—G.R. Steele, Keynes and Hayek: The Money Economy, Foundations of the Market Economy (London: Routledge Taylor and Francis e-Library, 2002), 173.
Friday, November 29, 2019
Constructivist Rationalism Pervades Socialism and Post-Keynesian Economics and Is Denounced by Austrian Economists
It is this kind of constructivist rationalism — which pervades post-Keynesian economics in particular and socialism more generally — that is emphatically denounced by Austrian economists. It is a ‘fatal conceit’ of intellectuals that they presume to determine structures for a beneficent social order. This is found in a conclusion that is familiar across diverse post-Keynesian analysis: that, although the world is fraught with difficulties that arise from decisions that must be undertaken in the face of uncertainty, a solution is at hand. With a heart-stopping leap — made without fear, hesitation or embarrassment — the void is crossed. The future is uncertain, but it can be shaped by the guidance of theorists who have understood Keynes correctly.
—G.R. Steele, Keynes and Hayek: The Money Economy, Foundations of the Market Economy (London: Routledge Taylor and Francis e-Library, 2002), 173.
—G.R. Steele, Keynes and Hayek: The Money Economy, Foundations of the Market Economy (London: Routledge Taylor and Francis e-Library, 2002), 173.
Wednesday, November 27, 2019
Hayek’s Thesis Is That Socialism Is a Lethal Scientific Error Resulting from Intellectual Arrogance
Since Keynes’s economic theory has been proven to be incorrect
on purely scientific grounds, it is permissible to analyze the factors
that made him susceptible to error. The ultimate source of Keynes’s error is captured by the title of Friedrich Hayek’s final book, The
Fatal Conceit: The Errors of Socialism (1988). What exactly did Hayek
mean by the expression “the fatal conceit”? Conceit is defined as
an exaggerated estimate of one’s own intellectual abilities. Thus,
the expression “fatal conceit” connotes deadly intellectual pride. As the book’s subtitle indicates, Hayek directs the term to the
advocates of socialism. Here then is Hayek’s thesis: socialism is a
lethal scientific error resulting from intellectual arrogance. Jesús
Huerta de Soto, a leading Hayek scholar, explains:
In the most intimate part of our nature lies the risk of succumbing to socialism, because its ideal tempts us, because humans rebel against their own nature. To live in a world with an uncertain future disturbs us, and the possibility of controlling that future, of eradicating uncertainty, attracts us. In The Fatal Conceit, Hayek writes that socialism is actually the social, political and economic manifestation of humankind’s original sin, pride. Humankind wants to be God, that is, omniscient… . The socialist considers him- or herself as overcoming this problem of radical ignorance which fundamentally discredits his (or her) social system. Hence, socialism is always a result of the sin of intellectual pride. Within every socialist there lies a pretentious person, a prideful intellectual.—Edward W. Fuller, “Keynes's Fatal Conceit,” Procesos de Mercado: Revista Europea de Economía Política 15, no. 2 (Autumn 2018): 15-16.
Monday, November 25, 2019
The Essential Causal Element in the Austrian School's Theory of Business Cycles Is Falsified Loan-Market Signals
While a visiting scholar at New York University in 1923–24, Friedrich A. Hayek focused his attention on the ten-year-old American central bank. He watched the early phases of the 1920’s boom and saw a connection between Federal Reserve policy and the ramped-up economic activities. The early dynamics of that decade mirrored the dynamics of an unsustainable boom as set out briefly by Ludwig von Mises in his Theory of Money and Credit. According to Hayek, the seeds of the downturn were sown in the US in the form of easy money maintained by the Federal Reserve during the 1920s, the most salient consequence of which was the accelerating — and increasingly unrealistic — stock prices. The most insidious consequences, however, stemmed from the policy-tainted loan-market signals that created conflicts within the economy’s capital structure. Falsified loan-market signals can throw early-stage production processes out of line with the temporal pattern of consumer demand. This is the essential causal element in the Austrian school’s theory of business cycles. Policy-tainted interest rates give rise to internally conflicted production activities.
Artificially low interest rates stimulate early-stage — or, more broadly, interest-rate sensitive —production processes, creating employment opportunities in those areas and hence raising incomes earned in those early-stage undertakings. Had the low interest rates been the consequence of increased saving rather than of policy actions by the Federal Reserve, the increase in early-stage capital formation would have been accompanied by a contemporaneous reduction of consumption — and hence a reduction in late-stage inputs and outputs. Accordingly, consumable output would have been shifted to the more distant future. This is the temporal pattern that characterizes sustainable, market-directed, economic growth. By contrast, a policy-induced boom as occurred in the 1920s and especially as it intensified near the end of that decade saw an increase in both early-stage production and contemporaneous consumer demand, creating a virtual tug-of-war centered on resources usable in both early-stage and late-stage markets — and with rising prices of those resources dimming profit prospects. These are the kinds of internal dynamics within the economy’s investment sector that lead to a crisis and warrant the charge that Keynesian theory is based on an overly aggregated macroeconomic framework.
—Roger W. Garrison, “Cycles and Slumps in an Overly Aggregated Theoretical Framework,” in What's Wrong with Keynesian Economic Theory? ed. Steven Kates (Cheltenham, UK: Edward Elgar Publishing, 2016), 93-94.
Artificially low interest rates stimulate early-stage — or, more broadly, interest-rate sensitive —production processes, creating employment opportunities in those areas and hence raising incomes earned in those early-stage undertakings. Had the low interest rates been the consequence of increased saving rather than of policy actions by the Federal Reserve, the increase in early-stage capital formation would have been accompanied by a contemporaneous reduction of consumption — and hence a reduction in late-stage inputs and outputs. Accordingly, consumable output would have been shifted to the more distant future. This is the temporal pattern that characterizes sustainable, market-directed, economic growth. By contrast, a policy-induced boom as occurred in the 1920s and especially as it intensified near the end of that decade saw an increase in both early-stage production and contemporaneous consumer demand, creating a virtual tug-of-war centered on resources usable in both early-stage and late-stage markets — and with rising prices of those resources dimming profit prospects. These are the kinds of internal dynamics within the economy’s investment sector that lead to a crisis and warrant the charge that Keynesian theory is based on an overly aggregated macroeconomic framework.
