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Economic Cycles (and Austrian Economics in general)

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My point is that Greenspan's cheap money (or the Federal Reserve system in general) caused the worst financial crisis in a century [...] one who believes in the Austrian Business Cycle (as I do)

Well, you probably know by now that I am not convinced of the Austrian Business Cycle theory--which is why I would also disagree with your characterization of "cheap money" being the main cause of the crisis. I think it was caused by the government's attempt to remove causality from the loan market: "insuring" deposits and encouraging banks to make unsound loans.

Either way, don't get me wrong. I think your paper is really good.

Thanks, I'm glad you like it. :)

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My thesis revolves around the fact that Greenspan's hand was forced--he had to lower rates dramatically to spur consumption and forestall a post 9/11 recession.

Greenspan attributes the unusually low interest rates early this decade to a massive flow of savings from emerging Asian economies and elsewhere. I don't think that that is completely unfounded because while central banks are big players - globally integrated financial markets (real factors of supply and demand) also have a significant effect.

Edited by ~Sophia~
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Greenspan attributes the unusually low interest rates early this decade to a massive flow of savings from emerging Asian economies and elsewhere. I don't think that that is completely unfounded because while central banks are big players - globally integrated financial markets (real factors of supply and demand) also have a significant effect.
This was almost certainly a factor; but it was a governmental factor. The Chinese government for trying to prop up the dollar (i.e. keep its own currency weak), and the U.S. government was running up the the debt (Federal and Agency) that the Chinese could buy. Without both governments playing a role, any potential problems would have been limited to private-party to private-party transactions.
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Without both governments playing a role, any potential problems would have been limited to private-party to private-party transactions.

If private parties are willing to lend money to private parties at low interest rates, can that ever be a problem? On a free market, low interest rates indicate that there is plenty of capital available to invest, and I think that is always a good thing.

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Could you please explain why you do not agree with the Austrian conception of the business cycle? Also, what, in your view, is the cause of business cycles?

You've denied that cheap money creates economic cycles in a few threads now, but you haven't proposed an alternative theory to explain the origin of economic booms and busts.

Edited by adrock3215
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Could you please explain why you do not agree with the Austrian conception of the business cycle?

I disagree with the very foundation of Austrian economics, which is subjectivism. While Austrian economists do make some cogent points which I wholeheartedly agree with, their theory of the business cycle is not one of them.

As far as I understand it, the theory seems to say that any "credit expansion" is going to cause a "boom" and then a "bust," regardless of whether it is enacted by private banks in a free economy or by a central bank. I understand that the term "credit expansion" refers to any expansion of the money supply resulting primarily out of the action of banks, as opposed to the action of gold mines. In a free, gold-based fractional banking system, that would mean the banks reducing their reserve rates, loaning out a greater proportion of their depositors' money. Under central banking, the mechanism is different, but the theory sees no essential difference: both are considered an "artificial" expansion of credit that creates a "false sense of prosperity," making producers somehow think that they can afford longer-term investments than they otherwise could. This leads to the "boom" phase. But then, the true time preferences somehow "reassert" themselves and the producers, who have apparently expected the low interest rates to last indefinitely and made them a part of their business plan, find that they cannot afford the additional loans they need to complement their original investments.

Am I more or less correct in my interpretation?

If I am, then there are several points that I am either in outright disagreement with or not convinced about. First of all, you cannot simply equate the actions of free banks and a central government bank and say that they both lead to the same undesirable economic consequence. Not if you are a supposed defender of capitalism who is arguing that the undesirable in economics is always the un-capitalist.

Second, I do not see how loaning out funds that, in the bank's judgment, are available for loaning out, can create a false sense of prosperity--unless the bank's judgment is incorrect, but banks that systematically make incorrect judgments do not stay in business for long in a free economy. If the bank has been thinking it necessary to keep a 50% reserve in gold, but the calculations of its experts indicate that a 45% reserve would now be enough to satisfy the demands of its clients (due to a change in market conditions, e.g. the more widespread use of credit cards), that means that 5% of the gold lying in its vaults is performing no useful function there. Far from being essentially similar to Greenspan, the bank's experts have performed a role comparable to that of the gold miners: they have found unused gold. The proper thing to do with unused wealth is to invest it where it is needed.

If the market conditions revert and a higher reserve rate is needed, then the bank should be prepared for that and adopt tighter lending policies until its reserves reach 50% again. Or, if the demand for gold as a means of payment continues to be outstripped by other payment forms (which I maintain is going to be the long-term trend), then the bank should consider lowering its reserve rate further.

It is also unclear to me what exactly is meant by the time preferences "reasserting" themselves. What actions by what market participants does that term refer to?

And why do the businessmen who plan the investments believe that a low interest rate today means they are going to be able to borrow at the same low interest rate 5 years from now? An interest rate is a price, and I have never heard of any rational manager expecting any prices to remain unchanged for years in a free market. Whenever you make a business plan, you have to factor in the possibility of the price of your own product declining, and the prices asked for by your suppliers, the wages asked for by your employees, and the interest asked for by your creditors increasing.

Also, what, in your view, is the cause of business cycles?

In a totally free market, there can be some cyclicality in the supply of goods that take a long time to produce caused by their producers being unable to predict the number of their competitors. For example, if oil is expensive, that is a signal for companies to do more oil exploration. But it is difficult to know how many other companies will also engage in similar exploration as a result of the high price, and even more difficult to predict how successful they will be at it. If a lot of companies end up finding large oil fields, the price of oil will drop precipitously, which in turn will cause businesses to divest from oil--but again, they are not guaranteed to predict with success how many others are also divesting, so if too many do, the price of oil may rise very high again, restarting the cycle. In the case of goods whose supply has a major impact on the economy, such as oil, this product-specific cycle may cause visible fluctuations in the general level of economic growth.

But a much more important factor in causing economic cycles in our present-day mixed economy is government intervention. A statist candidate is elected; his actions cause the economy to weaken; he sees the weak economy as a "failure of the market" and is eager to "fix" it with more statism--and soon you have a full-blown economic bust. Eventually, when there is a lull in government intervention, the creativity of producers manages to turn the economy around and growth picks up again. And if it were only up to the creativity of productive men, the growth could continue for millennia--but then, another statist comes along, and the cycle starts again.

