Economic Cycles (and Austrian Economics in general)

[Capitalism Forever]

It is not a peculiarly Austrian distinction. Real capital is the physical stuff, composed of all the various assets a business uses to produce value. Financial capital is claims to a share in the real capital or fruits of its use, based on how each claimant contributed funding to pay for the real capital, and is composed of debt and equity.

OK, those are valid concepts (although I would call them differently: simply "goods" and "claims").

Each year there is yay much physical resources produced, which could be directed towards the production of consumer goods or the production of producer goods. How people spend their money determines the relative proportions. The supply of real capital means the desire to direct resources in favour of the production of the real capital, which investors do by turning their money to the buying of new financial capital (and also by allowing businesses retain some or all of the earnings). The businesses then use the proceeds of the sale of that financial capital, or the earnings so retained, to buy resources to make production goods with, ie more real capital.

Credit expansion is the increase in one of the subtypes of financial capital other than by investor's desires to shift their balance of spending towards the production of real capital.

Aha, I think I finally get what you mean! So credit expansion is basically when a bank makes a loan or similar investment without a corresponding investment decision by one (or more) of its depositors or shareholders, right? And similarly when the central bank makes a loan, which is also without a corresponding decision by a productive individual.

That is, when I go to my bank's website and invest some money into a time deposit, and then the bank invests that money into some loan or corporate bond, so that it is eventually invested into a productive effort (i.e. "real capital"), then that is not credit expansion, because it is my investment decision that ultimately triggered it. On the other hand, if I simply have the same amount of money lying around on my checking account, and the bank invests some fraction of it into a loan, then that is credit expansion, because I did not mean to invest the money, right?

Yes, because of inflation expectations. The whole thing starts when the Fed first acts to push the actual funds rate below its natural rate, and it necessarily spirals from there for so long as that actual rate is lower than the natural rate. The increase in money supply will show up eventually in the form of increasing general prices. That consequence, and the expectation of that consequence, push up the natural rate of interest because people increase their inflation premiums to compensate. That then becomes felt in the reserve accounts because of people's actions affecting the bank's activities. So, to keep the actual funds rate down at the official target the Fed has to push harder and harder against a rising natural rate, which they do by creating more and more money to buy up assets from the banks. But that is adding fuel to the fire! It cannot be a one-off, and cannot be sustained merely by maintaining the same repo book or net holdings of T-bonds. It becomes a cycle triggered by the first appearance of the gap between the funds rate and the natural rate of interest, and which accelerates as the gap increases because the action to maintain that funds rate is pushing up the natural rate.

I see--so your position is basically that both repos and outright purchases act to increase the money supply and lower the funds rate, by virtue of providing the banks with more loanable reserves, right? But, according to this view, inflation would have to go hand in hand with low fund rates, and high fund rates would bring about disinflation (or even deflation). This does not seem to be confirmed by recent history; look e.g. at the weekly dollar-gold chart at http://www.goldprice.org/. The price of gold grew slowly while interest rates were low earlier in the decade, but started accelerating around the time when the Fed began hiking rates. Now, however, with the interest rates being low again, there has been a downward trend since early this year. Oil prices have been behaving similarly, only with even greater swings. What do you make of this?

[adrock3215]

Or at least we speak different languages. "Symmetric," in my language, means that the two are mirror images of each other--so that the peaks on the one correspond to the troughs on the other...

Ahh, ok. Sorry; we are on the same page then.

With that in mind, and regardless of the definition of that word, does this graph show a correlation between the rate of growth in the money supply and the Federal Funds rate? Please answer yes or no, and provide the relevant reasoning. If yes, what exactly is the correlation, according to you.

Edited December 11, 2008 by adrock3215

[Capitalism Forever]

does this graph show a correlation between the rate of growth in the money supply and the Federal Funds rate?