—Roger W. Garrison, “Cycles and Slumps in an Overly Aggregated Theoretical Framework,” in What's Wrong with Keynesian Economic Theory? ed. Steven Kates (Cheltenham, UK: Edward Elgar Publishing, 2016), 93-94.
Sunday, November 24, 2019
How Would Professor Rothbard Respond If Asked “Which of the Factors of Production Is Truly Productive?”
Does one of the factors of production allow for an output whose value exceeds the combined values of the factors of production? If such a factor exists, it would be productive in a very special sense. This factor would produce surplus value. If the search for the source of a supposed surplus value is confined to questions concerning the nature of the individual factors of production, the possible answers are few in number. A survey of the different positions taken, however, is revealing. Without digging very deep into the history of economic thought, we can find four points of view that, collectively, exhaust the possibilities.
Francois Quesnay believed that only land was capable of producing a surplus. The inherent productive powers of the soil allow for a given quantity of corn—employed as seed and worker sustenance—to be parlayed into a greater quantity of corn. The notion of land's natural fecundity lies at the root of Physiocratic thought.
Karl Marx believed that only labor can produce surplus value. Without labor, nothing at all can be produced. This one factor, then, is the ultimate source of all value. Income received by other factors represents not the productivity of those factors but the exploitation of labor.
Frank Knight believed that there is only one factor of production and that it should be called capital. Rather than argue in terms of a factor that yields a surplus, he argued in terms of a stock that yields a flow. Capital consists of all inputs that have the dimensions of a stock (land, machines, human capital); the corresponding flow is the annual output net of maintenance costs. This net yield is a consequence of capital productivity. The net yield divided by the capital stock is the rate of interest.
Joseph Schumpeter, following Leon Walras, denied that there was any surplus to be explained. In long-run general equilibrium, the sum of the values imputed to the several factors of production must fully exhaust the value of the economy's output. Schumpeter insisted that in the long run, the interest rate must be zero; the positive rate of interest that we actually observe is to be understood as a disequilibrium phenomenon.
We can pause at this point for a midterm exam: Which of the factors of production is truly productive? (a) Land; (b) Labor; (c) Capital; (d) None of the above. Quesnay, Marx, Knight, and Schumpeter would answer (a), (b), (c), and (d), respectively. Professor Rothbard would reject the question. The notion of productivity in this sense—and hence the issue of the source of such productivity—vanishes once we take adequate account of the temporal pattern of inputs and outputs and of the effects of time preference on their relative values.
—Roger W. Garrison, “Professor Rothbard and the Theory of Interest,” in Man, Economy, and Liberty: Essays in Honor of Murray N. Rothbard, ed. Walter Block and Llewellyn H. Rockwell Jr. (Auburn, AL: Ludwig von Mises Institute, 1988), 46-47.
Francois Quesnay believed that only land was capable of producing a surplus. The inherent productive powers of the soil allow for a given quantity of corn—employed as seed and worker sustenance—to be parlayed into a greater quantity of corn. The notion of land's natural fecundity lies at the root of Physiocratic thought.
Karl Marx believed that only labor can produce surplus value. Without labor, nothing at all can be produced. This one factor, then, is the ultimate source of all value. Income received by other factors represents not the productivity of those factors but the exploitation of labor.
Frank Knight believed that there is only one factor of production and that it should be called capital. Rather than argue in terms of a factor that yields a surplus, he argued in terms of a stock that yields a flow. Capital consists of all inputs that have the dimensions of a stock (land, machines, human capital); the corresponding flow is the annual output net of maintenance costs. This net yield is a consequence of capital productivity. The net yield divided by the capital stock is the rate of interest.
Joseph Schumpeter, following Leon Walras, denied that there was any surplus to be explained. In long-run general equilibrium, the sum of the values imputed to the several factors of production must fully exhaust the value of the economy's output. Schumpeter insisted that in the long run, the interest rate must be zero; the positive rate of interest that we actually observe is to be understood as a disequilibrium phenomenon.
We can pause at this point for a midterm exam: Which of the factors of production is truly productive? (a) Land; (b) Labor; (c) Capital; (d) None of the above. Quesnay, Marx, Knight, and Schumpeter would answer (a), (b), (c), and (d), respectively. Professor Rothbard would reject the question. The notion of productivity in this sense—and hence the issue of the source of such productivity—vanishes once we take adequate account of the temporal pattern of inputs and outputs and of the effects of time preference on their relative values.
—Roger W. Garrison, “Professor Rothbard and the Theory of Interest,” in Man, Economy, and Liberty: Essays in Honor of Murray N. Rothbard, ed. Walter Block and Llewellyn H. Rockwell Jr. (Auburn, AL: Ludwig von Mises Institute, 1988), 46-47.
The “Tendency Toward Equilibrium Spectrum” Has Lachmann (“Never”), Mises-Hayek (“Sometimes”), and Lucas (“Always”)
Roger Garrison's contribution to the Festschrift, “From Lachmann to Lucas:
On Institutions, Expectations, and Equilibrating Tendencies” is nothing short
of magnificent. By creating a “tendency toward equilibrium spectrum” and then
placing on it Lachmann (“never”), Mises-Hayek (“sometimes”), and Lucas
(“always”), Professor Garrison does more to elucidate the views of the Austrian,
the Rational Expectations, and the “kaleidic” schools of thought on the
equilibrating tendencies in an economy than an essay of ten thousand words
or more could have done. Through this astute and innovative feat, moreover,
the author of this chapter is able to once again establish praxeology as the
moderate and reasonable view that takes on an intermediate position between
two extremist beliefs that might otherwise have appeared more attractive than
they are.
Garrison uses Lachmann's concern with future expectations to cast doubt on Lucas's assertion that the economy must always and ever be in equilibrium. He mobilizes the Mises-Hayek insight that on the free market, those who are better able to anticipate consumer demands will tend to have command over more and more resources and thus will be able to cast a disproportionate impetus toward equilibrium. This undercuts the extreme Lachmannian skepticism that there can be even a tendency toward equilibration.
