http://snakepit.brokesnake.com/2009/04/07/a-theory-to-explain-business-cycles.aspx
The more damage you can inflict upon my argument, the better it will become. go nuts.
I like my explanation of business cycles better. Refer to my posts on the Compound Interest Paradox.
With fiat debt-based money, new money is created only when someone takes out a loan. Only the principal is created and not the required interest payments. This means that debt grows exponentially faster than the money supply. Continuous inflation is needed to keep the scam going. Old loans can be repaid only because new loans keep being issued.
During a recession/depression, fewer loans are issued. This causes a crash as people scramble to repay their loans. During a boom, people have access to easy credit and borrow to the maximum. If you aren’t “too big to fail”, you’ll get wiped out during the next deflationary recession/depression.
Boom/bust cycles happen pretty regularly every 5-10 years. Boom/bust cycles aren’t an economic law of nature. They’re a consequence of a fundamentally corrupt monetary system.
Some idiots here say “FSK is wrong about the Compound Interest Paradox”. I got frustrated debating idiots and normally focus on my own site. I haven’t seen any coherent counter-arguments to the Compound Interest Paradox. If I don’t waste time responding to an idiot, that doesn’t mean I accept their criticism.
The Compound Interest Paradox (also known as “The Debt Virus”) isn’t a proper part of “Austrian Economics”. It’s a very important idea. Mises is dead, so we can’t ask him what he thinks about the Compound Interest Paradox.
Forgive me if I’m missing something, but is this really a paradox? Suppose $1000 is lent to some guy at 10% interest. He needs to pay $1100 next year. Suppose we assume, as in your example, that while the $1000 of the principal is created, the $100 he’ll need to pay the interest is not. Is this really a problem? Only if we assume the $1000 can be spent only once. But since that $1000 will likely change hands numerous times, making possible the purchase of far more than $1000 worth of goods as it moves from one economic actor to the other, I don’t think a problem exists. The guy who borrowed the original $1000 will earn the $100 necessary to pay the interest from his work, where portions of that initial $1000 will circulate.
…not only that but furthermore, fsk has not provided a theory of ‘malinvestment’. he has not explained boom/bust cycle, he has merely assumed a bust. and not even mentioned a boom.
Nice point concerning the general applicability concerning price fixing and its flaws in regard to the business cycle, however, it might be useful to note that since the example of beer concerns only intratemporal discoordination it is less harmful than price fixing the interest rate which concerns intertemporal coordination.
However, at one point I think you put the cart before the horse. Moreover, I think you missed the point that any form of coercion (including fraud) circumvents the price system and therefore could be considered a form of price fixing. It is into this category that FRB fits, especially considering that it came before central banks, and in fact, central banks are the logical result of the fractional reserve banking.
With regards to your criticism of Keynesianism missing the point due to focusing on aggregates, I think you could go further, their macroeconomic theories are not connected to the microeconomic foundations of economics, furthermore, they do not understand the nature of time in regards to human action and as such the elaborate construction of the theory of capital. Hayek highlights this nicely in a footnote is his essay on the Ricardo Effect, which is a great read.
Upon further reflection it seems to me that Keynesian policies are almost a self fulfilling prophecy, what is needed is for workers to understand the necessity of reductions in wage rates, however Keynesian policies deny that this need be so and hence create the very problem they wish to solve. You correctly noted however that what is needed is flexibility in the market, especially in the labour market, since this allows resources to be put back to their most effective use and solve the problem that the boom creates.
I think you could take the third problem in the “Fool me once” section further, the fact of the matter is that even in an entirely free market entrepreneurs would never be able to know the true interest rate, the interest rate is charged merely tends to that rate, in a free market (defined as being without FRB) this is not a problem since banks who charge an interest that is way off would quickly lose money and be corrected, this is not so once FRB comes into the picture, since the profit and loss mechanism no longer works.
I think it might be useful to illustrate how natural growth (through a fall in time preference) occurs in an unhampered market in order to compare this with the artificial “growth” that results from an expansion of credit, but otherwise this is a very useful blog post, I take it if you’re posting it here you won’t mind if I link it in any other threads asking about the business cycle.