It does not show a definite correlation in the short term, and shows a positive correlation in the long term. If you look at the period from '85 to '91, for example, the monetary base grew faster when the funds rate was lower, and the monetary base grew slower when the funds rate was higher. Then, in '91-'92 and again in '95-'96, there was a period when both were going down. In the late '90s, the monetary base shot up sharply without a correspondingly significant change in the funds rate. From around '02, the monetary base has been growing slower than during most of the '80s and '90s, and at a decelerating rate, while interest rates have been significantly lower than in that previous period. The base growth rate followed the same downward trend in '02-'04, when the funds rate was less than 2%, as in '05-'07, when the funds rate went up to over 5%. So it's erratic at best in the short run, which I think reflects the fact that repos and outright purchases play a different role. But if you look at the overall trend shown by the two graphs, you can see that it has been downward on both--which shows that, in the long term, a low funds rate goes hand in hand with low inflation.

[adrock3215]

But if you look at the overall trend shown by the two graphs, you can see that it has been downward on both--which shows that, in the long term, a low funds rate goes hand in hand with low inflation.

No, that's not what it shows. It shows that, in the long-term, a low funds rate goes hand in hand with a high rate of growth in the monetary base, and vice versa.

Now, there is something more to be said here. Economic data is not like the data gathered in a physics experiment. Firstly, it is hard to measure economic data exactly. Secondly, since economics is the study of human action, and humans have free will and can decide to do whatever they want, there can be wide discrepency in compiled data. What is positive evidence of a correlation is a long-term trend, which this graph shows. Yes, after 9/11, monetary growth spiked up temporarily. However, let's look at the peaks and troughs and their relation to one another. They tend to be opposite each other. The data and the fits are not perfect and do not show a 1 to 1 correlation, but there is no economic data that will ever show a 1 to 1 correlation. Regardless, the correct conclusion to draw from this graph is that the FFR is manipulated primarily through expansions and contractions in the Monetary Base.

Before we go on...do you agree with this conclusion?

Edited December 12, 2008 by adrock3215

[adrock3215]

The figures we would need are the ones showing the total dollar value of outright purchases within a given period, vs. the total (not net) dollar value of repurchase agreements made in the same period.

And now, to put the nail in the coffin and finish this part of the debate, I will introduce the exact data that you described above. I already introduced the balance sheet, and the graph, both of which proved my point, but you claimed that neither was sufficient. Therefore, I have no choice but to disprove your position with the data you requested.

Here you will find a report from the Fed entitled "Domestic Open Market Operations During 2007". In said report, you will find a 38 page detailed summary of all open market operation processes that the Fed trading desk used last year, along with several historical graphs and charts. Please scroll down to Page 16. Here is the relevant quote:

The Federal Reserve holds two general types of financial assets in its domestic financial portfolio that it may adjust through open market operations, at the direction of the FOMC, to achieve monetary policy objectives: outright holdings of Treasury securities, which account for the bulk of the portfolio, and temporary repurchase (RP) agreements.

Now, let's see that graphed historically:

Hmmm....holdings of repurchase agreements appear negligible when compared with the big blue space. Scroll down to page 20:

The average outstanding balance of short-term RP's (reppurchase agreements) was $8.90 billion in 2007, modestly higher than in the previous year.

Continuing scrolling down to page 22 to compare it with the other fact we are talking about:

During 2007, the value of the permanent holdings in the SOMA portfolio drecrease by $39.3 billion, ending the year at $735.7 billion.

That's the end to that issue. John McVey introduced the mistaken concept that somehow repurchase agreements are the main conduit used to implement Fed policy, which Capitalism Forever seconded. Then Cap wrote: "What you showed is that the Fed's balance sheet contains a lot of securities held outright and not as many repurchase agreements." Granting him his premise that I did not adequately show my own point, I have subsequently given him the very information that he wrote would consitute absolute, definitive proof.

Edited December 12, 2008 by adrock3215

[John McVey]

So credit expansion is basically when a bank makes a loan or similar investment without a corresponding investment decision by one (or more) of its depositors or shareholders, right?

Providers of time deposits, yes, but not of demand deposits. As well as the time depositors and equity investors (ordinary and others), it also includes those why buy the bank's debt issues of various kinds.

And similarly when the central bank makes a loan, which is also without a corresponding decision by a productive individual.

More precisely, when it creates new money which the normal banks then use to make loans, yes.