Further, with this spectrum device, the Auburn University professor can focus attention on the crucially important role played by institutions. The Hayekian criticism of Keynes is that there is not enough disaggregation in this system to allow for the equilibrating role of entrepreneurial success. But this can only occur, shows Garrison, in a marketplace where businessmen can reap the reward of their superior insight. Paradoxically, or perhaps not so paradoxically, Keynesian-inspired government “stabilization” measures can actually retard movements toward equilibrium. Says Garrison: “They nullify the market forces that give rise to equilibrating tendencies, thus causing the economy to perform in the very way that Keynes envisioned it.”
—Walter Block, review of Subjectivism, Intelligibility and Economic Understanding: Essays in Honor of Ludwig M. Lachmann on His Eightieth Birthday, edited by Israel M. Kirzner, Review of Austrian Economics 3, no. 1 (1990): 223-224.
Garrison uses Lachmann's concern with future expectations to cast doubt on Lucas's assertion that the economy must always and ever be in equilibrium. He mobilizes the Mises-Hayek insight that on the free market, those who are better able to anticipate consumer demands will tend to have command over more and more resources and thus will be able to cast a disproportionate impetus toward equilibrium. This undercuts the extreme Lachmannian skepticism that there can be even a tendency toward equilibration.
Further, with this spectrum device, the Auburn University professor can focus attention on the crucially important role played by institutions. The Hayekian criticism of Keynes is that there is not enough disaggregation in this system to allow for the equilibrating role of entrepreneurial success. But this can only occur, shows Garrison, in a marketplace where businessmen can reap the reward of their superior insight. Paradoxically, or perhaps not so paradoxically, Keynesian-inspired government “stabilization” measures can actually retard movements toward equilibrium. Says Garrison: “They nullify the market forces that give rise to equilibrating tendencies, thus causing the economy to perform in the very way that Keynes envisioned it.”
—Walter Block, review of Subjectivism, Intelligibility and Economic Understanding: Essays in Honor of Ludwig M. Lachmann on His Eightieth Birthday, edited by Israel M. Kirzner, Review of Austrian Economics 3, no. 1 (1990): 223-224.
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.
—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.
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 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.
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.
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.
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:
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.
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.
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.
Saturday, November 16, 2019
In 2008, Bailouts for Everyone! Fannie Mae, Freddie Mac, AIG Insurance, TARP, etc., But Mainly for Citigroup (Again!)
Many Americans may remember the fall of 2008 as a chaotic and frightening series of teetering dominoes—huge financial firms that had bet too much on the housing market. Many Americans may also recall experiencing a tremendous anger as the government rescued one stumbling giant after another. In September, Washington bailed out the government-created mortgage investors Fannie Mae and Freddie Mac. Then the feds rescued the insurance titan AIG, effectively a bailout of all the Wall Street firms to which AIG owed money. Among the great financial houses, only Lehman Brothers was allowed to fail.
But the Lehman moment of market discipline didn’t last long. The government then came to the rescue of money market mutual funds and issuers of commercial paper. By early October, President George W. Bush had signed the Emergency Economic Stabilization Act into law, creating the $700 billion Troubled Asset Relief Program. Roughly ten days later, financial regulators began spending this pot of rescue money, announcing direct investments in America’s largest banks. But was there one bank in particular that had regulators scared enough to engage in such radical interventions in the economy?
In the fall of 2008, few people in America had access to more information about the health of American financial institutions than FDIC chairman Sheila Bair. Four years later, she looked back on that season of crisis and wrote: “I frequently wonder whether, if Citi had not been in trouble, we would have had those massive bailout programs. So many decisions were made through the prism of that one institution’s needs.”
—James Freeman and Vern McKinley, Borrowed Time: Two Centuries of Booms, Busts and Bailouts at Citi (New York: HarperCollins, 2018), e-book.
But the Lehman moment of market discipline didn’t last long. The government then came to the rescue of money market mutual funds and issuers of commercial paper. By early October, President George W. Bush had signed the Emergency Economic Stabilization Act into law, creating the $700 billion Troubled Asset Relief Program. Roughly ten days later, financial regulators began spending this pot of rescue money, announcing direct investments in America’s largest banks. But was there one bank in particular that had regulators scared enough to engage in such radical interventions in the economy?
In the fall of 2008, few people in America had access to more information about the health of American financial institutions than FDIC chairman Sheila Bair. Four years later, she looked back on that season of crisis and wrote: “I frequently wonder whether, if Citi had not been in trouble, we would have had those massive bailout programs. So many decisions were made through the prism of that one institution’s needs.”
—James Freeman and Vern McKinley, Borrowed Time: Two Centuries of Booms, Busts and Bailouts at Citi (New York: HarperCollins, 2018), e-book.
Friday, November 15, 2019
Different Credit Expansion Channels Do Not Affect the Basic Mechanism of the Business Cycle But Cause Differences in the Secondary Features of the Cycle
These different credit expansion channels do not affect the basic mechanism of the business cycle (characterized by erroneous investments as a result of the artificially lowered interest rate) but are responsible for the differences in the so-called secondary features of business cycles that make them nonidentical despite obvious similarities.
Finally, it is worth noting that the course of the business cycle and the implementation of the Cantillon effect are influenced not only by the investment policy of commercial banks, but also by other factors. I mention a few of them here. First of all, central banks may conduct monetary policy in various ways and create a monetary base, which has varied effects on credit expansion and, consequently, on the course of the business cycle. For example, quantitative easing is a different mechanism of introducing new money into the economy, relative to traditional open market operations, generating a slightly different first-round effect. While in the open market operations the most frequently purchased debt instruments are short-term Treasury bonds, quantitative easing may take place through also buying long-term bonds, including non-treasury bonds (e.g. corporate bonds or bonds secured by mortgages). This entails different redistributive effects, also affecting the yield curve and the risk premium in different ways.