One statist interventions you can count on to stymie any boom is ........... the raising of interest rates. According to the still-prevalent Keynesian fallacy, a growing economy is an unnatural condition that carries a danger of "overheating." The Keynesian mind cannot imagine that there can be any source of apparent growth other than inflation. So whenever the economy is growing, the Fed will sooner or later begin to worry about inflation and come to the "rescue" by deliberately cooling down the "overheating" economy.

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First of all, you cannot simply equate the actions of free banks and a central government bank and say that they both lead to the same undesirable economic consequence. Not if you are a supposed defender of capitalism who is arguing that the undesirable in economics is always the un-capitalist.

First, this is an argument from necessity. It does not look at whether the effects of the intended actions are the same or not. If you drop a ball to the earth, the size of the dent is not dependant on whether the ball was dropped by a bureacrat or a CEO.

Second, I do not see how loaning out funds that, in the bank's judgment, are available for loaning out, can create a false sense of prosperity--unless the bank's judgment is incorrect, but banks that systematically make incorrect judgments do not stay in business for long in a free economy. If the bank has been thinking it necessary to keep a 50% reserve in gold, but the calculations of its experts indicate that a 45% reserve would now be enough to satisfy the demands of its clients (due to a change in market conditions, e.g. the more widespread use of credit cards), that means that 5% of the gold lying in its vaults is performing no useful function there. Far from being essentially similar to Greenspan, the bank's experts have performed a role comparable to that of the gold miners: they have found unused gold. The proper thing to do with unused wealth is to invest it where it is needed.

If the market conditions revert and a higher reserve rate is needed, then the bank should be prepared for that and adopt tighter lending policies until its reserves reach 50% again. Or, if the demand for gold as a means of payment continues to be outstripped by other payment forms (which I maintain is going to be the long-term trend), then the bank should consider lowering its reserve rate further.

It is this mechanism by which a private market regulates rates, but please note, that this is not incompatible with the idea that loose credit policies cause booms. The difference is not in the effects of lowering rates. It is in the feedback mechanism that regulate a free market vs. those which do not regulate a govt market.

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It is this mechanism by which a private market regulates rates, but please note, that this is not incompatible with the idea that loose credit policies cause booms. The difference is not in the effects of lowering rates. It is in the feedback mechanism that regulate a free market vs. those which do not regulate a govt market.

Could you elaborate a little more on what you mean by this?

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Could you explain this a little more? What subjectivism are you referring to? The theory of value?

Yes, value, and more broadly, ethics. Consider the following quote from Human Action:

Ethical doctrines are intent upon establishing scales of value according to which man should act but does not necessarily always act. [...] This is not the attitude of praxeology and economics. They are fully aware of the fact that the ultimate ends of human action are not open to examination from any absolute standard. Ultimate ends are ultimately given, they are purely subjective, they differ with various people and with the same people at various moments in their lives. [...] Any examination of ultimate ends turns out to be purely subjective and therefore arbitrary.

What happens when you take this to its logical conclusion? I'll let von Mises state it himself:

It is useless to stand upon an alleged "natural" right of individuals to own property if other people assert that the foremost "natural" right is that of income equality.

And:

There is, however, no such thing as a perennial standard of what is just and what is unjust. Nature is alien to the idea of right and wrong.

[...]

For those not deluded by them it is obvious that the appeal to justice in a debate concerning the drafting of new laws is an instance of circular reasoning. [...] In considering changes in the nation's legal system, in rewriting or repealing existing laws and writing new laws, the issue is not justice, but social expediency and social welfare. There is no such thing as an absolute notion of justice not referring to a definite system of social organization. It is not justice that determines the decision in favor of a definite social system. It is, on the contrary, the social system which determines what should be deemed right and what wrong.

[...]

It is nonsensical to justify or to reject interventionism from the point of view of a fictitious and arbitrary idea of absolute justice.

What that last sentence amounts to is: "You cannot defend capitalism on a moral basis." And if you look at the passages where he is speaking out for capitalism, you'll find that he always does so on a utilitarian base. Capitalism is usually good at helping achieve the goal of human action--which he considers to be "the removal of felt uneasiness"--so let's have capitalism.

But what about the people who feel uneasy about the productivity and wealth of others and want to sabotage it? Given all the above, the answer is inevitable:

There are, as has been shown, cases in which a [governmental] restrictive measure can attain the end sought by its application. If those resorting to such a measure think that the attainment of this goal is more important than the disadvantages brought about by the restriction—i.e., the curtailment in the quantity of material goods available for consumption—the recourse to restriction is justified from the point of view of their value judgments. They incur costs and pay a price in order to get something that they value more than what they had to expend or to forego. Nobody, and certainly not the theorist, is in a position to argue with them about the propriety of their value judgments.
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Sorry Cap, I haven't had time to get around to this post. I will return to it later. For now, I will just say that Mises was a great economist and a terrible philosopher. We needn't look to him for moral guidance or metaphysical and epistemic clarity; rather, we look to Mises for his contribution to economic thought. We all know that abstractly Mises starts at the wrong premises (Rand knew that about him also), but that doesn't preclude his thought from consideration. Certainly the Austrian Business Cycle could be a rough description of observable and factual truth, despite the fact it was "created" from unsound and invalid premises. Sort of like the Christian that you manage to agree with on that one concrete issue.

The study of economics is a relatively new discipline (viewed from an historical perspective). Right now it is dominated by sundry variations of positivist methodologies. The only school that challenges these establishment methods is the Austrian School, which is why they aren't taken seriously. Austrians think economic truth can be deduced a priori, without reference to reality. I think that there is a lot of intellectual work to be done in terms of laying out a fully Aristotolean philosophical framework for economic thought and truth; that is to say: a rational and inductive basis for economics. Granted that we both agree on the fact that Mises did not achieve such an accomplishment, we can proceed with our discussion, seperating the supposedely "a priori" premises of Mises from observable concretes.

