peristaltor: (Default)
peristaltor ([personal profile] peristaltor) wrote2012-03-07 02:22 pm

To The Austrian School (And Others) I Take Exception

In one of the many recent money and finance posts and comments recently, I got a link to the Austrian business cycle theory. At first, it makes sense, echoing much of what I've been writing about, all this bank money creation and government money creation. Some points with which I am in general agreement:

Banks expand credit . . . often supported or encouraged by the setting of low interest rates by a central bank. This additional credit flow into the economy from increased borrowing for capital projects stimulates economic activity. Projects which would not have been started before, seem now profitable, creating malinvestment. They increase demand for production materials and for labor and their prices rise, which, in turn, leads to an increase in prices of consumption goods. If the banks would stop the extension of credit, the boom would be rapidly over. To prevent the sudden halt of this boom (and the resulting collapse of prices), the banks must create more and more credit, and the prices will rise even more.

But this expansion of credit cannot continue forever.


First, observant readers will note that I will in no way touch the Austrian concept of "malinvestment." Why is simple: I don't believe it exists. What people find worthy of their investment dollars is now and will always be what people find worthy of their investment dollars. Now, do I think some of those are insane as investments? That's a different question for a different day.

To rephrase the above intro to a business cycle, banks lend money into existence, which is spent on assets. Some of those assets yield profitable returns or resales; these assets are the subject of further investment. More and more borrow to themselves invest in these assets; the continuing increase in the money supply makes the continuing asset price rise possible. This continues until either the credit extension or the price rise balk.

With this I would agree.




That agreement doesn't, like a credit expansion, go on forever. First, note in the quoted block above an ellipsis. Here is the phrase I removed: ". . . well beyond their own assets and by the funds of their clients." Uh, what?

If a bank is under a strict gold standard that statement might be true. Most banking systems, though, count viable assets (such as the collateral used to secure loans) as legitimate backing. To reiterate the last crisis, let's use houses for an example. As long as the houses maintain their resale value, the bank is safe lending, since it can simply sell the foreclosed house after a default. Furthermore, as long as the bank maintains the required fractional reserve, the central bank will back any short-term shortfalls in currency assets that might occur if depositors make a "run" on the bank. The bankers might have to liquidate some assets to carry them over the hump of a run, but for the most part these panics are short-lived if they are backed by the central authority and some kind of insurance.

Therefore, the phrase "well beyond their own assets and by the funds of their clients" has little if any meaning. Let's continue from where I left off, shall we?

But this expansion of credit cannot continue forever. There is no additional capital or labor; there is only more money (and debt). The means of production and labor which have been diverted to the new enterprises have to be taken away from others. Society is not sufficiently rich to permit the creation of new enterprises without taking away from others.


I have a wee but significant problem with this description. Why? As long as there are un- and underemployed people in the society willing to work and able to do that work, most societies can expand their economic activity. I've worked in factories before. Most run one or two shifts; when business gets hopping, they run three. The argument that society "is not sufficiently rich to permit the creation of new enterprises without taking away from others" ignores under-utilized labor and another very, very important one: Mechanization.




When one of us does a job, we very seldom actually do the job. For example, this morning I took about 180 people to and from work (mostly, I assume, to). I must be a brute to lift all these people on my shoulders, what? No, I just drove the bus. (Actually, I "operated" the bus; "drive" is a word English speakers carried over from what we teamsters used to do with harnessed animals.) That 60-foot wheeled diesel machine did all the work. As long as tasks can be mechanized, and — here's the really important bit — as long as we can fuel those machines, we societies can indeed "permit the creation of new enterprises without taking away from others."

I was thinking about this point after I read beyond the introduction I'm quoting and found this tantalizing sentence: "The regularly occurring booms and and busts were observed from approximately late eighteenth century, along with the start of the Industrial Revolution." Aha! The era of steam brought with it an era of, er, expansion, which in turn led to an era of booms and busts unlike those from previous eras. Those eras, too, did have their financial disasters. Recall the tulipomania in Holland or the South Sea Company bubble in London. Both of these preceded the age of steam, true. But both of them resulted from the sudden injection of wealth made possible by harnessing energy with another technology, wind that filled the sails and drove (there's that misapplied word again!) ships filled with booty from far-away lands.

