Saturday, November 23, 2019

The Misesian Theory of Interest Depends Entirely on Subjective Time Preference with No Influence Attributed to Physical Productivity

Mises' disagreements with the Böhm-Bawerkian theory reflect a consistent theme. Mises was concerned with distilling Böhm-Bawerk's basic ideas from the nonsubjective, technical, and empirical garb in which they had been presented. Mises tried to show that Böhm-Bawerk's basic ideas flowed smoothly out of his own praxeological approach, or, in other words, that they could be cast in a strictly subjectivist mold. Knight (correctly) characterized Mises as taking an extreme Austrian position on interest by refusing to attribute any explanatory role to the objective, or physical, conditions governing production in a capital-using world. As the Austrian theory of value depends on utility considerations, with no recognition accorded objective costs, so, too, Knight explained, the Misesian theory of interest depends entirely on subjective time preference, with no influence attributed to physical productivity. One is reminded of Hayek's penetrating comment concerning the nature of Mises' contribution to economics. Remarking that “it is probably no exaggeration to say that every important advance in economic theory during the last hundred years was a further step in the consistent application of subjectivism,” Hayek cited Mises as the economist who most consistently carried out this subjectivist development: “Probably all characteristic features of his theories . . . follow directly . . . from this central position.”

—Israel M. Kirzner, “Ludwig von Mises and the Theory of Capital and Interest,” in The Economics of Ludwig von Mises: Toward a Critical Reappraisal, ed. Laurence S. Moss (Kansas City: Sheed and Ward, 1976), 54-55.


Paul Rosenstein-Rodan Told Ludwig Lachmann That “the Major Flaw in Hayek” Is the Question of Expectations

Lachmann had for a while been troubled by the influence of people's expectations on their actions, and felt that in Price and Production (1935a)  and Monetary Theory and the Trade Cycle (1933a) and in his debate with Keynes subsequent to the publication of Keynes's Treatise (1930), Hayek had neglected to adequately address expectations in the trade cycle story offered as a counter-argument to Keynes. Reading Keynes's General Theory (1936) upon its publication, he was surprised to find Keynes's extensive treatment of the subject.

Lachmann always maintained that the quarrel (the Hayek-Keynes debate) was unnecessary and that no important economic principles were at stake. It concerned empirical questions about how markets work in the modern industrial world (that is, which markets were fix-price and which were flex-price, in Hicks's terminology) although there were also some political undertones. Keynes had won, he thought, partly because he had introduced expectations most effectively into his theory, at least where it suited his purposes, whereas neither Mises nor Hayek responded in like manner. In 1934 Paul Rosenstein-Rodan had said to Lachmann that the question of expectations was ‘the major flaw in Hayek.’ Keynes had not made the same mistake.

—Peter Lewin, “Hayek and Lachmann,” in Elgar Companion to Hayekian Economics, ed. Roger W. Garrison and Norman Barry (Cheltenham, UK: Edward Elgar Publishing, 2014), 166.


Friday, November 22, 2019

The Subject of Expectations, a Subjective Element in Human Action, Is Eminently “Austrian”

Although old knowledge is continually being superseded by new knowledge, though nobody knows which piece will be obsolete tomorrow, men have to act with regard to the future and make plans based on expectations. Experience teaches us that in an uncertain world different men hold different expectations about the same future event. This fact has certain implications for growth theory—in my view important implications—with which I deal in my paper “Toward a Critique of Macroeconomics.” Here we are concerned with the fact that divergent expectations entail incoherent plans. At another place I argued that “what keeps this process in continuous motion is the occurrence of unexpected change as well as the inconsistency of human plans. Both are necessary conditions.” Are we entitled, then, to be confident that the market process will in the end eliminate incoherence of plans which would thus prove to be only transient? What is being asked here is a fairly fundamental question about the nature of the market process.