Edited by adrock3215
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Yes, value, and more broadly, ethics. Consider the following quote from Human Action:

If you don't ascribe to the Austrian theory of value, what do you hold as the the origin of value? It is indisputable that he value of an economic good is different for different people.

Value is based on individual value judgments. Is this what you disagree with?

As far as ethics go, Mises certainly made many errors, I remember noting quite a few when I read Human Action, but as adrock said:

we look to Mises for his contribution to economic thought.

His proposed ethics really don't have anything to do with his economic theory, just as Newton's ethics weren't involved with his work. I think we both agree that it is far more important to defend capitalism from a moral standpoint than to defend it from a utilitarian stand point. Objectivism explains the moral side of the equation, but we still need to have the utilitarian side.

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Mises was a great economist and a terrible philosopher.

I agree about the terrible philosopher part, but I wouldn't say he was more than a so-so economist. (That still puts him safely into the top 10 of the best economists in history, though...) I agree with perhaps around 50% of what he wrote (sometimes enthusiastically agree), but disagree with the other 50%--sometimes vehemently disagree. Now, that's a pretty good ratio for someone who's got most of his philosophy wrong, but philosophy is what's more fundamental, and the more fundamental is always the more important in the battle of ideas.

It is possible for someone to espouse some terrible philosophical ideas and still be, say, an excellent figure skater. But if it is so, it must be so because she has a more rational implicit philosophy that she relies on for her achievements in figure skating. When talking to you, she may say that the Law of Causality is an arbitrary social construct, but when in the rink, she must implicitly rely on the laws of gravity, friction, conservation of angular momentum, and so on--and thus, ultimately, the Law of Causality. If she didn't, she would make a great clown, but there is no way she could be a good figure skater.

But economics is an abstract science that is so close to philosophy that you cannot have a separate bad philosophy for explicit espousal and a good one for implicit use in economic thought. Whatever your philosophical ideas, they are going to make their impression on your economic ideas. There is a reason von Mises writes so much about his philosophy in his book: it is a statement of the premises and the methodology his entire system of economics is founded upon. In contrast with the figure skater who puts her disdain for causality aside while skating, von Mises keeps reiterating his philosophical premises whenever he wants to convince us of his economic ideas.

but that doesn't preclude his thought from consideration

It certainly doesn't, but consideration does not necessarily imply acceptance. It means that you look at the idea and check if it is consistent with all the facts of reality you know--including, first and foremost, the philosophical principles you have identified. If it does not, it may often be possible to find a somewhat modified form of it that does--but if that fails too, you have to reject it.

But the first step in considering an idea is to understand it, and I am still not sure I have successfully made even that first step in the case of the Austrian Business Cycle. So I am looking forward to your response on whether my interpretation is correct and to clearing up any misunderstandings I may have.

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If you don't ascribe to the Austrian theory of value, what do you hold as the the origin of value? It is indisputable that he value of an economic good is different for different people.

Value is based on individual value judgments. Is this what you disagree with?

I accept the Objectivist concept of value. That should answer all your questions. :)

His proposed ethics really don't have anything to do with his economic theory

Well, if the quote from him above is anything to go by, he appears to propose that there should be no ethics. People will always act in the way they think contributes most to removing the uneasiness they feel, and that is the end of the matter--there is no point in any further discussion; there is no point in having ethics. Studying human action, i.e. economics / "praxeology," is studying what people can do to remove their uneasiness.

But this is simply not the way it is. Ideas of morality are a factor in men's actions; in fact, they are the primary factor. Man, as a conceptual being, cannot escape the need for abstract principles to act on. And the most widely accepted ethical theories are precisely those that worship "uneasiness"--i.e., pain, suffering, self-abnegation, and all the rest. To study human action is to study ethics.

Austrian economics is well known, but it hasn't convinced many people of capitalism being the best system. The reason for that is that it has been trying to sell them something they don't want to buy. "Want to remove your uneasiness? Capitalism will do the job!" is the message of Human Action. "I need my uneasiness so I can go to Heaven, so I'd better stay far away from capitalism!" has been people's reaction.

I think we both agree that it is far more important to defend capitalism from a moral standpoint than to defend it from a utilitarian stand point.

It's not just that a moral defense is more important than a utilitarian one. A utilitarian attempt at defense is highly counter-productive!

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I accept the Objectivist concept of value. That should answer all your questions. :)

I don't mean a "concept of value," I mean an economic theory of value. Objectivism's theory of value does not explain prices.

Well, if the quote from him above is anything to go by, he appears to propose that there should be no ethics. People will always act in the way they think contributes most to removing the uneasiness they feel, and that is the end of the matter--there is no point in any further discussion; there is no point in having ethics. Studying human action, i.e. economics / "praxeology," is studying what people can do to remove their uneasiness.

But this is simply not the way it is. Ideas of morality are a factor in men's actions; in fact, they are the primary factor. Man, as a conceptual being, cannot escape the need for abstract principles to act on. And the most widely accepted ethical theories are precisely those that worship "uneasiness"--i.e., pain, suffering, self-abnegation, and all the rest. To study human action is to study ethics.

That's a great point, I've never really thought of that! Though I still don't see where his philosophic errors have lead to economic errors or why his ethics discredit his business cycle theory. Can you expand on that more?

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We had a tiny thread on von Mises's theory of value a while back. While von Mises's approach may be flawed, and may hinder the exploration of certain aspects of economics, it would seem that for many (most?) questions in economics, one does not need to know the underlying decision processes. In essence, those processes are "abstracted away".

For instance, people may want a particular brand of clothing because it is made of very high quality cloth, or because some movie star wears it, or even because they are making some mistake about it. The underlying factors would be pretty important to someone making economic decisions about investing in that clothing company. Similarly, the demand for whisky may be driven by a mix of motives across the mix of customers: some rational, other irrational. However, at the level of the economy, with the specifics abstracted away, the rationale behind the decision-making seems less important.

[CF: Feel free to move this back to the other thread, if you wish to keep this one about "cycles".]