Second, the type of entity that creates new money through the credit market and the way it is created is also important for the course of the business cycle and the implementation of the accompanying Cantillon effect. At present, a significant portion of loans are granted for the purpose of converting them into securities or, in general, by entities other than commercial banks. Indeed, banking activity has changed significantly in recent years and banks have largely abandoned traditional commercial banking based on taking deposits and lending, and instead adopted a business model based on loan securitization and their distribution to the so-called shadow banks. The effects of increasing the money supply (in the form of credit) vary, therefore, depending on what type of bank (rural or urban, small or large) or institution provides the loan. Loans can be created not only by commercial banks. Other depository institutions (such as savings banks or credit unions) and the so-called shadow banking system also participate in this. The creation of money by shadow banks seems particularly important in the modern economy, because securitization enables traditional commercial banks to increase lending (including through transfer of credit risk outside the bank balance sheets to investors purchasing securities), and intermediation of liabilities allows the so-called shadow banks to create loans by themselves. The creation of a loan through a shadow banking system implies a different implementation of the Cantillon effect, because the shadow banks’ asset structure differs from the structure of traditional banks’ assets, and certain types of loans are more readily used in the securitization process.
—Arkadiusz Sieroń, Money, Inflation and Business Cycles: The Cantillon Effect and the Economy, trans. Martin Turnau, Routledge International Studies in Money and Banking (Milton Park, UK: Routledge, 2019), 91-92.
Finally, it is worth noting that the course of the business cycle and the implementation of the Cantillon effect are influenced not only by the investment policy of commercial banks, but also by other factors. I mention a few of them here. First of all, central banks may conduct monetary policy in various ways and create a monetary base, which has varied effects on credit expansion and, consequently, on the course of the business cycle. For example, quantitative easing is a different mechanism of introducing new money into the economy, relative to traditional open market operations, generating a slightly different first-round effect. While in the open market operations the most frequently purchased debt instruments are short-term Treasury bonds, quantitative easing may take place through also buying long-term bonds, including non-treasury bonds (e.g. corporate bonds or bonds secured by mortgages). This entails different redistributive effects, also affecting the yield curve and the risk premium in different ways.
Second, the type of entity that creates new money through the credit market and the way it is created is also important for the course of the business cycle and the implementation of the accompanying Cantillon effect. At present, a significant portion of loans are granted for the purpose of converting them into securities or, in general, by entities other than commercial banks. Indeed, banking activity has changed significantly in recent years and banks have largely abandoned traditional commercial banking based on taking deposits and lending, and instead adopted a business model based on loan securitization and their distribution to the so-called shadow banks. The effects of increasing the money supply (in the form of credit) vary, therefore, depending on what type of bank (rural or urban, small or large) or institution provides the loan. Loans can be created not only by commercial banks. Other depository institutions (such as savings banks or credit unions) and the so-called shadow banking system also participate in this. The creation of money by shadow banks seems particularly important in the modern economy, because securitization enables traditional commercial banks to increase lending (including through transfer of credit risk outside the bank balance sheets to investors purchasing securities), and intermediation of liabilities allows the so-called shadow banks to create loans by themselves. The creation of a loan through a shadow banking system implies a different implementation of the Cantillon effect, because the shadow banks’ asset structure differs from the structure of traditional banks’ assets, and certain types of loans are more readily used in the securitization process.
—Arkadiusz Sieroń, Money, Inflation and Business Cycles: The Cantillon Effect and the Economy, trans. Martin Turnau, Routledge International Studies in Money and Banking (Milton Park, UK: Routledge, 2019), 91-92.
At the Heart of the Credit Crisis Is the Network of Highly-Leveraged Off-Balance-Sheet Vehicles—the Shadow Banking System
Pozsar’s initial paper outlined the “constellation of forces that drove the emergence of the network of highly-leveraged off-balance-sheet vehicles—the shadow banking system—that is at the heart of the credit crisis.”
Off-balance sheet (OBS) is an accounting maneuver used by companies to reduce their debt levels for reporting purposes. Enron perfected the use of OBS partnerships to hide its true liabilities from regulators and shareholders. Many at the Fed believed the OBS demon had been forever exorcized with Enron’s fall. But the demon had grown and metastasized, spreading little cancers throughout the financial system.
The resurrection of OBS vehicles had been made possible because banking had been reshaped by deregulation, innovation, and competition. Then the Fed lowered interest rates, creating “an abundance of credit for borrowers and a scarcity of yield for investors.” (Thank you, Alan Greenspan!)
Pozsar pinpointed the 1988 Basel I Accord as the main catalyst for the growth and advances of “credit risk transfer instruments” like CDOs [Collateralized Debt Obligations], MBSs [Mortgage-Backed Securities], asset-backed securities (ABS), asset-backed commercial paper (ABCP), commercial mortgage-backed securities (CMBS), and so on.
Issued after the banking crises of the late 1980s, the new Basel rules required that banks meet a minimum capital requirement and hold even more against riskier assets. For investment bankers seeking to maximize profits, and thus their own compensation, the changes created the need to hide liabilities in the shadows.
—Danielle DiMartino Booth, Fed Up: An Insider's Take on Why the Federal Reserve Is Bad for America (New York: Portfolio Penguin, 2017), e-book.
Off-balance sheet (OBS) is an accounting maneuver used by companies to reduce their debt levels for reporting purposes. Enron perfected the use of OBS partnerships to hide its true liabilities from regulators and shareholders. Many at the Fed believed the OBS demon had been forever exorcized with Enron’s fall. But the demon had grown and metastasized, spreading little cancers throughout the financial system.
The resurrection of OBS vehicles had been made possible because banking had been reshaped by deregulation, innovation, and competition. Then the Fed lowered interest rates, creating “an abundance of credit for borrowers and a scarcity of yield for investors.” (Thank you, Alan Greenspan!)
Pozsar pinpointed the 1988 Basel I Accord as the main catalyst for the growth and advances of “credit risk transfer instruments” like CDOs [Collateralized Debt Obligations], MBSs [Mortgage-Backed Securities], asset-backed securities (ABS), asset-backed commercial paper (ABCP), commercial mortgage-backed securities (CMBS), and so on.