The subject of expectations, a subjective element in human action, is eminently “Austrian.” Expectations must be regarded as autonomous, as autonomous as human preferences are. To be sure, they are modified by experience, but we are unable to postulate any particular mode of change. To say that the market gradually produces a consistency among plans is to say that the divergence of expectations, on which the initial incoherence of plans rests, will gradually be turned into convergence. But to reach this conclusion we must deny the autonomous character of expectations. We have to make the (diminishing) degree of divergence of expectations a function of the time sequence of the stages of the market process. If the stream of knowledge is not a function of anything, how can the degree of divergence of expectations, which are but rudimentary forms of incomplete knowledge, be made a function of time?

—Ludwig M. Lachmann, “On the Central Concept of Austrian Economics: Market Process,” in The Foundations of Modern Austrian Economics, ed. Edwin G. Dolan, Studies in Economic Theory (Kansas City: Sheed and Ward, 1976), 128-129.


The Characterization of Canadian Commercial Banking as a Regulated Monopoly Is Not a Controversial One

Canada’s mortgage market was (and continues to be) structured to provide a steady source of rents to a small number of large financial institutions. Around 70% of residential mortgage debt was held by commercial banks, and the five largest Canadian banks accounted for nearly 90% of that share of mortgage debt. Around 60% of Canadian mortgage debt, then, was essentially held by an oligopoly regulated by the OSFI [Office of the Superintendent of Financial Institutions]. This oligopoly enjoyed a benchmark mortgage rate that was about 110 basis points above that of the United States. This was true despite the Canadian benchmark being a 5-year rate while the US benchmark is for the 30-year fixed rate on conforming mortgages. Furthermore, in the case of default holders of Canadian mortgage debt generally had recourse to all of a borrower’s assets. In the United States recourse was limited to foreclosure on the mortgaged property and home.

The five largest Canadian banks had a privileged position in the mortgage market that included insurance provided by the government-owned CMHC [Canada Mortgage and Housing Corporation]. The CMHC was essentially a monopoly insurer of Canadian mortgage debt. The CMHC insured directly almost half of that debt. Another 13% of that mortgage debt was insured by private companies for which the CMHC guaranteed the vast majority of any losses. Furthermore, 90% of securitizations were guaranteed by the CMHC. Not only did a regulated oligopoly of commercial banks hold most Canadian mortgage debt and enjoy relatively (to the United States) high interest rates. The CMHC also covered potential losses on the vast majority of that mortgage debt.

The characterization of Canadian commercial banking as a regulated monopoly is not a controversial one. As Bhushan (2010) states, the Canadian banking system “has been described a oligopolistic with six large banks accounting for over 85% of bank assets” and during the 1990s “growth in financial sector concentration in Canada was unmatched by any other major economy[.]” This protected oligopoly was given room to expand by a 1992 amendment to the Canadian Bank Act permitting banks to acquire trust and loan companies that had previously been important players in the mortgage market (Bhushan, 2010). Compare this to US policy innovations regarding the GSEs [Government-Sponsored Entities] that promoted the proliferation of mortgage companies and brokers. Even though government intervention into the mortgage market expanded in both the United States and Canada, only in the latter did it lead to the bulk of both mortgage origination and debt being concentrated in a handful of large commercial banks.

—Andrew T. Young, “Canadian Versus US Mortgage Markets: A Comparative Study from an Austrian Perspective,” in Studies in Austrian Macroeconomics, ed. Steven Horwitz, Advances in Austrian Economics 20 (Bingley, UK: Emerald Group Publishing, 2016), 204-205.


Thursday, November 21, 2019

The Notion of Heterogeneous Capital Is Crucial Not Just for Austrian Capital Theory, but for Austrian Economics in General