You haven’t been looking very hard. (a) There is no requirement to pay the money back in one lump payment, and (b) the bank spends the money it receives from loan repayment back into the general economy. To clarify on (b), the bank has to pay all its employees, who spend the money on everyday goods and services.
As I pointed out earlier, G. Edward Griffin covers this in The Creature from Jekyll Island. No one is trying to marginalize you, only to get you to be a little less paranoid and think it through. Think about a non-fractional reserve banking system, whose loans create absolutely no new money. Shouldn’t such loans be even more difficult to repay?
What is your solution? Get rid of credit? money?
Thanks for the response, Giles.
This blog is a little less than “scholarly”. I did not want to write as though I were speaking purely to college graduates or intellectuals. I’m afraid using words like intertemporal might start to lose the audience.
You do make some good points, that I will reincorporate into my post. Thanks.
As far as the naturally lower interest rate, I may save that for another post on this topic. I’d like to make a ABCT post every 3-4 months, just to try to hammer into these rednecks heads the core principles of the Austrian theory. I don’t need everyone to pick up all the intracacies in my first post on the subject.
There is no such as the “compound interest paradox” when the Federal Reserve constantly engages in creating debt free money by paying off security holders, monetizing government debt, and paying interest on member banks’ reserves. The discount rate is rarely used these days, except when bailing out a financial institution, and money created via fractional reserve banking is not withdrawn from the system when a loan is paid back, it is simply paid out in dividends and/or reinvested.
But of course you can go ahead by poisioning the well and using other logical fallacies to cover up fact.
In order to understand how the business cycle occurs, you need to understand how normal economic growth occurs.
Normal economic growth occurs when some people decide to save their money, while others are able to borrow that money and invest it. For example, putting your money in a bank allows others to borrow it. Buying a bond is a direct way to lend your money. Buying stocks and other securities is a very indirect way of lending, since you raise the price of that security and thereby allow the company to issue more in order to raise capital. Either way, you forego spending so that someone else can go ahead and spend in your stead. That person can then go ahead and buy whatever they want and hopefully they’ll pay you back.
Bubble economic growth occurs when new money is created and then loaned out. Because nobody is saving to enable this borrowing, the products most sensitive to interest rates will increase in price, all else equal. For example, because nobody is foregoing buying a house or car to fund the loan that someone is using to buy a different house or car, the prices for both have to rise. Even if they do not rise, this can only be because more houses and more cars are being produced, taking away workers from other sectors of the economy.
This bubble economy cannot exist forever because when that newly created money circulates in the economy, it will raise the prices of other goods relative to the interest rate-sensitive goods, and thus diminish the inflation corrected value of those interest rate sensitive goods. The businesses that were producing these interest rate sensitive goods have to cut down on costs since they no longer have as much profits, which means that they have to lower wages and/or lay off workers. Businesses which invested in these businesses are also make a lower return on their investment than expected. This leads to a downfall in investment and consumption as there are less workers spending as much money and less businesses able to reinvest their returns. This creates what we call a recession.
That’s pretty much the most stripped down version of ABCT I was able to think of. An additional plus is that it doesn’t use Austrian-specific terminology like “higher order” and “lower order” goods, making it easier to understand for non-Austrians and economic laymen. It’s important to stress that if Person A is saving to fund Person B’s loan, then the prices of whatever Person B buys are not being bid up. However, if Person B takes out a loan that was created out of thin air, they are, in fact, bidding up the prices of whatever they buy, therefore distorting the economic structure by making certain investments more profitable. Essentially, ABCT is about the non-neutrality of money.
Well, my points were merely nitpicks because after 2 readings I didn’t find anything else wrong.
Does Huerta de Soto not say that even if the extra savings are not lent they will be lead to an increase in savings? Assume that an individual begins to save more and that all this entails is a decrease in consumption (without a corresponding decrease in savings or investment) the fact that they will stop purchasing consumer goods will drive the prices down consumer goods causing the companies closest to production to record accounting losses, set in motion the Ricardo Effect and cause the prices of capital goods to rise because of the decreased interest rates (not construed in the sense of the money market sense).
Once again, this is really just an irrelevant nitpick, especially since the process you described is how it actually occurs in the real world.
Yes, technically speaking, if you save but do not put your money in a bank, bond, or security, you are still freeing up resources by not consuming while reducing interest rates by not borrowing.