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ABCT is sound. Inflationary expansion of the currency means creating more titles to money (paper) than there is money (gold, silver or whatever the money comodity is). Under a fiat money system every cent created is inflation. Whether it is the government perpetuating this fraud or a private bank, the effects are the same.

Fractional reserve banking is fraud. No reserve fiat money is fraud on crack.

As for Mises, his epistemology is a rudimentary form of skepticism, his ethics utilitarian. As a philosopher, he fails. His economics, on the other hand, are brilliant. The way he managed to get away with that was:

1- He intentionally disregards why people do what they do. A "values free" economics is a "untennable ethics free" economics;

2- He (accidentally or otherwise) chose as axioms and general assumptions things that are true;

3- His economic theory focuses at the level where economic decisions actually take place: the individual.

PS: Mise's "subjective theory of value" certainly raises red flags if you are an Objectivist. But, in practice, the term "subjective" in that expression means "individual context dependent" - in that he simply assumes that each individual's values differ from the others due to factors outside the economist's scope of analysis. Despite the name he chose, it is a valid theoretical artifice.

Edited by mrocktor
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I don't mean a "concept of value," I mean an economic theory of value. Objectivism's theory of value does not explain prices.

I'm never quite sure what people are looking for when they seek an "explanation"/"origin" of values/prices/etc. (Bohm-Bawerk's rejection of many economic theories because they don't "explain the origin of interest" is a good example. I've never been able to figure out what exactly it was he missed from those theories.)

If you mean the level of prices, i.e. whether something costs $8 or $10, they are determined by supply and demand. In a rational society, supply and demand will be determined by the objective value judgments and productive choices of individuals based on the facts of reality, using life as their ultimate standard of value.

Though I still don't see where his philosophic errors have lead to economic errors

For example, he holds that labor is usually a disutility to the person doing it--meaning that people don't like their work. Ayn Rand's heroes all love their work, and so do all great producers in real life. Remember that Roark was willing to design Cortlandt for free, and without getting credit for it--his sole reward being that it would be "my work, done my way." And do you think Neil Armstrong would ever have made it to the moon if he had disliked being an astronaut?

Or, what I see as an even greater flaw of his economics, he views the capitalist economy as a "consumers' democracy," in which the producers are "mandataries" of the consumers, "subordinated" to their preferences--which are subjective and inexplicable, i.e. whims. This has wide-ranging implications, because his entire price theory is built on this. E.g., he considers any producer who is able to sell his products at prices that allow him to earn a greater-than-ordinary return on investment to be a "monopolist" (see Part 4, Chapter XVI, Section 6, bullet 3) who "infringes the supremacy of the consumers."

or why his ethics discredit his business cycle theory.

They don't. B) I have meanwhile amended the title of the thread to reflect the fact that the discussion has become a bit broader; I certainly didn't mean the post above as an argument against the business cycle theory specifically. As I wrote to adrock above, I still haven't finished making my mind up on the cycle theory, because I'm not sure I have even understood it correctly yet. To be honest, I have found all descriptions of it that I have read to be rather difficult to follow, making what appear to me to be logical leaps, and using concepts whose connection to reality I am not sure about. This is why I am tending "unconvinced" at the moment.

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I think that it is possible to discuss solely the Austrian theory of the business cycle while rejecting other tenets of Mises' work. I will do that in this thread, since that is what it was originally predicated upon. There may be others here with a better understanding economics than I, so please correct me if I am wrong in any regard.

As far as I understand it, the theory seems to say that any "credit expansion" is going to cause a "boom" and then a "bust," regardless of whether it is enacted by private banks in a free economy or by a central bank. I understand that the term "credit expansion" refers to any expansion of the money supply resulting primarily out of the action of banks, as opposed to the action of gold mines. In a free, gold-based fractional banking system, that would mean the banks reducing their reserve rates, loaning out a greater proportion of their depositors' money. Under central banking, the mechanism is different, but the theory sees no essential difference

This isn't correct.

When banks in a free economy reduce their reserve ratios and loan out funds gathered from depositors, they have the choice to loan out gold from the vault or claims on gold which remains in the vault, i.e. banknotes. Either way, the supply of actual money is static and does not change. What changes is either the number of banknotes in circulation, or the amount of gold in the vault. But the total amount of gold, i.e. the money supply, in the economy remains the same, and therefore the theory actually does see an entirely essential difference between the two scenarios described.

I will attempt to explain the theory better.

The essence of the Austrian Business Cycle is deduced by Mises from the "a priori" premise that man must act. While Mises is epistemically incorrect, he ends at a conclusion which can be supported by inductive premises. We can inductively reason that man has free will, that his survival depends upon the use of his reasoning mind, and that he must act under the guidance of reason to survive, rather than plant his feet in the ground and wait for rain and sunlight.

But the fact that a man must act--indeed, that he acts at all--implies the foundational principle of economics; namely, that life can be viewed as essentially two arbitrary periods: current and future. The totality of life as action is a tradeoff between current consumption and future consumption or current production and future production. Depending on an individuals preferences for his own time and its value therein, he allocates his consumption and production between present and future.

But actions in an exchange economy include another factor which affects the preferences of economic actors between present and future. This is identified as interest. Interest rates as such reflect the value that an individual places on his or her time. For instance, I may loan you $100 at 10% for a year because I feel that the rate of interest adequately compenstates me for the fact that I won't be able to use my $100 in the next year while you have it. Likewise, I may feel that 5% is not adequate compensation for my loss of utility, and therefore I will not extend the loan to you. Depending on the length of time I loan my money to you, I determine the appropriate level of compensation. The marginal utility of $100 to me within the next hour may be very low, because I don't plan on leaving the house and spending $100 within the next hour. However, within the next month, $100 may have a greater marginal utility to me, because I will need it to pay my phone bill at the end of the month. In a free market, the supply and demand of loanable funds based on the time preferences of economic actors will set the prevailing market interest rate in the same way prices of any other good are set.