The Austrian approach to capital generated considerable controversy, both within the school itself and between the Austrians and rival schools of economic thought. Given the attention devoted to the problem of measuring a heterogeneous capital stock, it is surprising that relatively little analytical effort has been devoted to the concept of heterogeneity itself. The notion of heterogeneous capital is crucial not just for Austrian capital theory, but for (Austrian) economics in general. For example, the Austrian position in the socialist calculation debate of the 1930s (Hayek, 1933; Mises, 1920 ) is based on an entrepreneurial concept of the market process, one in which the entrepreneur’s primary function is to choose among the various combinations of factors suitable for producing particular goods (and to decide whether these goods should be produced at all), based on current prices for the factors and expected future prices of the final goods. If capital is shmoo [a homogeneous blob] with one price, then entrepreneurship is reduced to choosing between shmoo-intensive and labor-intensive production methods (or among types of labor), a problem a central planner could potentially solve. The failure of socialism, in Mises’ (1920) formulation, follows precisely from the complexity of the economy’s capital structure, and the subsequent need for entrepreneurial appraisal. As Lachmann (1956: 16) points out, real-world entrepreneurship consists primarily of choosing among combinations of capital assets:
[T]he entrepreneur’s function … is to specify and make decisions on the concrete form the capital resources shall have. He specifies and modifies the layout of his plant. … As long as we disregard the heterogeneity of capital, the true function of the entrepreneur must also remain hidden.
—Nicolai J. Foss and Peter G. Klein, Organizing Entrepreneurial Judgment: A New Approach to the Firm (New York: Cambridge University Press, 2012), 116-117.


Tuesday, November 19, 2019

A Fund of Consumers’ Goods Ready to Support Workers Is the Prerequisite for Every Form of Production

The root of the wages fund theory can be traced back to authors writing before Adam Smith. But only with the latter this theory starts to receive a more systematic treatment. We are not concerned with the detailed historical development of the theory. In essence, it is “nearly self-evident,” a “truism” as Jevons calls it; yet, an important truism apparently – even Jevons himself employs it.

To begin with, Adam Smith and his epigones are very well aware of the correct order of things. Before production can be started, there has to be something else in existence that maintains the workers until they have finished the product. This is, though trivial, a basic insight. A fund for the payment of wages, however defined, has to be there before work can be done. The idea is clearly taken from the conditions prevailing in agriculture. Harvest is reaped only once a year. But until this point in time, people working in the farm production have to be supported. And this cannot be done with the help of their own product because it doesn’t exist in consumable form, yet. The consumers’ goods, or the means to obtain consumers' goods, have to be “advanced” to the workers out of the product of past labour. The store out of which these consumers’ goods are paid the classics call “funds destined for the maintenance of productive labour,” “the fund out of which their [labourers’] wages are wholly paid,” or simply the “wages fund.” As the wages fund is meant to serve for the payment of workers, it “embraces the various articles intended for ‘the use and accommodation of the labouring class.’”

As far as only periodic production is concerned, like in agriculture, even important critics of the wages fund theory admit that “a special store is obviously needed.” However, the classical economists are of the opinion that a fund of consumers’ goods ready to support workers is the prerequisite not only of agriculture, but of every form of production. Before soil can be cultivated, something “must be provided for the support of the labourers employed upon it, in like manner as it must be provided for the support of those engaged in manufactures, or other branches of industry.” Now, as the wages are paid out of a special fund, it naturally follows that wages depend on this fund on the one hand, and the number of labourers that share this fund on the other. General wages depend, in this view, “on the Extent of the Fund for the maintenance of Labourers, compared with the number of Labourers to be maintained.” These are the two variables that the classical wages fund theory is composed of: the wages fund and (working) population. From here the theory can easily be extended in a way to allow for a demand and supply analysis. Wages are paid out of the wages fund, which is the demand for labour. The number of the workers constitutes the supply of labour. If the former grows, wages will rise, if the latter grows, wages will decrease.

—Eduard Braun, “Financial Markets and Economic Growth” (Dr. rer. pol. diss., Université d'Angers, 2011), 93-94.


Sunday, November 17, 2019

Greece and Other Troubled States Were Already Being Bailed Out Before the Sovereign Debt Crisis Emerged

Unsatisfied with the course of political events, a group of economists, joined by a former professor of law at the University of Erlangen-Nürnberg, Karl Albrecht Schachtschneider, have questioned the legitimacy of the bailout in front of the German Federal [Constitutional] Court, the Bundesverfassungsgericht. These individuals had already fought and lost one case against the German adoption of the Euro in 1998. This time, however, they insisted on their position that the Greek bailout would turn the ‘European Union into an inflationary union.’ Indeed, financial aid to Greece seems to constitute a breach of European Law. Article 125 of the Treaty on the Functioning of the European Union clearly states that the Union shall not be liable for or assume the commitments of central governments of any member state. Guarantees by the member states for Greek bonds constitute a breach of that rule.