Anyone read this:
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1354336
I’m not sure it’s at all significant - there’re probably a million “critiques” of ABCT by mainstream economists.
I read it once. Here is Bob Murphy’s response:
I was actually looking for a critique of how my post may have veered outside of the “Austrian School” theory.
An excellent summary.
Although some discussion points:
- “The Austrian explanation seems to fit many of the apparent booms and busts throughout American history, such as the busts in 1819, 1837, 1857, 1873, 1893, 1921, 1929, 1973, 1975, 1981, 1990, 2001, and 2008. The theory also applies to Japan in the 1990s”.
The other framework which fits this model is the Georgist model (even if you may disagree with Mr George’s remedy, this does not mean his analysis is flawed). Every single recession you identify was preceded by either commercial or residential property speculation (indeed, in my view stagflation is a perfectly Georgist-Austrian explanation, which is the theme of by current book). Anyways, George argued high rents, due to increases in productivity or development, increase rents, which erode business profits and force investment into land. Austrians, of course, reply by saying it is credit expansion itself which increases land values, signalling faulty price signals which generate “malinvestments” - new money then percolates downward from the business borrowers to the factors of production: to the landowners and capital owners who sold assets to the newly indebted businessmen. The problem with this is that booms and bust exist even under full reserve banking in Holland or when credit expansion was merely low. This is because land, which is fixed in supply, almost always emits good price signals (as if there were credit expansion) in the event of development or population growth. Every single piece of development or saving (public or private) is deposited in the land market once such price signals commence. As Winston Churchill explains:
“Roads are made, streets are made, railway services are improved, population grows, electric light turns night into day, electric trams glide swiftly to and fro, water is brought from reservoirs a hundred miles off in the mountains — and all the while the landlord [speculator] sits still".
Evidence? Well, its called Ricardo’s law of rent. First, in Australia in 1884 (before the infamous land boom) advances were constant, even negative, yet the influx of immigrants and the country was being development. Land values lept 25%. Thus, fundamental themselves emit positive price signals (as if there were credit expansion!). Credit adds fuel to the fire. Second, in Holland land values exploded (rising by 35%) even under full reserve banking, because savings (and real resources) were still funnelled into the land market (as immigration and infrastructure was built). It paid to speculate on natural events like immigration policy or infrastructural development. Rents made businesses unprofitable. Third, the 1980s, with avg interest rates 15%, commercial property boom saw a huge boom - because of demand. Landlords notice these positive signals (which fundamentals themselves cause), buyers then enter and then credit expansion adds to the boom.
Thus, even before credit expansion, there are faulty price signals (investment could be made in production rather than speculation). Similar observations can be see in France (the absence of credit markets, yet both land speculation and downturns exist) and the Roman Empire: http://business.smh.com.au/business/wanted-a-new-economic-theory-20090206-7z7h.html?page=-1
There also remains the issue of whether high rents can shut down businesses (ABC learning is one example: http://www.theaustralian.news.com.au/story/0,25197,24994007-2702,00.html or https://www.businessspectator.com.au/bs.nsf/Article/High-rent-staff-levels-may-have-led-to-centres-col-LJJK6?OpenDocument&src=tnb) - recent surveys show businesses are shutting down because rents are too high. In Bondi, for example, there have been 7 different businsses one site o er one year, because rents are that high: http://www.news.com.au/dailytelegraph/story/0,22049,24990395-5013110,00.html This also raises doubts that unemployment is always voluntary. High rents can generate a cluster of business errors and unemployment may be forced, not simply voluntary. Indeed, the reason enterprise zones failed was speculators withdrew land from supply, rising rents shutting down employment opportunities. I’ve written a paper on this topic and developed a mathematical model which fits the data: the fact rents tripled in one year after enterprise zones were introduced made once profitable businesses unaffordable, squeezing profits.
- This involves fiat currency, central banking, and fractional reserve banking, which are beyond the scope of this post.
I think Austrians have a brilliant theory. However, I think they politicise otherwise beautiful explanations . I do not think “fiat currency” is the cause, but credit. Now, you will tell me, “wtf, Steven, these are the same thing - central bank injects funds, which multiply through credit marks”. In fact, credit and the money supply is almost entirely endogenous. The very act of creating credit serves as reserves or bank deposits. You don’t even need to borrow funds from other banks or even for the government to create new fiat currency. Banks do it themselves: where there is demand there is supply. Where is the evidence?