Issued after the banking crises of the late 1980s, the new Basel rules required that banks meet a minimum capital requirement and hold even more against riskier assets. For investment bankers seeking to maximize profits, and thus their own compensation, the changes created the need to hide liabilities in the shadows.
—Danielle DiMartino Booth, Fed Up: An Insider's Take on Why the Federal Reserve Is Bad for America (New York: Portfolio Penguin, 2017), e-book.
Thursday, November 14, 2019
In September 2007, Northern Rock Triggering the First High Street Bank Run in the UK Since 1866
The British bank Northern Rock played a starring role in the unfolding drama of the financial crisis. In September 2007, news that Northern Rock had used emergency liquidity support from the Bank of England led to the first high street bank run in the United Kingdom since Overend, Gurney and Co. in 1866. Following unsuccessful attempts at finding a private-sector buyer, Northern Rock was nationalized in February 2008, a policy outcome that would have struck many people as unthinkable just a few months before. Indeed, the speed at which “the Rock” had gone from being the darling of the city to a symbol of the meltdown was breathtaking. Following its listing on the FTSE 100 in 2000, the share price had been steadily increasing, and the company posted profits of more than £440 million in 2006. Around 5 percent of annual profit was being paid into the Northern Rock Foundation, which grew to be one of the United Kingdom’s largest corporation foundations (giving grants of more than £27 million in 2006), and the company had emerged as a beacon of North East economic renewal through its sponsorship of local sports teams and the planned development of new headquarters. If loyal customers were surprised at the speed of the bank’s downfall, they weren’t alone.
The main problem with Northern Rock’s business model was that its rapid expansion entailed two things: (1) allowing mortgage products to constitute a high proportion of its assets (about 75 percent) and (2) funding this through wholesale markets. [Note that unlike the situation facing many US banks, it wasn’t an increase in defaults on mortgage payments that got Northern Rock into trouble but the freezing up of funding.] In hindsight, the errors seem obvious, but the board was so oblivious that it planned a 30-percent increase in dividends as late as July 2007. And yet just two months after making a voluntary choice to reduce capital, it required emergency liquidity provisions. When questioned about this decision, Adam Applegarth (then CEO) pointed out that it wasn’t only the board that failed to anticipate the problem; the company had been focused on compliance with the Basel II international standards, working alongside the Financial Services Authority (FSA). Indeed, regulators deserve blame for two elements of this. First, the regulations themselves encouraged aspects of the problem: “Mortgage products had been made so attractive by IRB [internal-ratings-based] adherence to Basel II, that there was an incentive to grow them more quickly than could be funded by depositors.” There is little reason to think that stoking a housing bubble was an aim of Basel II, suggesting that it was an unintended consequence, that the Basel committee was simply ignorant of the activity that it was encouraging. The second failure of regulators was in not identifying the problems after they had begun to emerge. In June 2007, the FSA had approved the approach taken by Northern Rock to satisfy Basel II, partly because “they had Tier 1 capital of a ‘healthy’ 11.3 per cent of RAW [risk-weighted assets].” Despite retrospective protestations, the FSA was hardly trying to rein in a reckless company.
—Anthony J. Evans, “The Financial Crisis in the United Kingdom: Uncertainty, Calculation, and Error,” in The Oxford Handbook of Austrian Economics, ed. Peter J. Boettke and Christopher J. Coyne (New York: Oxford University Press, 2015), 749-750.
The main problem with Northern Rock’s business model was that its rapid expansion entailed two things: (1) allowing mortgage products to constitute a high proportion of its assets (about 75 percent) and (2) funding this through wholesale markets. [Note that unlike the situation facing many US banks, it wasn’t an increase in defaults on mortgage payments that got Northern Rock into trouble but the freezing up of funding.] In hindsight, the errors seem obvious, but the board was so oblivious that it planned a 30-percent increase in dividends as late as July 2007. And yet just two months after making a voluntary choice to reduce capital, it required emergency liquidity provisions. When questioned about this decision, Adam Applegarth (then CEO) pointed out that it wasn’t only the board that failed to anticipate the problem; the company had been focused on compliance with the Basel II international standards, working alongside the Financial Services Authority (FSA). Indeed, regulators deserve blame for two elements of this. First, the regulations themselves encouraged aspects of the problem: “Mortgage products had been made so attractive by IRB [internal-ratings-based] adherence to Basel II, that there was an incentive to grow them more quickly than could be funded by depositors.” There is little reason to think that stoking a housing bubble was an aim of Basel II, suggesting that it was an unintended consequence, that the Basel committee was simply ignorant of the activity that it was encouraging. The second failure of regulators was in not identifying the problems after they had begun to emerge. In June 2007, the FSA had approved the approach taken by Northern Rock to satisfy Basel II, partly because “they had Tier 1 capital of a ‘healthy’ 11.3 per cent of RAW [risk-weighted assets].” Despite retrospective protestations, the FSA was hardly trying to rein in a reckless company.
—Anthony J. Evans, “The Financial Crisis in the United Kingdom: Uncertainty, Calculation, and Error,” in The Oxford Handbook of Austrian Economics, ed. Peter J. Boettke and Christopher J. Coyne (New York: Oxford University Press, 2015), 749-750.
With the 2007–2008 Crisis, the Instabilities Arising from Maturity Mismatches Appeared in New and Hidden Forms Such as Mortgage-Backed Securities
Austrian economics provides fundamental but too often ignored insights into the challenges of monetary and macroeconomic policymaking. The Austrian theory of the business cycle offers a persuasive account of the genesis of the 2007–2008 crisis: it was made possible by the reliance of central banks worldwide on the reduction of short-term rates of interest to promote private sector spending. This encouraged an unsustainable expansion of money and credit. The only substantive difference from previous financial crises, something that allowed the preceding credit boom to proceed for so far and so long, was that instabilities arising from maturity mismatches appeared in new and therefore hidden variants, through money market funding of mortgage-backed securities and other structured credit assets. Austrian economics also provides a valuable explanation of previous episodes of global economic instability, for example the breakdown in the early 1970s of the post-war Bretton-Woods fixed exchange rate system based on a gold exchange standard as a consequence of insufficient discipline on US monetary creation.