In an economy where interest rates are manipulated by central planners, the supply and demand of loanable funds is distorted and the price-signaling-mechanism of interest rates for the time preferences of economic actors is lost. As a concrete illustration of this manipulated economy: an increase in loanable funds based on a shift in consumer preferences towards higher savings rates becomes fundamentally indistinguishable from an increase in loanable funds based on the increase of the monetary base. The effect of both is a decrease in interest rates, although one represents an increase in actual wealth produced while the other represents an increase in paper notes.

In regard to the business cycle, a nonproductive, paper-money induced decrease in interest rates leads to the boom phase of a business cycle. One of the major contributions of the Austrians is the discovery that capital is heterogeneous. Under this theory, the term structure of interest rates represents the increased uncertainty associated with longer term capital loans. This means that the interest rate on a two year loan is not simply the interest rate on a one year loan given today plus the interest rate on a one year loan given one year from now. There is a premium demanded by the lender for the time his money is lent out which increases in proportion to the length of the loan. When interest rates decrease in a free market, preferences of consumers are revealed to be longer-term, and therefore investment by producers in more capitalistic (longer-term) enterprises increases relative to investment by producers in less capitalistic (shorter-term) enterprises (although investment in both increases). The plant which makes the transistors to sell to Dell (long-term capital stock) is cheaper to finance when capital becomes less expensive relative to the Dell computer store that sells to consumers (short-term capital stock). But when rates are lowered without any change in consumer preference or any increase in savings, present consumption becomes cheaper to finance AND producers allocate capital toward future production. Thus during the boom phase, when interest rates are artificially low, producers invest in longer-term capital stock than is actually warranted by the amount of savings in the economy, while consumers will want to increase current consumption. That is: there is no real transfer of wealth from savers to entrepreneurs, only a scramble for resources between producers and consumers, one of whom wants to produce more and the other wants to consume more.

I think we can look at the current crisis to see this sort of process. This is the day of the 6 and 7 year car loan and the 40 year mortgage. New investment products created under the period of cheap money are becoming longer and longer in maturity, because artificially cheap money stimulates long-term investment. Moreover, since 1998, the median US consumer has increased consumption by 38% while income has risen by something like 3.8%, because cheap money stimulates current consumption.

There's probably more to write, but I spent long enough writing this, and I'll be back later anyhow.

Edited by adrock3215
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There's probably more to write, but I spent long enough writing this, and I'll be back later anyhow.

Thanks for taking your time to write it, and I already have a couple of remarks/questions on what you wrote that could themselves be a trigger for further discussion. Let me start with the most fundamental ones:

When banks in a free economy reduce their reserve ratios and loan out funds gathered from depositors, they have the choice to loan out gold from the vault or claims on gold which remains in the vault, i.e. banknotes. Either way, the supply of actual money is static and does not change. What changes is either the number of banknotes in circulation, or the amount of gold in the vault. But the total amount of gold, i.e. the money supply, in the economy remains the same, and therefore the theory actually does see an entirely essential difference between the two scenarios described.

Yes, the total amount of gold does remain the same, but the supply of the means of exchange is increased. I know that von Mises does not call banknotes etc. money, just "money substitutes," but I would say they should be called money because the essential characteristic of money is that it is a means of exchange and what he calls "money substitutes" can be used to facilitate trade just as well as gold can.

For the determination of the price level, it is the total supply of means of exchange that is relevant, not just the supply of gold. The M in MV = PQ should include gold as well as substitutes, not just gold. (But then, von Mises does not even consider the price level to be a valid concept, and dismisses the Equation of Exchange as "mathematical economics"--so it is clear that there are some very fundamental conceptual differences between him and me.)

In an economy where interest rates are manipulated by central planners, the supply and demand of loanable funds is distorted and the price-signaling-mechanism of interest rates for the time preferences of economic actors is lost. As a concrete illustration of this manipulated economy: an increase in loanable funds based on a shift in consumer preferences towards higher savings rates becomes fundamentally indistinguishable from an increase in loanable funds based on the increase of the monetary base. The effect of both is a decrease in interest rates, although one represents an increase in actual wealth produced while the other represents an increase in paper notes.

How would you view an increase in gold mined in an unmanipulated capitalist economy? It is clear that it would constitute an increase in loanable funds, but would that be an increase in wealth produced or just an increase in the money supply? Would it lead to an undesirable boom-bust sequence, or would it be "kosher with Austrians" (so to speak :lol: i.e., would they consider it "cycle-neutral")?

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For the determination of the price level, it is the total supply of means of exchange that is relevant, not just the supply of gold. The M in MV = PQ should include gold as well as substitutes, not just gold.

Ok, so where do you draw the line in defining money? Is commercial paper money? Are repurchase agreements money? Are money market mutual fund investments money? I have a post in the Fractional Reserve Banking thread under the Ethics forum that defines the various measures of money and monetary aggregates (M0 through M3), both in today's fiat environment, and in a future free market economy.

Money is gold and any other commodity accepted at a depository institution. The notes that a depository institution creates are NOT money, they are substitutes for monies deposited.

How would you view an increase in gold mined in an unmanipulated capitalist economy? It is clear that it would constitute an increase in loanable funds, but would that be an increase in wealth produced or just an increase in the money supply? Would it lead to an undesirable boom-bust sequence, or would it be "kosher with Austrians" (so to speak :lol: i.e., would they consider it "cycle-neutral")?

It would be an increase in produced wealth, and an increase in the (current) money supply. It would not lead to an undesirable boom-bust sequence, because it is an increase in actual productive wealth, as opposed to an increase in paper bills.

The reason gold is a value is two-fold in a free society. One is that it serves as a medium of exchange; the second is that it can be used for other purposes like jewelry, decorating, etc.

Assume that gold is found and mined in the free society. This decreases the value of each gold unit in terms of other goods; in other words, the valuation given to gold because of its utility as a medium of exchange falls. However, the decrease in the value of a gold unit will mean that one can purchase a unit of gold for less "other goods". Therefore, demand for gold based on its "other purpose" value will rise. In so much as this happens, the utility of gold as a facilitator of exchange will diminish and its utility as jewelry will increase. It is possible that, given enough new production, people would simply stop using gold as a medium of exchange (because it is too abundant, i.e. not scarce enough), and switch to some other commodity (say) silver.