That is, when I go to my bank's website and invest some money into a time deposit, and then the bank invests that money into some loan or corporate bond, so that it is eventually invested into a productive effort (i.e. "real capital"), then that is not credit expansion, because it is my investment decision that ultimately triggered it.

Spot on. I should specify what the resources are: they are human capacity for labour (of which the fundamental root is human intellgence), as supplemented by prior produced capital goods, be they land or plant or tools or raw materials etc. So, you - as an ultimate owner of resources arising from your productive efforts that are both part of and have contributed to the creation of - are providing funding in a particular way that creates a shift in what those resources are used to make when you invest money in a time deposit instead of spending it on consumption. You are increasing investment spending while decreasing consumption spending by same amount (ignoring changes in your demand for money itself), reflecting the fact that there is only yay much resources in total available for allocation this way or that.

On the other hand, if I simply have the same amount of money lying around on my checking account, and the bank invests some fraction of it into a loan, then that is credit expansion, because I did not mean to invest the money, right?

Bingo. By putting physical specie money in a demand deposit what you're doing is just making the ready-holding and spending of that money more convenient for yourself. You didn't mean to invest, as you are continuing the same holding demand and same spending rate as before. The only thing that changed is that now you're doing the transactions by paper or plastic or electronically instead of lugging around the specie, where that specie is kept by a bank in a vault in its capacity as a storehouse of it. If instead of being a storehouse the banking system (by whatever means) also lends out from the physical money at the same time as you spending the more convenient money substitutes, or in a fiat currency system the banks loan out new money created out of thin air by the central bank, it is giving the various markets conflicting signals about your spending preferences for consumption versus investment. The banking system is thereby giving producers of both classes of goods the false impression that the relative proportions of how resources are to be used is increased in both their favours, which is impossible.

In an economy with a central bank, this is credit expansion because it is the credit market that is being used as the initial point of entry for the extra money. In an economy without one, it is credit expansion because, on the one hand, the banks are using the new money it creates by fractional-reserve notes for expanding its lending activities, and on the other, the banks are generating new money by making multiple dollars of loans on the back of a single dollar of demand deposit. The end result is the same: credit markets being given the wrong impression about the preferences of the ultimate owners of the resources that the funding is spent on.

I see--so your position is basically that both repos and outright purchases act to increase the money supply and lower the funds rate, by virtue of providing the banks with more loanable reserves, right? But, according to this view, inflation would have to go hand in hand with low fund rates, and high fund rates would bring about disinflation (or even deflation).

Not high and low in an absolute sense. There is no permanent relationship between the rates of interest and the quantity of money. The natural rate of interest will be what it will be, irrespective of whatever the quantity of money will be, once things are settled. It is only that the influx of new money into credit markets temporarily lowers the rates of the moment down below their natural rates (and conversely that the pulling out of money pulls rates up). Once fluctuations in the value of money subside the inflation premium component will diminish, leaving behind time preference and risk aversiveness as the chief components of interest rates, which are set by people independently of their attitudes toward the money supply and its vicissitudes.

There is no law of economics that says a low interest rate is always inflationary and a high one deflationary. It is the maintenance of a fed funds rate at a target that differs from the natural rate that is inflationary or deflationary, irrespective of how high or low those rates actually are. When inflation expectations get considerable even a high fed funds rate target (eg 18%pa at one time I recall!) can remain inflationary because the natural rate is higher still at say 20%, causing the Fed to have to continue injecting more new money to maintain the rate at target against upwards pressure despite that target being screamingly high. Similarly, if there were little or no inflation expectations, and people had low time-preferences and low risk-aversiveness, a fed funds rate as low as say 3% can yet be deflationary if it is above the natural rate which may be at say 2.5%, requiring the Fed to keep on soaking up money. In both cases, these actions by the Fed worsen the very difference it is trying to stave off by those actions, generating an accelerating cycle.

This does not seem to be confirmed by recent history; ... The price of gold grew slowly while interest rates were low earlier in the decade, but started accelerating around the time when the Fed began hiking rates.... What do you make of this?

In addition to referring to that the theory is based on expectations and forecasts as much as it is on actual consequences, I'd make of it that there is more at work in the real world than just what has been discussed so far.

