Domino effect of failing banks, role of inflation, and critique of Austrian economics

Economics Economics Questions
1

A cousin of my wife is an investor (his political beliefs are moderately conservative). I’ve been having a discussion with him about Austrian economics and the current events. He is clearly not an Austrian, and although I read articles on Mises.org, I am a biologist, and he is an investor, so he clearly knows more than I do. I was interested what people might say to some of his arguments (not so that I can rebuke him, but so that I understand more clearly why he is wrong).

I am quoting from his latest reply:

  1. The money supply needs to increase along with the growth rate of the economy to get zero inflation. That way, there are more dollars out there when the total value of goods and services goes up. [In the previous e-mail, he claimed that while excessive inflation if clearly bad, some level of inflation needs to happen. So, once the government establishes that “healthy” level of inflation, things will be hunky-dory.]

I agree that going off the gold standard caused much of the hyperinflation of the '70s. Since that was brought under control, inflation has been relatively tame. It was the transition to fiat currency that caused the hyperinflation, not being on it.

Yes, the economy grew in the 19th century, but it was a tiny fraction of the growth we have had in the last 30 years! Lack of inflation doesn’t lead to no growth, it leads to very slow growth.

  1. It’s just not true that most booms and busts are caused by monetary policy- throughout history there have been booms and busts, caused by various factors, including environmental, mercantile, emotional, etc. The great depression was before fiat currency, as was tulip mania in The Netherlands, countless famines, and hundreds of other crises of tremendous severity. Mistakes managing interest rates can cause booms and busts, but not managing at all practically guarantees them, and ones of much greater severity.

  2. [I am particularly interested in a response to this point:]

The national housing crisis is over already, so it’s not possible for it to continue. Housing prices in much of the country have already begun to come up. The exceptions are places with unusually large numbers of forclosures, where it will be awhile before those can be worked through. Those areas will hinder growth somewhat in the near term, but will not have a huge impact.

Many of those numbers cited were just the federal government giving a large enough backstop to banks and others so that the market would not question their ability to pay- those huge amounts never changed hands and never will. They could have doubled those numbers yet again and it would have zero impact.

If students of the Austrian school had made all of those decisions in 2009 [to let the banks fail, etc.], we would be in a depression right now, because there would have been a domino effect among failing institutions, most large companies would be wiped out (including ones that were never in any danger under the scenario that actually took place), the unemployment rate would be about 10% higher, and the US government’s balance sheet would actually be worse (because the depression would reduce tax receipts by much more than they “spent” on the bailouts and stimuli. We wouldn’t be falling as long because we would have hit rock bottom too quickly. The economy might have begun rising more quickly (though I’m not convinced), but still would be way behind where it is now, and probably would be for another 5 years, because it would have fallen so far.

Thanks…

2

I am also actually interested in the point of 19th century vs. 20th century. If the government’s monetary policies were so disastrous in the 20th century, why has the rate of economic growith after WWII been greater than in the 19th century? (Or has it?)

3

Here he’s implicitly appealing to the notion of “price stability”. My question to him is why “price stability” is necessary at all.

There was no hyperinflation in the '70s. If there had been, people would’ve stuffed the trunks of their cars with dollars before heading off to wait in the gas lines. He’s referring to inflation, not hyperinflation.

This is just a bare assertion on his part. There’s no reasoning here.

An argument could be made that bank notes from fractional-reserve banks are fiat currency to some extent. Otherwise, the Austrian Business-Cycle Theory (ABCT) doesn’t rely upon fiat currency per se to explain business cycles. It relies upon fractional-reserve banking which is under some degree of central, systematic control. Even before the Federal Reserve System was established, there was centralized control of money and banking in the US under the National Banking Acts.