The increased production of a gold mine is simply that: increased production. Thus it adds to the pool of wealth, and is not the same as printing letters on a piece of paper. Producing gold and exchanging it for other goods and services is exchanging something for something, not nothing for something (fiat systems).

Edited by adrock3215
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Ok, so where do you draw the line in defining money?

I define money as the means of exchange. Thus, in its strictest sense, money means all those assets that are widely accepted as forms of payment and are held exclusively to facilitate transactions. In a gold-based free economy, this inclues:

  • gold coins
  • non-gold coins convertible into gold at a fixed rate
  • gold certificates
  • bills
  • checking accounts
  • traveler's checks
  • debit cards
  • PayPal balances

and the like. In a broader sense of the term, you could include all dollar-denominated assets that are liquid enough to be easily convertible into gold at a fixed rate, such as:

  • AAA-rated bonds
  • savings accounts
  • certificates of deposit

Sometimes, people use the term even more broadly, and refer to their riskier bonds and even their stock holdings as their "money." At the end of the scale, all material wealth is sometimes referred to as "money" (e.g. in the phrase "making money" used to describe the creation of wealth); this is similar to how a 90-year old woman sometimes ends up being referred to as a "girl."

Money is gold and any other commodity accepted at a depository institution. The notes that a depository institution creates are NOT money, they are substitutes for monies deposited.

That is what von Mises says--and I disagree. If the dollar bills issued by banks are accepted just as readily as a form of payment as gold coins are, then the two can be used interchangeably for transactional purposes and there is no essential difference between them. Defining money by its "goldness" is an example of definition by non-essentials; it would be like insisting that "transportation" means only walking (and swimming, etc.) and that any technology created by walkers to make their lives easier, be it a buggy or an automobile or an airplane, is NOT transportation but a "transportation substitute."

If you want to refer to gold specifically, we already have a concept for that: "gold." (I am not sure what you mean by "any other commodity accepted at a depository institution," but if it is the possibility of other precious metals serving as money you want to indicate, then one can use the phrase "the money metal" instead of "gold.")

It would be an increase in produced wealth, and an increase in the (current) money supply. It would not lead to an undesirable boom-bust sequence, because it is an increase in actual productive wealth

Good, we agree so far. Do you also agree with my statement that it would be an increase in loanable funds ? If so, do you think it would lower the interest rate?

The increased production of a gold mine is simply that: increased production. Thus it adds to the pool of wealth, and is not the same as printing letters on a piece of paper.

Which brings us to the next question I wanted to ask: If a bank in a fully capitalist, gold-based economy decided to lower its reserve rate, i.e. "print more letters on pieces of paper," would that bring about the boom-bust sequence? In other words, do you think the undesirable effects can arise in a free market? (We are operating under the assumption that all the bank's depositors have been fully aware of the possibility of this from day 1 and still were happy to entrust their money with the bank--so there is no question of any fraud being involved.)

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I define money as the means of exchange....

In your view, is there a difference between an ounce of actual gold, and a note printed by a bank that says "Redeemable for 1 ounce of gold"? If both of the above consitute "money", then you have muddied the definition of money to include everything under the sun by defining it as 'means of exchange'.

J.P Morgan said: "Only gold is money; all the rest is paper." A paper note redeemable for gold is, by definition, a paper note redeemable for gold, and is therefore NOT "as good as gold", because it is subject to default risk by the issuing bank. Therefore, it is NOT the same thing as the underlying value, or money. The banknote is worth a certain amount of money, in the same way a mortgage note is worth $300,000 and a car note is worth $25,000. Notes are, by definition, convertible into money, but they are NOT money.

When I take my gold note to the butcher and buy meat, I give him my Bank A banknote. He takes that to Bank B, where he deposits it. Bank B contacts Bank A, and the corresponding amount of gold reserves are transferred from the vaults of Bank A to the vaults of Bank B. The underlying value that made possible the transaction is gold, it was not the banknote. The banknote helped in so much as it substituted for gold. Certainly the butcher wouldn't take a piece of paper that I scribbled "Redeemable for 1 ounce of gold" on with a crayon just before I walked in the door. The butcher would prefer to be paid in gold, because there is less risk involved, but he is happy to sell his meat in exchange for a reputable banknote backed by gold.

Do you also agree with my statement that it would be an increase in loanable funds ? If so, do you think it would lower the interest rate?

It would be an increase in loanable funds of gold. It would lower the interest rate of gold. It would decrease the utility of gold qua medium of exchange and increase the utility of gold qua jewelry. In a free economy, there is not one central manipulated interest rate (i.e. Fed Funds rate), which all other rates follow, so the question sort of contains a false premise.

Which brings us to the next question I wanted to ask: If a bank in a fully capitalist, gold-based economy decided to lower its reserve rate, i.e. "print more letters on pieces of paper," would that bring about the boom-bust sequence? In other words, do you think the undesirable effects can arise in a free market?

That depends. A boom-bust sequence has to have widespread participation by many economic actors. So, the answer presupposes that there would only be one bank and one banknote in the entire economy. I don't believe that monopolies occur in a free market; I believe that they only occur with the aid of government coercion.

Edited by adrock3215
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In your view, is there a difference between an ounce of actual gold, and a note printed by a bank that says "Redeemable for 1 ounce of gold"? If both of the above consitute "money", then you have muddied the definition of money to include everything under the sun by defining it as 'means of exchange'.

Now don't be silly. Everything under the sun is not a means of exchange, so defining money as such does not mean it includes everything under the sun.

There are, however, certain specific things that people do use from time to time as means of exchange. Items that are redeemable in gold, but are not gold themselves. Wouldn't you agree that it is useful to have a concept to capture this characteristic of these items?

If not, how do you define money? What do you think is its essential characteristic?