Even if some people are fully aware of how the growth in the money supply is inflationary, there are those who are not and so wont change their expectations until the trend is evident in the more popular statistics. If the expectations don't change then neither will the natural rates. I don't know precisely, but I can easily imagine that the people's readings of those statistics were what made them both take more interest in gold and cut back on their lending, arising from their increased inflation expectations - gold has always been seen as an inflation hedge. That then makes the banks more likely to have shortfalls (for various reasons), and so the Fed would have to increase its pace of injection to more dangerous levels if it didn't raise its target. The Fed's people can read those same statistics plus others, figure out for themselves why this is so, and recognise the need to make that call.

(Rant about the pitiful state of financial education deleted)

Additionally, there are other considerations going into the price of internationally traded goods than just the consequences of inflation one would expect by looking at an economy solely as a closed system rather than one open to international trade (recall what von Mises mentioned in the passages you quoted about various schools of economic thought forgetting this fact). For instance, there is also that there are woes in other economies besides the US one, where the US is still seen as a comparative safe haven. China and key EU countries are revealing themselves to be in worse shape than the US, and so there can be a flight to the US dollar from foreign currencies, lowering the price of everything traded internationally while denominated in USD, even despite the inflation of the US dollar.

JJM

[Capitalism Forever]

No, that's not what it shows. It shows that, in the long-term, a low funds rate goes hand in hand with a high rate of growth in the monetary base, and vice versa.

I don't really understand why you think so. In the '80s, both the funds rate and the monetary base growth were high, while in recent years, they have both been lower.

[Capitalism Forever]

Hmmm....holdings of repurchase agreements appear negligible when compared with the big blue space.

But that is not the data I requested. You see, a repurchase agreement expires after a brief period (usually something like two weeks, I believe), after which it disappears from the Fed's balance sheet. So if the Fed made a two-week repo agreement on February 1, 2008, it showed up on their balance sheet on February 2, 2008, and on the 3rd, and so on, right until February 15. But on February 16, 2008, it was gone. If they had made an outright purchase on February 1, 2008, though, then it would still show up on the balance sheet, unless they entered the open market again to sell it. But, while selling may not be very rare, it is certainly less frequent than buying, so there tends to be a net accumulation of outright holdings. Repos, on the other hand, do not accumulate, because they have a built-in self-destruction mechanism, so to speak.

So the current balance sheet of the Fed includes all the outright holdings that have accumulated throughout the decades of the Fed's existence, while the repos showing up on the current balance sheet are only those they made in the last two weeks (or whatever period they last). This is why comparing holdings is not very meaningful. Comparing the number of times the Fed went on the open market to make an outright purchase vs. the times they went on the open market to make a repo would be more useful. But of course, if the amounts involved in a single transaction vary, then what we really need is to sum up the amounts of the individual transactions. That is the data I asked for.

[Capitalism Forever]

Bingo. By putting physical specie money in a demand deposit what you're doing is just making the ready-holding and spending of that money more convenient for yourself. You didn't mean to invest, as you are continuing the same holding demand and same spending rate as before.

But IMO, if I put my money into a fractional-reserve account, then I sort of did mean to invest. You yourself have insisted on an earlier thread that such depositors are in fact creditors of the bank--and becoming a creditor is an investment, isn't it? There is clearly some risk involved (not much, but still), and also a little return (composed of not having to pay a fee for the account, or at least not one as high as would be charged for a 100%-reserve account, plus any interest that the fractional account may pay). So I think having your money on such an account is actually an investment decision: you decide to invest into the bank's ability to find a fruitful use for your money while you're not using it, while at the same time maintaining a pretty good likelihood of making the money available to you at whatever time you do require it.

The key idea here is that if you make it your goal to always maintain a holding of at least, say, $500 on your checking account, then your account is in fact almost like a permanent investment of that amount of money. Sure, your balance will occasionally dip below $500, but if 100 people have the same target and each has an average balance of $400 over time, then taken together they have permanently invested $40,000 into their checking accounts. I think it would be wrong to think that this wealth is something they want to consume immediately: if you look at the actual outcome of what happens with the money, what you see is that it keeps staying on their accounts--and they're happy with it.