Regarding the “tulip mania” in the Netherlands, yes that could be considered to be a speculative bubble, but speculative bubbles per se are in no way the same thing as business cycles. If there’s any causality involved between the two, then either speculative bubbles (can) cause business cycles or business cycles (can) cause speculative bubbles. In the former case, the questions arise as to what then causes speculative bubbles and when do they actually cause business cycles. Likewise, in the latter case, the questions arise as to what then causes business cycles and when do they actually cause speculative bubbles.

More bare assertions. Does he have any reasoning or evidence to support these claims?

What “numbers cited” is he talking about?

The Austrian-school rejoinder is this: the “domino effect” would’ve happened for a reason - namely to liquidate malinvestments and reallocate capital. His argument boils down to the notion that, had nothing been done back in 2008 and so forth, more people would’ve lost their shirts, and this is necessarily a bad thing. Austrian-school economists don’t agree with that last part.

As a piece of historical counter-evidence to your wife’s cousin’s “argument”, I present the “German economic miracle”.

4

Something that’s good to remember is that investment does not equal economics. Knowing a great deal about the way that specific markets function does not tell one how it is that all markets function

“The money supply needs to increase along with the growth rate of the economy to get zero inflation. That way, there are more dollars out there when the total value of goods and services goes up. [In the previous e-mail, he claimed that while excessive inflation if clearly bad, some level of inflation needs to happen. So, once the government establishes that “healthy” level of inflation, things will be hunky-dory.]”

This will lead to inflation, it will not lead to price inflation, however. The fact is that this still increases the money supply and therefore disalligns the monetary structure, and thereby the structure of production. Just because the population grows by a specific number in no way means that the demand of money will keep up. Money is not neutral, and so its flow will be unpredictable, and there will be miscalculation no matter what monetary policy is adopted.

“I agree that going off the gold standard caused much of the hyperinflation of the '70s. Since that was brought under control, inflation has been relatively tame. It was the transition to fiat currency that caused the hyperinflation, not being on it.”

It’s actually fairly true to say that increases in the money supply have been “relatively tame”, since going off the gold standard after the 70’s. It was about the same as before, actually. But with this said I think it’s hyperbole to say that the main reason the hyperinflation occurred was because of “transition”, rather than conscious monetary policy.

“Yes, the economy grew in the 19th century, but it was a tiny fraction of the growth we have had in the last 30 years! Lack of inflation doesn’t lead to no growth, it leads to very slow growth.”

By this same logic you could point to how real wages were going up much more when there was deflation in that time as opposed to now. Correlation does not equal causation, and the reason that it was but a “tiny fraction of current growth” was because the economy now is far, far larger because of the growth of the past! He offers no backing to his claim besides supposedly “historical” evidence.

I’ll address the other two points later. The second point is pretty foolish and mostly misses the issue, but it has grain of truth, and I actually agree with a lot of the third point.

5

Thanks for the responses.

I just wanted to mention quickly about the 19th century statement. It was in response to my statement earlier that in the 19th century, there was no or little inflation, yet there was economic growth. To which he replied that the economic growth was much lower than in the 20th century.

6

So, just thinking theoretically: wouldn’t you still need more money in the economy as the number of products rose? Enough money to get all the transactions going?

I understand that on a gold standards, greater demand for gold would produce greater supply (through price of gold rising). But how would this regulation happen under the fiat-money system if the government doesn’t set a low and constant inflation rate?

7

No. Why do you think that the amount of money should match the amounts of products/services, and what does that even mean? The same amount of money could “cover” twice the amount of products/services at half the price. Also, since under a fractional reserve system all new money must be lent into existence (created as debt), this would mean that the amount of credit/debt should match the amounts of products/services which is absurd.

What is an “investor”?

8

I’d ask him to support his assertion with evidence and methodology.

9

No. As z1235 also said, if the amount of money in an economy stayed the same over a period of time, while the number of products rose, the same unit of money would purchase more products at the end of the time period than at the beginning (ceteris paribus - all other things being equal). Furthermore, the increase in purchasing power would match the increase in the number of products.