Austrian economics is also the only free-market orientated school of thought drawing full attention to the deficiencies of the global policy response since 2007–2008. Central banks and governments around the world have mitigated the impact of the crisis on output and employment, providing more than $10 trillion dollars of financial support to prevent bank failures, cutting short-term interest rates for all the major currencies close to zero and engaging in a sustained and aggressive fiscal expansion that has more than doubled the ratio of public sector debt to GDP.
These measures may have been effective short-term palliatives, but they have done little to deal with underlying causes. While substantial increases in regulatory capital requirements and a wide range of other regulations have reduced tax-payer exposure to banking risks, investors have been left in little doubt that they will be protected once again should the entire financial system once again be threatened. The resumption of growth in the advanced economies is based as before on credit creation and maturity mismatch. The mispricing of assets and misallocations of capital evident before the crisis have continued, in many cases becoming even more marked. Economic expansion has been much stronger than was generally expected in the 18 months following the collapse of Lehman brothers, but this recovery has not been strong enough to allow a winding down of fiscal expansion. A policy of temporary ‘pump priming’ has turned into a policy of permanent and unsustainable fiscal deficits.
—Alistair Milne, “Cryptocurrencies from an Austrian Perspective,” in Banking and Monetary Policy from the Perspective of Austrian Economics, ed. Annette Godart-van der Kroon and Patrik Vonlanthen (Cham, CH: Springer International Publishing, 2018), 223-224.
Austrian economics is also the only free-market orientated school of thought drawing full attention to the deficiencies of the global policy response since 2007–2008. Central banks and governments around the world have mitigated the impact of the crisis on output and employment, providing more than $10 trillion dollars of financial support to prevent bank failures, cutting short-term interest rates for all the major currencies close to zero and engaging in a sustained and aggressive fiscal expansion that has more than doubled the ratio of public sector debt to GDP.
These measures may have been effective short-term palliatives, but they have done little to deal with underlying causes. While substantial increases in regulatory capital requirements and a wide range of other regulations have reduced tax-payer exposure to banking risks, investors have been left in little doubt that they will be protected once again should the entire financial system once again be threatened. The resumption of growth in the advanced economies is based as before on credit creation and maturity mismatch. The mispricing of assets and misallocations of capital evident before the crisis have continued, in many cases becoming even more marked. Economic expansion has been much stronger than was generally expected in the 18 months following the collapse of Lehman brothers, but this recovery has not been strong enough to allow a winding down of fiscal expansion. A policy of temporary ‘pump priming’ has turned into a policy of permanent and unsustainable fiscal deficits.
—Alistair Milne, “Cryptocurrencies from an Austrian Perspective,” in Banking and Monetary Policy from the Perspective of Austrian Economics, ed. Annette Godart-van der Kroon and Patrik Vonlanthen (Cham, CH: Springer International Publishing, 2018), 223-224.
Wednesday, November 13, 2019
Since Credit Default Swaps Can Be Used to Take Down Banks, They Can Be a Financial Weapon of Mass Destruction
Icelandic banks had no difficulties as long as international liquidity was ample and they could easily renew their short-term foreign-denominated debts. In early 2006, however, problems in the interbank market surfaced, in what would later be called the “Geyser crisis.” Price inflation increased and the króna depreciated as foreign money started getting nervous about the sustainability of the Icelandic boom. . . .
A vicious spiral may set in. Rising spreads indicate the market’s distrust of the banks, spurring even further demand for insurance, leading to even higher spreads on the debt, and so on, until the distrust in the bank reaches a point where the bank cannot receive further funding and it fails. Due to this self-reinforcing spiral of distrust and rising bank funding costs, reputable investors, commentators, and economists (most notably Warren Buffet), have called CDS [Credit Default Swaps] instruments weapons of mass destruction. Indeed, CDSs can be used to take banks down by lowering the confidence in them. Yet they can only work if banks are vulnerable; that is, if they violate the golden rule of banking and mismatch maturities, or they mismatch currencies, or they do both. Only then will the distrust translate into funding problems that threaten the bank’s liquidity and eventually its solvency. When the bank matches maturities and currencies and holds 100 percent reserves to cover its deposits, the distrust may lead to a loss of consumers as some depositors do not continue rolling their funding over; that is, they withdraw their deposits. This, however, will not take down the bank, as no liquidity loss will result. Only a mismatch makes the banks vulnerable to this type of failure.
—Philipp Bagus and David Howden, Deep Freeze: Iceland's Economic Collapse (Auburn, AL: Ludwig von Mises Institute, 2011), 73-74.
A vicious spiral may set in. Rising spreads indicate the market’s distrust of the banks, spurring even further demand for insurance, leading to even higher spreads on the debt, and so on, until the distrust in the bank reaches a point where the bank cannot receive further funding and it fails. Due to this self-reinforcing spiral of distrust and rising bank funding costs, reputable investors, commentators, and economists (most notably Warren Buffet), have called CDS [Credit Default Swaps] instruments weapons of mass destruction. Indeed, CDSs can be used to take banks down by lowering the confidence in them. Yet they can only work if banks are vulnerable; that is, if they violate the golden rule of banking and mismatch maturities, or they mismatch currencies, or they do both. Only then will the distrust translate into funding problems that threaten the bank’s liquidity and eventually its solvency. When the bank matches maturities and currencies and holds 100 percent reserves to cover its deposits, the distrust may lead to a loss of consumers as some depositors do not continue rolling their funding over; that is, they withdraw their deposits. This, however, will not take down the bank, as no liquidity loss will result. Only a mismatch makes the banks vulnerable to this type of failure.
—Philipp Bagus and David Howden, Deep Freeze: Iceland's Economic Collapse (Auburn, AL: Ludwig von Mises Institute, 2011), 73-74.