I don't think there is an essential difference in this respect between investing $500 into a safe bond that is traded frequently and thus easy to sell at any time, and keeping $500 on your checking account. The goal is in both cases to have some money ready in case you should need it; the returns, risks, and ease of conversion into specie may be different, so you weigh them and choose the bond if you like its characteristics better, or the checking account if you prefer its. (Or perhaps you split your money in some ratio between the two.)

At any rate, I don't think the intent with transactional holdings is to null them out; the intent is to maintain them at a certain level. This means that they are not meant to be consumed; they form a part of your working capital.

It is the maintenance of a fed funds rate at a target that differs from the natural rate that is inflationary or deflationary, irrespective of how high or low those rates actually are. [...] a fed funds rate as low as say 3% can yet be deflationary if it is above the natural rate which may be at say 2.5%, requiring the Fed to keep on soaking up money.

This brings us to the next question I wanted to ask, whether you think the Fed can bring the funds rate above what is natural, and what you think its effect would be. Well, your answer is pretty obvious from the above. I don't say I'm surprised, given that this is the generally accepted view, I just don't agree with it. The root of our disagreement is that I don't see why the funds rate would be determined by what amounts of reserves the banks have. In general, do you think interest rates are determined by the money supply? Say in a laissez-faire economy, without fractional-reserve banking, to eliminate all those complications. Would a gold find lower the prevailing interest rates, and would a poorer-than-expected year of gold production raise them? If yes, why?

[softwareNerd]

That is the data I asked for.

That data is here, but it is sort-of raw. I don't think it is summarized in the FRED database, but I might have missed it. [i did process some of this a while back, and that's what the attached graph shows. The Fed kept replacing repos with still larger repos, and then even introduced a 28-day lending facility.]

The Repos are of different amounts and durations. Though they typically expire in the very short term (as short as 1 day), there is also a general understanding that equivalent repos will replace them. When the Fed decides to increase high-power money, they might do a combination of repos, so,e 1-day, some 7-days, some as long as 14 days. However, depending on where they see themselves in the cycle, banks can make pretty decent guesses about the near-future. The Greenspan term, in particular, emphasized the idea that the Fed should usually hint at what it is going to do in the near future. Therefore, when the Fed embarks on a loosening phase, one could be reasonably certain that they will not stop it all of a sudden. One could get temporary funds for (say) 7 days, with a very good chance that one would renew for a year or two.

In summary, the Fed rate is legally ultra-short, but de facto more like a 6-month rate.

Of course, the sale/purchase of securities is a big factor too. The short and long-term money creation can be up or down, which leads to four possibilities. For instance, the Fed can pump in short term money, while selling securities, thus mopping up longer term money. In fact, this has been the Feds approach to the current downturn. They call it "sterilizing" -- i.e. they're trying to keep the total money supply from growing too much, even while they pump short-term money into the system. So, your notion of one affecting money and the other affecting short-term interest rates is actually applicable in that scenario. (However, the Fed is now threatening to shift to buying securities as well.)

Edited December 13, 2008 by softwareNerd

[John McVey]

But IMO, if I put my money into a fractional-reserve account, then I sort of did mean to invest.

You've glossed over the part about there being the same spending rate as before. That's the key part of this section of the discussion.

In the realm of the physical resources, you can't have your cake and eat it, too. Either you direct some part of available resources to generating consumption goods or to generating production goods. Everything alway comes back to this. If you can understand that, and what it means for rates of interest and profit, then you've got the essence. The physical world is paramount, and cannot be defied with impunity.

In the realm of your spending, for each portion of resources you are entitled to direct, as proxied by your purchasing power, you either spend on consumption or spend on investment. You cannot both mean to invest and mean to spend the same one unit at the same time. What merely happens is that the extra money and spending generated by the banking system is divied up between the two in a manner that is both confusing and which jacks up the prices of resources and from there to the price of everything.

By putting money into a non-fractional account, you're just changing the concrete method by which you make your directions that allocates resources to consumption. By putting money into a fractional account you (and the banking system) are just confusing the real-world allocation system.

You yourself have insisted on an earlier thread that such depositors are in fact creditors of the bank--and becoming a creditor is an investment, isn't it?