First, quoting Keen’s note:
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The creation of credit money should happen after the creation of government money or low interest rates. In the model, the banking system can’t create credit until it receives new deposits from the public or the Fed (that in turn originate from the government) and therefore finds itself with excess reserves that it can lend out. Since the lending, depositing and relending process takes time, there should be a substantial time lag between an injection of new government-created money and the growth of credit money.
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The amount of money in the economy should exceed the amount of debt, with the difference representing the government’s initial creation of money. In the example above, the total of all bank deposits tapers towards $10,000, the total of loans converges to $9,000, and the difference is $1,000, which is the amount of initial government money injected into the system. Therefore the ratio of Debt to Money should be less than one, and close to (1-Reserve Ratio): in the example above, D/M=0.9, which is 1 minus the reserve ratio of 10% or 0.1
Testing the first hypothesis takes some sophisticated data analysis, which was done by two leading neoclassical economists in 1990: http://www.minneapolisfed.org/publications_papers/pub_display.cfm?id=225
The hypothesis were true, changes in M0 should precede changes in M2. The time pattern of the data should look like the graph below: an initial injection of government “fiat” money, followed by a gradual creation of a much larger amount of credit money:Their empirical conclusion was just the opposite: rather than fiat money being created first and credit money following with a lag, the sequence was reversed: credit money was created first, and fiat money was then created about a year later:
“There is no evidence that either the monetary base or M1 leads the cycle, although some economists still believe this monetary myth. Both the monetary base and M1 series are generally procyclical and, if anything, the monetary base lags the cycle slightly. (p. 11)
The difference in the behavior of M1 and M2 suggests that the difference of these aggregates (M2 minus M1) should be considered… The difference of M2 - M1 leads the cycle by even more than M2, with the lead being about three quarters.” (p. 12)
Second, Baseil Moore in “The Endogenous Money Stock" (1983) also observes: “In the real world, banks extend credit, creating deposits in the process, and look for reserves later".
Thus, again, even before low interest rates, credit is, essentially, endless in supply, rising in an expoential fashion: banks are willing to lend as much debt as borrowers want to take on. Blame fractional reserve banking, not the central bank. YES the central bank merely compounds to the problem rather than causing the problem. This may explain why there were booms and busts even before central banks were established: credit expansion reinforces itself (falling collateral means less credit and credit expansion serves as bank reserves)..
A case study validates the above point. Indeed, you can completely abolish central banks and essentially have free banking with a gold standard like Australia did in 1890s (which resulted in the “great Melbourne land boom” - but the problem an endogenous money supply still exists (ie falling collateral means less credit; while high collateral means more credit which means even higher collateral; credit expansion serves as bank reserves). Recall under 1890s free banking banks reduced interest rates to 2-3% - as if there were a central bank (so much for saying a free market forces interest rates to be a higher, “natural”! This was ultimately lifted to 6% over a 1.5 years. This is essentially what happen in Japan (IR were 2.5% then lifted to 6%) and in America (interest rates were 1% then lifted to 6%). This is because price signals in the land market, generated endless reserves (land values go up, credit expansion takes place etc). The problem is land speculation and fractional reserve banking. Central banking is part of the problem, but not the cause.
This, in my view, if the cause of recessions. The remedy, I think, is a combination of fiscal and monetary reforms.
Not necessarily. When the Fed buys securities, it doesn’t immediately create money to pay for the security. It only prints the money when someone demands it. In other words, the Fed buys securities and gives a check to an investor, the investor (usually a bank) then can use that check to purchase other/more securities from other investors. Eventually, someone demands their money’s worth, and demands money from the Fed.
Also, the efficient market hypothesis could easily explain this by stating that banks anticipate fiat monetary creation and therefore expand credit, expecting an increase in fiat credit later.
“Not necessarily”, eh? Actually, what you described, did happen in the 1980s. So point taken.