Hedge Funds Could Bet on the Downfall of Icelandic Banks by Buying Credit Default Swaps
Credit default swaps written on Icelandic banks soared. A credit default swap (CDS) is a form of insurance that investors buy to compensate for a loss if a particular debtor defaults on its obligation. Thus, when an investor holds a million-dollar bond issued by Glitnir and the insurance premium is twenty-five basis points or 0.25 percent, he can insure himself against a default by paying an annual fee of 0.25 percent of one million, i.e., $2,500. An intriguing aspect of credit default swaps is that you may buy them even though you do not own any debt issued by the company, Glitnir in this example. Lacking ownership in the underlying company, you are just betting that Glitnir will default on its obligation. By paying just $2,500 a hedge fund could make a gross profit $1 million if Glitnir defaulted on its obligations. Funds could bet on the downfall of Icelandic banks by buying credit default swaps, and by the very act of buying the swaps they could hope to undermine confidence in the banks and promote their own investment. The CDS spread on a bond is like an insurance premium in that it indicates the confidence in the bond. At the beginning of 2006 investors started to bet against Icelandic banks because of the banks’ high dependence on wholesale short-term funding and their burgeoning size, which made them too big to be bailed out by the Icelandic government. As foreign investors increased their demand for protection against defaults by Icelandic banks, the price of the insurance increased in CDS markets; that is, spreads on the banks rose.
—Philipp Bagus and David Howden, Deep Freeze: Iceland's Economic Collapse (Auburn, AL: Ludwig von Mises Institute, 2011), 73-74.
—Philipp Bagus and David Howden, Deep Freeze: Iceland's Economic Collapse (Auburn, AL: Ludwig von Mises Institute, 2011), 73-74.
Tuesday, November 12, 2019
A Price Deflation Might Bring Down a Fractional Reserve Banking System as the Real Burden of Debt Increases
A price deflation might bring down a fractional reserve banking system. This is so, because a price deflation can lead to bankruptcies as the real burden of debt increases. Especially in a recession after an artificial boom, a credit contraction and bankruptcies due to the malinvestments occurs. As a consequence of the bankruptcies that are induced by the price deflation, loans that banks gave out will turn bad. The stocks of the bankrupt companies that other banks hold will lose value, perhaps even to the point of becoming worthless. In general, the assets of banks will fall in value. In order to preserve solvency banks will restrict credits and put pressure on its corporate partners and other banks. The decline in one bank’s assets’ values might induce doubts in the solvency and liquidity of other banks. Due to the credit restriction, corporate partners might go bankrupt. Other banks also financing these corporations get into financial difficulty as well. Bank runs might occur. In a fractional reserve system, by definition, the bank cannot pay out all demand deposit claims that exist. The bank will go bankrupt. If one bank collapses this instability might spread to other fractional reserve banks due to their interconnectedness. The bankruptcy will induce fear about the solvency of other banks, further reduce the value of their assets’ value, and lead to systematic bank runs. A bank panic ensues. This might bring the whole fractional reserve banking system down if the central bank fails to bail out the banking system. This possible consequence of price deflation is beneficial as it purges the old banking system making place for a 100% gold standard as Rothbard points out.
—Philipp Bagus, In Defense of Deflation, Financial and Monetary Policy Studies 41 (Cham, CH: Springer International, 2015), 90.
—Philipp Bagus, In Defense of Deflation, Financial and Monetary Policy Studies 41 (Cham, CH: Springer International, 2015), 90.
Sunday, November 10, 2019
The Boom in Residential Real Estate in Toronto, Vancouver, and Sydney Far Outside the Commodity Producing Regions
These housing market issues become of particular relevance to small- and medium-sized economies under the regime of the 2% inflation standard.
The governments/central banks here face a particular dilemma, especially if there is an attractive narrative which could buoy speculative interest (carry trades) in their national currency. For example, a range of commodity producing and/or emerging market economies have found themselves during the present asset price inflation episode encountering huge demand for their still-positive interest rate monies. That narrative is sometimes rapid growth potential. And a sequence of capital gains on the related currency carry trade imparts positive feedback loops to still more participation in that. . . .
In the great asset price inflation of the present decade, policy-makers in a range of small- or medium-sized countries rejected following the defiant path of hard money. For example, Canada and Australia found their currencies under tremendous upward pressure in the first stage of the US monetary inflation as dollar depreciation and the China monetary boom drove the prices of their key commodity exports towards the sky. The central banks of both Commonwealth countries took the same tack—not allowing interest rates to rise in line with economic expansion fed by commodity export boom so as to contain the strength of their currencies. The result: a boom in residential real estate in the star cities (Sydney, Toronto and Vancouver) far outside the commodity producing regions. A lead narrative featured the flood of newly rich Chinese investors and occupiers of these. And though low, the interest rates had sparkled to a range of income-famished investors in the world outside, including European central banks and other sovereign wealth funds diversifying into these still-positive interest rate monies. Another feature of the monetary policies followed was the build-up of a consumer debt boom, in part taking advantage of the raised value of real estate collateral.
—Brendan Brown, The Case Against 2 Per Cent Inflation: From Negative Interest Rates to a 21st Century Gold Standard (Cham, CH: Springer International Publishing, 2018), 140-142.
The governments/central banks here face a particular dilemma, especially if there is an attractive narrative which could buoy speculative interest (carry trades) in their national currency. For example, a range of commodity producing and/or emerging market economies have found themselves during the present asset price inflation episode encountering huge demand for their still-positive interest rate monies. That narrative is sometimes rapid growth potential. And a sequence of capital gains on the related currency carry trade imparts positive feedback loops to still more participation in that. . . .
In the great asset price inflation of the present decade, policy-makers in a range of small- or medium-sized countries rejected following the defiant path of hard money. For example, Canada and Australia found their currencies under tremendous upward pressure in the first stage of the US monetary inflation as dollar depreciation and the China monetary boom drove the prices of their key commodity exports towards the sky. The central banks of both Commonwealth countries took the same tack—not allowing interest rates to rise in line with economic expansion fed by commodity export boom so as to contain the strength of their currencies. The result: a boom in residential real estate in the star cities (Sydney, Toronto and Vancouver) far outside the commodity producing regions. A lead narrative featured the flood of newly rich Chinese investors and occupiers of these. And though low, the interest rates had sparkled to a range of income-famished investors in the world outside, including European central banks and other sovereign wealth funds diversifying into these still-positive interest rate monies. Another feature of the monetary policies followed was the build-up of a consumer debt boom, in part taking advantage of the raised value of real estate collateral.