Even ignoring the more explicit bailouts, a tacit bailout was already undertaken in recent years. As Bagus (2010) points out, the ECB has long accepted Greek bonds as collateral for new loans. Since the interest rate at which banks borrow money from the central bank is lower than the interest received from the government bonds, demand for Greek bonds was induced. Had the ECB not accepted Greek bonds as collateral, Greece would have had to pay even higher interest rates than they did. Hence, Greece and other troubled states were already being bailed out by the rest of the Eurozone before the sovereign debt crisis even emerged, as their debt was effectively monetized. In November 2010, every second Euro that the ECB lent to banks went to the ‘financially weak countries.’

—Malte Tobias Kähler, “From German Rules to European Discretion: Policy's Slippery Slope,” in Institutions in Crisis: European Perspectives on the Recession, ed. David Howden (Cheltenham, UK: Edward Elgar Publishing, 2011), 170-171.


On the Analogy Between Modern Financial Theory and “Lysenkoism” in Stalin's Soviet Union

Yet, intellectually impressive as it is, most of this theoretical edifice was based on a deeply flawed understanding of the way the world actually works. Like medieval alchemy, it was an elegant and internally consistent intellectual structure based on flawed assumptions.

One of these was that stock price movements obey a Gaussian distribution. While the Gaussian distribution is the best-known distribution, it is only one of many, and has the special property that its “tails” are very thin—i.e., that events from outside the norm are truly rare, never-in-the-history-of-the-universe rare. History tells us that's not right; markets surprise us quite often.

Among some of the other common but manifestly indefensible claims of Modern Finance are that:
  • modern “free markets” ensure that financial innovation is a good thing, which benefits consumers and makes the financial system more stable;
  • risks are foreseeable and, incredibly, that you can assess risks using a risk measure, the Value-at-Risk or VaR, that gives you no idea of what might happen if a bad event actually occurs;
  • highly complex models based on unrealistic assumptions give us reliable means of valuing complicated positions and of assessing the risks they entail;
  • high leverage (or borrowing) doesn't matter and is in any case tax-efficient; and
  • the regulatory system or the government will protect you if some “bad apple” in the financial services industry rips you off, as happens all too often.
The invention and dissemination of Modern Financial Theory is a startling example of the ability to achieve fame and fortune through the propagation of error that becomes generally accepted. In this, it is eerily reminiscent of the work of the Soviet biologist Trofim Denisovich Lysenko, a man of modest education whose career began when he claimed to be able to fertilize fields without using fertilizer.

Instead of being dismissed as so much fertilizer themselves, Lysenko's claims were highly convenient to the authorities in the Soviet Union, and he was elevated to a position of great power and influence. He went on to espouse a theory, “Lysenkoism,” that flatly contradicted the emerging science of genetics and was raised to the level of a virtual scientific state religion. Those who opposed his theories were persecuted, often harshly. Lysenko's theories of agricultural alchemy in the end proved highly damaging and indeed embarrassing to Soviet science, and Lysenko himself died in disgrace.

Of course, the analogy is not perfect: proponents of Modern Financial Theory did not rely on Stalin to promote their ideas and silence their opponents, nor did they rely on the prison camps. Instead, their critics were sidelined and had great difficulty getting their work published in top journals, so ending up teaching in the academic “gulag” of less influential, lower-tier schools. But what the two systems share in common is a demonstrably false ideology raised to a dominant position where it inflicted massive damage, and an illusion of “scientific” respectability combined with a very unscientific unwillingness to listen to criticism.

—Kevin Dowd and Martin Hutchinson, introduction to Alchemists of Loss: How Modern Finance and Government Intervention Crashed the Financial System (Chichester, UK: John Wiley and Sons, 2010), 5-6.