But that merely added to the problem…for the rest of the time (eg REITs in Australia in the 70s - no central bank could engage in transactions - or Melbourne in 1890 - no central bank even existed - or the data from the 1970s), the supply of money in these institutions increased expontentially, without any central bank. Why? Because banks are willing to print as much money as debtors are willing to take on. Currency is created. Credit can serve as reserves. They lend them out, and banks look for reserves later. Hence, why you have boom and busts even before you had central banks (ie debt deflations ultimatley result). The problem therefore is debt: you get debt binges, because the reality is, the Fed adds to the problem, it does not cause the problem. The money supply is predominately…endogenous (to penetrate the market place, you need to borrow) while interet rates…exogenous.
This does not injure the Austrian theory per se. It’s criticisms against fractional reserve lending remain,and indeed are enhanced by such analysis. I am merely saying abolish the Fed, sure, but you still have downturns, which historically is the case, because of the debt problem.
So, I completely agree with you - but I argue the Fed adds to the problem (even if you include expectations from the efficient markets hypothesis, which btw I am not a fan of), it does not cause downturns, because to say otherwise, is to ignore history itself (ie booms and bust happened under a free banking system with no regulation or central bank —> Melbourne Land Boom).
This is false. If it were true, then there would be no need for any savings; one would not be able to accrue interest on savings held in a bank, since banks would be able to print money. The only lower boundary for interest rates would be rates which cover the costs of banks and make them profitable - meaning any interest rate above 0%. Banks would perpetually print money until depressions and hyperinflations forced them to close.
In the real world, banks will only loan money if they think the loan is profitable. In a free market, no loans can be made in excess of reserves since other banks would demand the reserves instead of certificates from other banks. The reason why booms and busts occurred before central banking is because governments excuses politically favored banks from making specie payments. This was the same as bailing out a bank today - it was excusing banks from their contractual obligations. This made it possible to lend out money in excess of reserves and still remain profitable.
The problem is not debt; booms and busts have occurred at times with relatively low amounts of debt. Using your system of banks making loans and looking for reserves later, there would be no upper ceiling for debt, as people would be able to borrow at negative real interest rates. Thus, borrowing would pile up on top of previous borrowing, leading to a never ending Ponzi scheme, which maybe only hyperinflation could stop. But this is not how the macroeconomy actually works. Because interest rates are set lower, certain businesses get a boost - e.g. construction. These businesses are able to return greater profits to investors, higher salaries to workers, and more jobs to the economy in general. Those investors and workers, because their spending/saving ratio has essentially remained unchanged, then go out and spend most of their money, making consumption based businesses (e.g. retail) more profitable. These consumption-based businesses then outbid the interest rate sensitive businesses for resources, making the latter much less profitable or unprofitable, forcing them to lay off workers, which in turn reduces consumption and forces consumption based businesses to return less to investors, lower wages, etc. Thus, the problem lies not with debt, but with the economic structural imbalances that credit creation causes.
As I wrote above, previous booms and busts were the result of other government actions which prompted private banks to expand credit by themselves. Of course only abolishing the Federal Reserve would not cure the nation of booms and busts because:
- We’d still have regulations in place that essentially bail out fractional reserve banks.
- Credit creation would still occur in foreign nations and be imported into the United States to fund capital projects here.
I haven’t got time to reply in detail, but suffice to say:
My model places savings at the heart of economics. You say: “If it were true, then there would be no need for any savings; one would not be able to accrue interest on savings held in a bank, since banks would be able to print money”. Erm, actually, this proves my precise point: the very process of savings creates reserves (see the graph above of an inital fiat injection), which banks then create more reserves, creating credit, which also serves are deposits under a fractional reserve system. I refer you to the above analysis by Basil Moore. Duh dam:
Anyways…
I do agree with you on the specie payment issue i.e. the Panic of 1819, 1837, 57 etc were all created by government preferring certain banks over others. I agree. But you’re point still doesn’t address my point: 1970 Australia and 1890 Australia. As for the role of government creating boom and busts during the Melbourne Land Boom, there was very little regulation, if any regulation (banks could set there own rules) - government intervention came indirectly through building infrastructure, which ignited a land boom - but much the same would have happened no matter who built the infrastructure, as infrastructure development and population growth is deposited through higher land values (Ricardo’s Law). So collateral values go up, banks become more liberal in their lending, and the credit cycle is ignited by the natural processes like population growth itself, fuelling the malinvesments. So yes “because interest rates are set lower, certain businesses get a boost - e.g. construction” - but that to understand why, we need to read JS Mill and the classical economists first to see why land values always emit good price signals (interestingly, during the Melbourne Land boom, interest rates were set by each banks, but they were generally very low - around 2%). Even when interest rates were 10% a few years before, land values were going up by 34%, with CPI only at around 2%. Add credit into the equation and we get even more rent seeking behaviour and yes…a construction boom. In the book I’m writing, this seems to be the case from Japan since 1860s, America since 1792, Australia since 1890s till today etc
Hence… my view government compounds to the problem, quite severly, but it does not cause it.