There’s no reason for more money to be needed in an economy where the number of products is rising, unless one is devoted to the notion of “price stability”. If the latter is true, then the question is why he’s devoted to that notion. (It probably has to do with rent-seeking.)

When gold is used as money, the price of gold (as money) is the same thing as its purchasing power. If people come to prefer owning more gold than other commodities, their demand for those commodities will fall. Ceteris paribus, this means the prices of those commodities will also fall.

Under a fiat-currency regime with a constant money supply, the same will hold true. Gold is now just another commodity; it has no special value as money.

10

I’d ask him to support his assertion with evidence and methodology.

Well, do we have any way of measuring growth of absolute wealth per capita in the 19th century vs. teh last three decades?

11

Well, for instance, if someone has mortgage, and the deflation happens, wouldn’t that hurt his mortgage? The same goes, I guess, for any loans…

12

I’m not sure, but my point was that the burden of proof lies with him.

13

If someone was doing something that hurt them, I would advise them to stop doing it or, at least, to do less of it.

14

Deflation can hurt a mortgage (or any other loan) if it’s interest rate is variable. I think it’s doubtful that wages and salaries would actually go down during deflation because businesses would still be more profitable, ceteris paribus - the same level of revenue could purchase more goods and services. However, it’s possible that incomes for some self-employed people may go down, as the prices of the goods and/or services they provide go down. I think the people who would face diminishing incomes during deflation would be those people whose productivity hasn’t risen.

15

“2. It’s just not true that most booms and busts are caused by monetary policy- throughout history there have been booms and busts, caused by various factors, including environmental, mercantile, emotional, etc. The great depression was before fiat currency, as was tulip mania in The Netherlands, countless famines, and hundreds of other crises of tremendous severity. Mistakes managing interest rates can cause booms and busts, but not managing at all practically guarantees them, and ones of much greater severity.”

As Rothbard points out practically every time that he talks about the business cycle is that they are all characterized by the fact that they are not caused by any evident factor. Indeed in all traditional models of the business cycle, except for real business cycle theory, is that there is no actual change in aggregate supply which leads to the recession, it is caused by a mismanagement of production. Name the last time that a “business cycle” was caused by an obviously “real” phenomenon, rather than the way that production has been carried out. It is especially difficult to describe the “boom” phase of the business cycle if you are referring to “real” causes.

So environmental factors would obviously be “real” causes, but they are really talking about a “downturn in business” or a “decrease in aggregate supply” rather than talking about a business cycle. I don’t really know what a “mercantile” business cycle would mean, unless he’s talking about trade wars and the like, in which case this would act in the same way that “environmental” factors would. Finally, “emotional” factors can count for small business fluctuations and business cycles, but there’s no reason why it is that entrepreneurs who are usually so amazingly reliable and who are good at organizing the structure of production, should suddenly all make mal-investments. Bubbles and emotional explanations are non-answers. They don’t explain anything beyond a small business cycle. Perhaps amazing overoptimism could create a small bubble, overriding people’s better judgment, but why would it be that it would fool thousands of people whose job it is to be hard-headed and to assess these sorts of things? Indeed the only way that this could be a major problem would be if the government propped up businesses in some way or other, which I would blame the current recession on as much as traditional business cycle theory.

He doesn’t provide any reasoning, just assertion.

“The national housing crisis is over already, so it’s not possible for it to continue. Housing prices in much of the country have already begun to come up. The exceptions are places with unusually large numbers of foreclosures, where it will be awhile before those can be worked through. Those areas will hinder growth somewhat in the near term, but will not have a huge impact”

I’m not entirely qualified to say this, but if I had to guess then I’d say that this was bull, because the government has done everything in its power to prop up home prices and keep the bubble inflated as much as possible.

“Many of those numbers cited were just the federal government giving a large enough backstop to banks and others so that the market would not question their ability to pay- those huge amounts never changed hands and never will. They could have doubled those numbers yet again and it would have zero impact.”

This is econ-jargon which when decoded means: We backed up institutions with bad loans/that were fraudulent.