It would be an increase in loanable funds of gold. It would lower the interest rate of gold. It would decrease the utility of gold qua medium of exchange and increase the utility of gold qua jewelry. In a free economy, there is not one central manipulated interest rate (i.e. Fed Funds rate), which all other rates follow, so the question sort of contains a false premise.

So am I correct to infer that you hold that, in a free economy, the interest rates of loans made in gold can be permanently and significantly lower than similar loans made and repaid, say, by check? But if gold can be borrowed at 4%, why would anyone borrow by check at 7%? People are not fools. If someone needed $100,000 in his checking account, he would borrow $100,000 in gold, put it into his trunk and deliver it into his bank to deposit it into his account. No one would insist on borrowing any significant sum by check if it cost him 7%, while borrowing in gold only cost 4%.

Of course there would be many different interest rates, but the differences would be caused by things like the creditworthiness of the borrower and the riskiness of the venture he is proposing. The means by which the funds are transferred from the borrower to the lender and vice versa should make no difference.

And why do you say that additional gold would "increase the utility of gold qua jewelry" ? If there is more gold, that makes it less precious, doesn't it?

Anyway, the reason I asked the original question was because I do not believe that an increase in gold mining would necessarily lower the interest rate--any interest rate. In a free market, interest rates are determined by the supply of and demand for a certain type of capital : the kind of capital that is the opposite of venture capital--the more "conservative" forms of capital, i.e. loans and bonds, as opposed to stocks or the "lottery"-like funding of ventures. There is no direct connection between the supply of gold and the supply of and demand for such "conservative" capital. The newly-found gold becomes the property of the miners who found it, and it is up to them to decide what to do with it.

Let's say, for example, that a miner has mined $1,000,000 worth of gold, and that he wants to spend it on a new home. The home he has in mind costs $1,750,000, so he takes the $1,000,000 of gold to the seller and borrows $750,000 from a bank. What has happened, then, is that the demand for loan capital has increased by $750,000, putting an upward pressure on interest rates, while the supply of loan capital ... well, that depends on what the seller of the house does. If he decides to keep the $1,000,000 in his vault, the supply of capital remains unchanged. But that is the least likely scenario. He might want to invest the money "conservatively," in which case supply of such capital will increase by $1,000,000--or he could decide to buy a house for $1,500,000, borrowing the $500,000 and thus again adding further to the demand for loans, and then the outcome further depends on what the seller of that house decides to do with the $1,000,000 in gold ... and so on.

So what we really have is more money circulating in the economy. Some of the new money may be converted into jewels, so another effect is that we'll have more gold jewelry in the economy. Thus, the new gold has increased the supply of: 1., money, and 2., jewels. But it has no definite effect on the supply of, nor the demand for, loan capital--and therefore, no definite effect on any interest rate. This is one of the major points where I disagree with the Austrians (and probably every other economist in existence today other than Richard Salsman): An increase in the money supply does not necessarily mean lower interest rates, nor vice versa.

The same is true for the gold that becomes available when a bank realizes that it can safely lower its reserve rate. It adds to the money supply, and to the supply of gold jewelry, but it has no direct connection to the rates charged on loans.

That depends. A boom-bust sequence has to have widespread participation by many economic actors. So, the answer presupposes that there would only be one bank and one banknote in the entire economy. I don't believe that monopolies occur in a free market; I believe that they only occur with the aid of government coercion.

If most of the economy's major banks decided to lower their reserve rates within a short timespan, though, would that cause a boom-bust?

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It is also unclear to me what exactly is meant by the time preferences "reasserting" themselves. What actions by what market participants does that term refer to?

Time preferences are asserted in the first place by the process of individuals, first, looking at their existing investments (if any) and their incomes, and second, then deciding whether to add to, maintain, or draw down their investments and altering their spending habits to suit. To add means to direct the resources received as income towards investment, while to draw down means to take resources out of investment and add to final consumption instead.

The root criterion is people's varying preferences to consume now versus consuming in the future. Everyone, to varying degrees, prefers to consume sooner rather than later, but we can be induced to consume later (ie induced to invest instead), by the promise of getting a return on the resources we could use for either purpose. The core component of interest rates is the numerical manifestation of that time preference, which exists even before consideration of risk. Thus different people have different core risk-free rates of return that must be on offer in order for them to invest.

On top of that comes a risk premium for the amount of risk associated with an investment being contemplated. Most people are risk averse, that the more risk there is in a given investment the higher the return that people will want from it as compensation for bearing that risk. Just as there are different degrees of time preference for different individuals so are there different degrees of risk aversiveness for different individuals.

Lastly, in addition to the two core elements there is a third important element. There must also be a premium to compensate for a decline in (or, more rarely, a discount for an increase in) - the purchasing power of money. In short, there must be an inflation premium. The more that people expect the purchasing power of money to decline by the future time they will spend that money at, the higher the premium they will require as compensation.

Those three combined - the risk-free rate, the risk premium, and the inflation premium - are the great bulk of what makes up interest rates on loans and expected ROE's on stocks. The market rates of return, whether in the form of debt interest or equity profits, are the aggregate of all individuals acting to supply or demand capital based on their time preferences, degrees of risk aversiveness, and expectations of changes in purchasing power. The actual ROR goes down as capital supplied goes up (ceteris paribus, of course), because that capital is funding more competition both for custmers and suppliers. The required ROR goes up as capital goes up because there is less need felt to invest and because as consumption goes down the per-unit value attached to what consumption is retained goes up. If the actual RORs are above the required RORs, people will invest more until the actual RORs come down and the required RORs go up to match. Likewise, if actual RORs are below the required RORs, people will withhold or withdraw investments until the actual returns rise and required returns fall to match.

A financial institution is a medium by which this aggregation process can take place more efficiently than would occur without it. However - and here is an important point - the actions of a financial institution cannot alter the two fundamental determinants, though it can alter the third through its influence on the money supply. Those two core determinents are the entirely province of the judgements of individuals, who are the true owners of all resources. All that an institution can do, through its taking resources from those individuals and investing them, is either speed up or slow down the adjustment of what actual returns are generated to line up with what kind of returns people would prefer to have for the varying risk levels. "Assertion" and "reassertion" is just reference to the aggregate of individuals' preferences being eventually reflected in how investments are made. Ultimately, individuals producers and consumers will not be denied, irrespective of what intermediating institutions do in the short term.