—Brendan Brown, The Case Against 2 Per Cent Inflation: From Negative Interest Rates to a 21st Century Gold Standard (Cham, CH: Springer International Publishing, 2018), 140-142.
The Mercantilist Idea that Increasing the Money Supply Increases Prosperity Was Exposed as an Error Centuries Ago by Richard Cantillon
We now turn our attention to what happens with an increase in the
money supply, rather than an increase in savings. This is critically important. The mercantilist idea that increasing the money supply increases
prosperity was exposed as an error centuries ago by Richard Cantillon. However, modern mainstream economists, including the monetarists,
Keynesians of various sorts, and the now-fashionable market monetarists,
fully embrace the idea that printing money is necessary for prosperity.
In fact, the major central banks of the world have embarked on an unprecedented policy of monetary expansion both before and after the financial crisis of 2008. These central banks are led by people with advanced degrees in “economics,” and they have large research staffs of people with PhDs in mainstream economics. The result is a world currency war whereby each currency is printed in an effort to implement an economic expansion by a beggar-thy-neighbor policy, another widely discredited idea.
The beggar-thy-neighbor policy involves printing money to reduce the value of your domestic currency vs. foreign currencies. Reducing the value of your currency reduces the relative price of your exports and makes foreign products relatively more expensive so that you increase exports and domestically produced goods and reduce imports. Th e problem is that you also increase the price of imports and decrease efficiency. Ultimately this policy does not work: in the end you are worse off .
—Mark Thornton, The Skyscraper Curse: And How Austrian Economists Predicted Every Major Economic Crisis of the Last Century (Auburn, AL: Mises Institute, 2018), 59-60.
In fact, the major central banks of the world have embarked on an unprecedented policy of monetary expansion both before and after the financial crisis of 2008. These central banks are led by people with advanced degrees in “economics,” and they have large research staffs of people with PhDs in mainstream economics. The result is a world currency war whereby each currency is printed in an effort to implement an economic expansion by a beggar-thy-neighbor policy, another widely discredited idea.
The beggar-thy-neighbor policy involves printing money to reduce the value of your domestic currency vs. foreign currencies. Reducing the value of your currency reduces the relative price of your exports and makes foreign products relatively more expensive so that you increase exports and domestically produced goods and reduce imports. Th e problem is that you also increase the price of imports and decrease efficiency. Ultimately this policy does not work: in the end you are worse off .
—Mark Thornton, The Skyscraper Curse: And How Austrian Economists Predicted Every Major Economic Crisis of the Last Century (Auburn, AL: Mises Institute, 2018), 59-60.
Saturday, November 9, 2019
The Sovereign Debt Crisis in the European Monetary Union in 2010—12/13 Triggered Huge Demand for the Swiss Franc as Safe Haven
Both countries (Canada and Australia) remained loyal and committed members of the 2% inflation standard. And so did that once hard money country Switzerland. In the 1990s it slowly drifted away from its monetarist past and adopted an inflation-targeting regime, albeit not so laser fixated on 2% as was more broadly the case. The sovereign debt crisis within the European Monetary Union in 2010—12/13 triggered huge demand for the Swiss franc as safe haven, to which the Swiss authorities responded by massive foreign exchange market intervention, a spell of fixing a ceiling to the currency, and ultimately a journey into an emergency negative interest rate regime which persisted for years. The big difference from the Australian and Canadian experiences was the massive foreign exchange market intervention and the adoption of radical monetary-easing measures—perhaps indicative of an even greater potential “overshoot” of the currency which might have occurred if the Swiss had held their hard money ground.
—Brendan Brown, The Case Against 2 Per Cent Inflation: From Negative Interest Rates to a 21st Century Gold Standard (Cham, CH: Springer International Publishing, 2018), 142-143.
—Brendan Brown, The Case Against 2 Per Cent Inflation: From Negative Interest Rates to a 21st Century Gold Standard (Cham, CH: Springer International Publishing, 2018), 142-143.
Friday, November 8, 2019
Japan Is the Battleground for Monetary Theorists; The Architects of the 2% Inflation Standard Can View Japan as a Laboratory Where the Most Powerful Non-Conventional Tools Have Been Deployed
And in looking further back, to before the journey started, the huge scope of the Japanese bubble and bubble economy in the late 1980s is a challenge to any serious purveyor of monetary or broader economic theory. Can this theory explain what happened and what went wrong in Japan? Our examination should also test any such theory in the story of Japanese deflation (itself largely myth rather than fact). The battle has been joined by sound money theorists drawing on Austrian School economics, who argue that Japan’s and indeed the globe’s economic outcome would have been much better if in fact there had been some period of declining prices.
We could describe Japan as the battleground for monetary theorists. The architects of the 2% inflation standard can view Japan as a laboratory where in recent years the most powerful non-conventional tools yet have been deployed. The Abe government was victorious in the political arena in terms of taking Japan on to the 2% inflation standard and in authorizing such tools. And at the time of writing, the world is basking in a stock market boom and global economic upturn in which Japan is fully sharing. Its apparent successes could be pyrrhic if indeed Japan adds to the evidence that the 2% global inflation standard is harmful to prosperity.
—Brendan Brown, The Case Against 2 Per Cent Inflation: From Negative Interest Rates to a 21st Century Gold Standard (Cham, CH: Springer International Publishing, 2018), 96.
We could describe Japan as the battleground for monetary theorists. The architects of the 2% inflation standard can view Japan as a laboratory where in recent years the most powerful non-conventional tools yet have been deployed. The Abe government was victorious in the political arena in terms of taking Japan on to the 2% inflation standard and in authorizing such tools. And at the time of writing, the world is basking in a stock market boom and global economic upturn in which Japan is fully sharing. Its apparent successes could be pyrrhic if indeed Japan adds to the evidence that the 2% global inflation standard is harmful to prosperity.
—Brendan Brown, The Case Against 2 Per Cent Inflation: From Negative Interest Rates to a 21st Century Gold Standard (Cham, CH: Springer International Publishing, 2018), 96.
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