would cause a business cycle just as fractional reserve banking does - minus the demand deposit bank runs.

  The reason why is any significant increase in the money supply has the effect of lowering interest rates below what would prevail in the absence of the new money. It isn't direct like central bank intervention or fractional reserve bank lending, but indirect in that because an increase in the money supply leads (sooner or later) to an increase in the amount of money available to lend - that pushes the price of lending money down.

  It is this distortion to the interest rate that causes entrepreneurs and top level management to make investments they wouldn't otherwise make - it is also this same distortion that increases consumer spending (money is cheaper, after all) - these investments and excess consumption (often funded by debt) are malinvestments in the truest sense of the word.

  There wouldn't be bank runs under such a system (after all, your demand deposits would be safe and separate from the rest of the assets of the bank - they couldn't claim them as their own assets), but there would still be tons of bad loans made by banks with time deposits.

  Published: October 27, 2008 4:01 AM

• Current

  Kilmore: "I just cannot agree. If central banks did nothing else than printing of new paper (I mean really printing) then there would be no business cycle at all. Similarly gold mining does not cause business cycle. The reason is not as some suggest relatively small amount of mined out metal. Even swift inflow of gold into economy would not cause any cluster of errors."

  I disagree. A swift inflow of gold would perhaps not cause problems if the money holding public knew about it. The problem though is information. You say that if central banks only printed money then there would be no business cycle. I fail to understand why.

  Holders of money do not know how the central bank will behave, they cannot make plans for it. A business cycle is inevitable.

  Kilmore: "One serious problem of your example (Britain under gold standard) is the fact that it supports my position, not yours :) Though it was impossible to create money per se, for it was impossible to print gold, business cycle was present."
  There were crises under Britain's gold standard. However they were linked to wars, foreign events and devaluations.

  Kilmore: "Socialized banking system must always cause boom-bust, inflation is only easy way to finance it."
  You keep saying that, without presenting an argument for it. Why?

  Kilmore: "If government imposed tax on tax holdings, for example three percents, and then gave this huge sum to central bank thus enabling it to lower interest rate what would be the difference between such scheme and inflation? None. Yet you would be rather unwilling to relate taxation with business cycle."
  I think what you are suggesting is that the government impose a tax on money holdings. Let's consider what would happen if they did this. A large amount of money would leave the accounts of money holders. This would obviously drive up interest rates as financing becomes more scarce.

  That money would then be transferred to the central bank. Now, how would the central bank decrease interest rates? To do so they must lend out what they have taken from taxes and increase money supply. In your scheme it is unlikely if the interest rate could actually be changed. To change the interest rate requires money issue or destruction of money.
  

  Published: October 28, 2008 7:06 AM

• Nima

  I think Robert Murphy unwittingly pointed out a little shortcoming of the ABCT. Please find my views on this issue here:

  http://www.economicsjunkie.com/austrian-economists-
  need-to-get-their-business-cycle-theory-straight/

  Let me just point out: I did not say that the ABCT (in its commonly known form) does not account for increased consumption spending. I say that it does not explain why producers actually produce more consumption goods than before. I do understand the tug of war concept, and the increased demand for consumer goods. However, I maintain that it does not sufficiently explain why the entire structure of production during the boom is being aligned to actually respond to this increasing demand by PRODUCING more consumer goods and NEGLECTING the procuction of capital goods.

  Robert Murphy's Sushi is actually a perfect example for what I propose to call the consumption business cycle. In his example, more resources are allocated to the production of consumer goods (gathering rice, catching fish), and fewer are being allocated to the upkeep of capital goods (maintenance of boats and fishnets).

  During the equilibrium state 25 people were employed in the capital goods industry. After Krugman's advice it's only 10 people, out of which only 5 perform the criucial task of boat maintenance. He perfectly explains the phenomenon of increased consumption and corresponding production of consumer goods, but it does not occur due to a channeling of resources away from short term projects toward longer term projects. In fact, it occurs due to the exact opposite. Resources are taken from projects that yield an output at a later point in time (maintaining boats), and are directed toward projects that yield an immediate output (collecting rice, fish, and combining the two).

  Published: July 20, 2009 1:28 AM

• Rick Weber

  Question: What are some examples of intermediate goods that we've seen neglected in this (and/or past) recession(s)?

  Thanks for an excellent post!

  Published: September 8, 2009 11:37 AM

• Konstantin

  I like this article very much but did I miss something? The island economy seems to lack money. They do have division of labor which is altered by Krugman's interventions but there is no analogue of a Fed creating "fake warehouse receipts".

  Published: October 15, 2009 1:54 AM