“If students of the Austrian school had made all of those decisions in 2009 [to let the banks fail, etc.], we would be in a depression right now, because there would have been a domino effect among failing institutions, most large companies would be wiped out (including ones that were never in any danger under the scenario that actually took place), the unemployment rate would be about 10% higher, and the US government’s balance sheet would actually be worse (because the depression would reduce tax receipts by much more than they “spent” on the bailouts and stimuli. We wouldn’t be falling as long because we would have hit rock bottom too quickly. The economy might have begun rising more quickly (though I’m not convinced), but still would be way behind where it is now, and probably would be for another 5 years, because it would have fallen so far.”

The fact is that there are a large variety of problems with the current financial system, all arising from the inherently unbacked nature of modern fiat currency. To let the banks fail would have meant the death of the modern financial system. There would never have been a crash like it because there would have been an utter collapse of the banking system, specifically because they couldn’t repay their loans or make up for their current losses. I would have to say that no matter how the situation was handled then the fact would have been that the costs of the bailout were less than what the alternative would have been. The chain reaction would have caused the dollar itself to collapsed and standards of living would have decreased drastically because interest rates would have skyrocketed and new businesses would have had an extremely difficult time funding themselves. With all of this said this whole problem is caused by the failures of the current system, of the fractional reserve process, all of which was the fault of the government and the federal reserve.

So you couldn’t just let the banks fail, but the problem and the reason why you couldn’t is due to the nature itself.

16

Do you think such a systemic collapse is now guaranteed not to happen in the future? Or do you think it’s been merely delayed by the bailouts and such?

17

Spoken like a true investor. Ask him to explain how not managing rates ‘practically guarantees booms and busts’. Ask him what interest rates are, and what they signify to investors and then come back with his answers.

Also Business Cycle Theory does not depend on the existence of a central bank like the Federal Reserve System. National Treasuries have often behaved like central banks by adjusting reserve requirements and “injecting liquidity”. (See: L.M. Shaw and Lyman Gage)

Prices rising on homes doesn’t necessarily mean that the housing market has hit its true floor. When the Fed purchased massive amounts of Mortgage securities at top dollar it raised the actual housing floor from what the price level would have been.

So what did we do instead? We bailed out insolvent banks and put the cost on the taxpayers. This is clearly immoral. But such arguments have no traction and are relatively meaningless in a case of ‘what should be done for the best outcome’. So what’s next?

There’s stacks on stacks of new money sitting in the reserves of the big banks. Should the economy recover and cash circulation picks up again, this cash will be dumped onto the market causing inflation. We already have some significant inflation despite the bank’s tenuous lending practices. Meanwhile the government’s interventions have prevented the structures of production from re-alligning to actually existing price signals. They have kept prices from falling, thus disallowing a structure of production that would be more profitable in todays’ conditions. Granted it is true that this action prevented monetary contraction and numerous bankruptcies. Despite that act, there is the looming cloud of the coming depression. Companies laid off workers to ‘strip off the fat’, banks are holding reserves out of fear that the long whip of debt exposure will snap in one of their faces, all the while food stamp participation has been skyrocketing (and this service is contracted to JP Morgan by the way). The economy is defined by fear. Consumers are afraid to put their cash out while the government continually attempts to coax them out, simultaneously making it easy for the government to continue spending and the banks to have a chance of survival.

So instead of letting the shock wipe out the debtors (causing bankruptcies and unemployment), readjust the structures of production to the needs of the consumers, we have floated the banks, given the big companies breathing room, loaded the citizens with debt, inflation, and less unemployment, and there’s still the bigger shock on the horizon.

So the question is: do you prefer 2 financial shocks with a depression in between, giving a chance to the banks to make off like thieves? Or 1 financial shock. Both options are painful, but most of us are under the impression that if we can just keep the DJIA at a certain level, the second crash won’t come. But the money printing hasn’t made the economy more productive or profitable, it’s simply sustained the structures of production that were incompatible to the consumers by cheapening debt.