A reassertion will start forming in the works when an institution (including government) starts acting to increase investment in a manner that is not warranted by aggregate time preference and risk aversiveness. An institution can only do this either by, first, lowering its reserve fractions, or, second, the central bank inflating the fiat currency and giving the new money to the financial institutions.

The mechanics of the reassertion start churning even before the funds exit the bank. The institution is in competition with others, so to fend off that competition it lowers its interest rates for given risk levels, yet increases its profits through an increased volume made possible by raiding the reserves or free booty from the central bank. Other institutions follow suit to meet that competition (many do, some don't), and so returns are eventually lowered across all risk levels. The reassertion becomes due because the risk-return profile actually receivable in the marketplace is at now odds with what the individuals who own the resources would prefer, but the process must play itself out for the reassertion to be made manifest.

This is the process. The insitution then gets a business customer who borrows extra funds from it. The business then spends the funds to buy extra labour and capital goods. The revenue from the purchase of capital goods then becomes yet more income to other labourers, plus additional profit for the suppliers, interest revenue for debt investors, and more spending on yet more capital goods by them in turn. That process goes on and on, over time, until all spending can be resolved into personal income as wages, profits, or interest. As those funds make their way into the hands of individuals as personal income, those individuals must then decide what they are going to do with their money. That decision, in aggregate, is the beginnings of the reassertion itself. They decide as described above, by chosing whether to invest or borrow depending on the prevailing actual RORs and their required ROR's. But, the actions of the originating institutions caused actual returns to fall, so that inclines people to save and invest less on the one hand and to disinvest (including borrow) to spend on consumption on the other. This action means that financial institutions start experiencing a drain on their funding sources, because people aren't saving and investing at the same level as before. However, they don't notice it straight away because they are initially getting additional funding either by raiding the reserves or getting a cut of central bank largesse and because as noted it takes time for the funding to fully make its way to the hands of individuals (there are also other capital goods and labour markets difficulties, but that's secondary to the question at hand). That means at the start of a boom they can afford to lower their interest rates and creditworthiness criteria, but without an increase in the raiding or booty-gathering the assertion of individuals' time preferences and risk premiums will force them to undo it to cover the cost required in regaining that funding.

To make matters worse, the extra consumer spending causes consumer prices to rise. When this happens the inflation that was generated by the government or the fractional bank starts to show up. This then occasions people to start expecting more price rises in future, which then inclines them to increase their inflation premiums required to invest. In turn, that makes them increase their overall required ROR's quite substantially, in turn worsening the drain on financial institutions' deposits etc.

So, now we have a problem: the action of instititions has artificially lowered actual ROR's while increasing required ROR's, with the consequences of the inflation making this situation harder and harder for the institutions to maintain. The only way that this can be maintained is by an acceleration of the reserves raiding or fiat currency expansion - but that only eventually acts to increase general prices and expectations of future inflation, increasing actual-required gap even more. The whole thing collapses when the institutions relent and allow the market rates rise to match required rates, ending the raiding party and so curtailing lending to business. The reassertion of time preferences in this context is that part relating to financial institutions curtailing their lending activities down to the level warranted by the funding that individuals will provide.

And why do the businessmen who plan the investments believe that a low interest rate today means they are going to be able to borrow at the same low interest rate 5 years from now? An interest rate is a price, and I have never heard of any rational manager expecting any prices to remain unchanged for years in a free market. Whenever you make a business plan, you have to factor in the possibility of the price of your own product declining, and the prices asked for by your suppliers

There is a local zinc smelter project that opened earlier this year and was forced to close down just a few weeks ago because they projected zinc prices to remain high (they fell) and coal prices to remain low (they rose). They whined in the local paper that they would never have opened up the smelter had they known that prices would change. Why is it so hard to expand that kind of mentality to others doing likewise in consideration of interest rates? Not every manager is always completely rational.

In a totally free market, there can be some cyclicality in the supply of goods that take a long time to produce caused by their producers being unable to predict the number of their competitors.

Yes, but without intereference in the financial markets through manipulation of interest rates and the money supply all the different markets' variations as you speak of would largely diversify against each other, leaving behind a rather minor "noise" signal on top of what would otherwise be an orderly non-boom period of smooth growth that would follow the changes in time preference and risk aversiveness, both of which would change slowly in a laissez-faire economy. The issue is why there is such an enormous correlation of everyone investing and disinvesting at the same time, why everyone's expectations of risk and changes in purchasing power all move in unison across the whole economy. In a laissez-faire economy the only vehicle for that is the financial sector through changes in reserve ratios down or up, while in a fiat-currency economy it is currency expansion and contraction, either scenarios of which move interest rates down or up accordingly and messing with people's plans.

But a much more important factor in causing economic cycles in our present-day mixed economy is government intervention.

Intervention interferes with investment because it lowers actual returns through jacking up costs and raising expected returns through making people increase their risk premiums to compensate or expectation of more such costs in future (which may go all the way to mean total loss of capital). One of the reasons why the markets are jittery right now is because the government officials haven't sorted out exactly what they are going to do, which makes for risk and uncertainty that are too difficult to pin down all that well, making it much harder to evaluate existing and potential investments in the current economic climate.

This definitely makes a contribution to the economic cycle, but it is not the originator of the core cycle at work.

One statist interventions you can count on to stymie any boom is ........... the raising of interest rates.

The offending banks must eventually raise rates because it cannot keep on doing what it has to do to keep them that low. If the offender is the central bank, it cannot keep on accelerating fiat currency expansion because that is leading to general price increases. It is partially doing the right thing, but only as a hyper-crude approximation of what would happen in a free market. If the offender is a normal bank, it cannot keep rates low because this it must eventually run out of reserves to raid, or have its profits cut because it raises offered rates to get more reserves in, or face a run (starting with a mere walk, so to speak) because it is losing customers.

JJM

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