“borrowing would pile up on top of previous borrowing, leading to a never ending Ponzi scheme, which maybe only hyperinflation could stop”
Well, actually, that is what stagflation essentially was - stagflation was a debt induced (construction boom) - due to low interest rates (of course!) - soothed out by inflation (huge government spending, deficits etc). This merely delayed the inevitable bust (till today). Anyways, you write: “Thus, the problem lies not with debt, but with the economic structural imbalances that credit creation causes” - again I agree - my point, however, is that credit ( working in tandem with a tax system which taxes peoples wages and profits, over rents), creates a “structural” imbalance - land values slowly rise, interest rates fall, people take on alot of debt to build homes and commercial property bla bla (capital intensive goods), interest rates rise, land because too expensive, profit margins fall, malinvestments are exposed (eg the rents or inflows of the projects cannot service the debts as initally expected), people cannot pay of their debt, the money supply contracts (banks are less likely to loan credit), banks loose capital, become insolvent bla bla bla, deflation sets it, real debt burden rises - the more debtors owe, the more they pay. So debt is part of that structural imbalance, a major part in fact. A (monetary or real?) shock hits, the emperor has no clothes (ie if property prices plummet), people are exposed to debt and is magnified throughout the economy. I mean, during the great depression, for example, 25% of all new investment was in construction, so when the bubble burst…and people become unemployed, that’s alot of people who couldn’t pay of their business and personal debt! This is what turns a recession into a depression.
So, when I and other performed a few econometric tests…shock:
So, sure, you have a business cycle without debt, but you do not have depressions (1819, 1837, 1929, 2010) without large sums of nominal and ultimately (real) debt (Fisher’s paradox).
Haha!
You clearly stated that banks expand credit and then look for reserves. This means that no savings would be needed at all, since banks would be involved in a never ending expansion of credit and they would never worry about seeking for reserves, since their own credit expansion would provide them with reserves.
It’s called the Reserve Bank of Australia and all of the regulations associated with it, the Bank of England, Dutch free coinage, and the importation of cheap foreign credit.
That is a logically invalid argument. An increase in land values could not cause any kind of lending boom. As explained before, any lending in a free banking system cannot occur without reserves. In a free banking system, banks must ask for payments of reserves, forcing other banks to remain financially sound. Thus, an increase in land values could not promote fractional reserves, since any bank practicing fractional reserves would quickly go bankrupt due to other banks demanding reserves. The fact remains that in a free banking system, all money lent is first saved, making an unsustainable boom impossible.
Rothbard has dealt with this problem in depth, I suggest you read his works on banking and fractional reserves.
Debt is not the cause. Even if we wiped all debt from everyone’s balance sheets and even if such a major intrusion created no unintended consequences (such as higher future interest rates), a severe recession/depression would still occur to fix structural imbalances. Thus, I do not see why “debt” is such a major fixation of yours.
Again, I do not see the reason for your fixation over debt. The depression would still occur regardless of the debt. Busts don’t occur because of accumulated debt, they occur because investments were made which are not profitable even if the loans used to start them have been paid off. Consumption based industries are simply able to outbid the interest rate sensitive industries, thereby making the latter unprofitable.
Equating debt with booms and busts is nothing more than a cum hoc fallacy. Debt is not the reason why these business cycles occur, even though they are closely correlated with the ups and downs of business cycles. Below market level interest rates are what causes structural imbalances across the economy. Low interest rates and perceived changes in time preferences throughout the duration of a boom and bust also encourage debt accumulation, which makes your correlations seem likely when using only empirical reasoning, though they are false.