So, continuing after "along with the start of the Industrial Revolution," we read: "Sudden economic crisis, when some king made war or confiscated the property of his subject were known; but there was no sign of the modern phenomena of general and fairly regular swings in business fortunes, of expansions and contractions." Didn't I just list two such crises? Ah, but these are one-off blips in economic weirdness, not "fairly regular swings in business fortunes."


Stephenson's Rocket, the first
practical steam locomotive, 1829.

When we got to the Industrial Revolution, changes that would have taken a century with mechanized help from wind transport started to take but decades; the rapid accumulation of change would have in turn affected the banking cycle of lending and the monetary creation implied therein. More wealth means more collateral means more lending.




From here on, though, the exceptions I take get drastic. Continuing, this time with emphasis:

As long as the expansion of credit is continued this [shifting of resources] will not be noticed, but it can't be pushed indefinitely. The inflation and the boom can last only as long as the public thinks that the prices will stop rising in the near future. When the public becomes aware, that there the inflation will not end, and that prices will continue to rise, panic sets in.


Here the Austrian School is talking out of its collective asses.

Think about it. You are an investor. Why are you an investor? Because inflation is constantly eating the value of your bank- and mattress-deposited cash. You seek an asset that has been lately increasing in value (or, even better, you think will do just that in the future). You buy it. That house is all yours. A prominent article featuring your neighborhood gets published and it's off to the paper equity races.

Others hoping to ride this bonanza take out bank loans for their own up-and-coming fixer. The price skyrockets, buoyed not just by the enthusiasm houses have fired, but by the increase in dollars floating about looking for purchases. If enough enthusiasm flames for long enough, even bankers will forget prudent lending standards and issue loans to questionable lenders using their iffy houses closing for double-you-tee-eff prices.

As long as the resale prices continue to rise, or as long as bankers continue to honor the resale value of these houses with collateral status, inflation will continue, which, unlike what the Austrian School maintains in the selected quote, is exactly what the investors hope will happen. Once a house fails to resell or, more likely, once a buyer goes delinquent on his or her loan, though, the party is just about over. It is inflation's end, not the threat of its continuance, that panics investors. Finally:

Eventually, people may give up the currency and rush to exchange money for goods, buying things they have no use for, just in order to get rid of the money (the so-called "flight into real values.")


In case you think that might be a typo, here they repeat the theme. Why in the living hell we call banking would they do that?!? As bank debts backed by falling house prices continue to default, the remaining money in circulation becomes more valuable! Things of value are hoarded, not abandoned!

I do think there is a lot of buying and selling as a bubble deflates, but that is probably just the fire sale following a crash. People may have lost value in their house, yes, but that doesn't end the contractual obligation for them to repay the loan that bought that house. Liquidating other assets might be the only recourse they have. Oh, and let's not forget that, unlike the Austrian concept, no one gets "rid of the money" when we buy and sell. It goes from one hand to another. The only main destroyer of money is deflation; the main cause of deflation is a loan default and collateral value collapse.




I should specify that I have nothing against the Austrian School of economics. Nothing personal, that is. I invite those who claim allegiance to Mises and Hayek and the rest to correct me as they feel needed. Better yet, go back to the source material and see if the Mises Wiki is wrong at all. As long as the Austrian School of Economics hopes to be considered in any way scientific, however, diversions from empirical reality such as those I outlined above must be abandoned, or at the very least amended to conform to empirical tests.

After I read this entry a week or so ago, I started to ponder what a "theory" actually was, especially a scientific theory. Empirical testing is but one element of a theory. I'll ponder what other benefits a theory must have later.

X-Posted to [livejournal.com profile] talk_politics.

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