I guess there is a third option, and it is foreseeable: that the central banks continue to cheapen debt and print money until the currency loses is value. This option is in-line with the state academics/intellectuals refusal to acknowledge a problem with their models and also with the powerful interests associated with the Fed that don’t want to see their asset prices sink like a stone.

P.S. Cantillon Effect.

18

I have to admit, it was a total chore to read his nonsense, but I think it will be useful to have proper responses here.

Mmmkay. And my cat’s breath smells like cat food. So?

Who says we need prices to stay exactly the same? And what the hell makes him think a handful of people in an expensive room in Washington can micromanage an economy of 300 million people? Is he still under the impression that central planning works? Did he miss the day they taught history in history class?

You mean since the way inflation is officially measured has been changed, official measurements of inflation have been relatively tame…right?

First of all, that’s like saying “it was setting the house on fire that caused it to burn…not the house being on fire.”

Second, what hyperinflation? When? What is he talking about?

Source? Where is he getting this from? How is he defining “growth”? And more importantly, how is he measuring it? Did he just make this up and is expecting it to be true?

Source?

Emotional booms and busts? Is he serious? Is he trying to sound knowledgeable by just throwing out words? Honestly he sounds like the pony. “Emotional booms and busts.” Give me a fucking break.

Didn’t everyone already try that one on the current crisis? Wasn’t I told that “greed” was the culprit? Kind of like the time I was told “gravity” was the reason the plane crashed?

I guess it’s clear being an “investor” doesn’t qualify you as a historian. (Read: he needs to go back to class)

No one said anything about fiat currency being necessary for bubbles to occur. It’s about increases in the supply of money.

Name the ones you’re thinking of and I’ll help you understand their origins.

I suppose he’s under the impression the things he listed prior to this sentence serve as supporting examples of this ridiculous claim, but in fact they don’t. I provided two separate links to excellent resources regarding the only two specific crises he named, and if he would be so kind as to offer examples of any others, I could do the same for those.

I’d really hate to see this “investor’s” portfolio.

Right. And I’m sure those are perfectly reasonable, market prices…not at all inflated or propped up, or in any way affected by the tax credits, tax deductions, guaranteed loans, and any of the 18+ programs designed to artificially influence consumer behavior in the housing market…let alone the trillions in new money the Fed continues to create out of thin air.

Oh. So you mean the down market will continue. That’s funny cuz two sentences ago I could have sworn you told me it was impossible for it to continue. Must have been my imagination.

Just like the crisis was “contained” in the subprime market and wouldn’t “spill over” into prime mortgages? Just like we wouldn’t see an overall dip in housing across the country because “housing is local?” Has he been listening to this guy again?

What “numbers”? What the hell is he talking about?

…and of course he has proof of all that.

I’m quite interested how he’s concluding that scenario…and even more interested where this 20% unemployment rate is coming from. Certainly not the government’s figures. They said without the recovery plan unemployment would peak at 9%. As we all know, unemployment was well above that (even earlier than their time tables).

I don’t even have to provide any counter evidence (even though I could), because he hasn’t provided any of his own. He’s given no support for anything he’s said so far…just the same scare stories Congress gave while they were trying to pass a bill while trying to claim there wasn’t even time to read it.

I don’t get it. It sounds like he just admitted we have farther to fall. Wasn’t his whole premise that we are already out of the woods and growing again?

This guy is incredibly confused. Send him a copy of Meltdown or Crash Proof or Financial Fiasco. Also for more info you might check the links here and here.

19

:slight_smile:

Thanks for the reply. I need time to process it.

Sorry, the “numbers” that I quoted my cousin-in-law talking about were from my previous e-mail. I listened to Doug French’s talk on the housing market and said that the government practically bailed out the banks for 7.7 trillion dollars. Plus, whatever Mr. French said about the aid to BoA, etc.

20

Was there fiat currency in the US before the Great Depression? I am also an ignoramus.