Yes, it is credit, and depositors become creditors, this has never been denied. What is denied is that this credit expansion constitutes real investment viable in the long term. This new credit is merely expansionary, and dilutory of both purchasing power and the real value of all outstanding investments. The on-investment in financial capital made by the bank does not and cannot increase the amount of resources available for investment in real capital, it merely shifts purchasing power into the hands of those who get the new money first. The first recipients then malinvest resources they got at now improperly low prices, those who get money later either pay higher prices bid up by the first or to some extent just go without.

The only reason why in the modern world total real investment seems to increase is because minimum wages, union demands and the like are causing productive capacity (including people looking for work) to be held idle. The influx of new money devalues the real value of those demands because there are now more dollars chasing the same nominal minimum prices. The unemployment will thereafter stay low, and the investment remain viable, for so long as the nominal amounts demanded don't increase in response to the increase in the cost of living caused by the expansion of the money supply. Deliberately creating inflation for that purpose, to overcome the "downward stickiness of wages", is the shabby truth behind Keynes and those influenced by him in this regard.

There is clearly some risk involved (not much, but still), and also a little return.

Once people realise the truth of the first real argument (credit expansion caused by furthering fractional banking or fiat money messes with allocation of real resources), the second real argument against fractional banking is that people will then price risk at a higher level than the nominal return generated. Once that happens, the remaining market for fractional accounts will start evaporating.

So I think having your money on such an account is actually an investment decision: you decide to invest into the bank's ability to find a fruitful use for your money while you're not using it, while at the same time maintaining a pretty good likelihood of making the money available to you at whatever time you do require it.

And that is the fallacy of the idle gold. No matter what, that part of the money supply that individuals aren't planning to spend now but keep aside for unplanned expenditures in the future is always going to remain idle, always going to lie around unused, until consciously spent on either consumption on the one hand or on investment that is not immediately liquidatable on the other. Having the banking sector engage in credit expansion with it is not going to change this one litle bit. It is not real investment, financial appearances to the contrary notwithstanding.

The key idea here is that if you make it your goal to always maintain a holding of at least, say, $500 on your checking account, then your account is in fact almost like a permanent investment of that amount of money.

If you are keeping $500 in that account just in the same way as you would keep $500 in coin then it means your demand for money has remain unchanged and what the bank is doing is what I have already said: giving the various markets conflicting signals about what are the rightful proportions and individual contents of your share of the allocation of total available resources.

If on the other hand you are keeping $500 in accounts but wouldn't keep that much in coin if cheque accounts did not exist then you are correct to point out that it is functionally equivalent to holding the same in liquid securities, where you're just getting the bank to do it for you. But, there is one big assumption most overlook when judging that functional equivalency - fair financial weather. If that does not hold then the equivalency breaks down. In a crisis the fractional system will cause the money supply to be reduced, itself making things worse until the reserve fraction rises to an acceptable level, while in a proper system of individuals non-fractionally owning liquid securities there is no threat to the money supply. I noted to Agrippa that if a market were sufficiently free then even a fractional system can proceed happily without incident. This lends credence to the functional-equivalence by allowing people to not be given reason to specify and question that assumption of fair weather. We are then left with the core issue of the misallocation of real resources.

This brings us to the next question I wanted to ask, whether you think the Fed can bring the funds rate above what is natural, and what you think its effect would be. Well, your answer is pretty obvious from the above.

Obvious? I specified it outright. The fed extracts money from reserve accounts by selling assets at below-market prices (eg 25 basis points is the official difference used by the RBA) to banks with excesses in their reserve accounts. That leaves less money in the reserve account system to lend to banks with settlement shortfalls to cover, so those other banks have to offer to pay more interest to attract lending from the first banks instead of buying cheap assets. And with that, the actual rate of the moment rises to meet the target rate.

The root of our disagreement is that I don't see why the funds rate would be determined by what amounts of reserves the banks have. In general, do you think interest rates are determined by the money supply?

I've already said that the natural rates of interest in a settled economy are independent of the size of the money supply. The core components are time preference and risk aversiveness. The first is entirely a real-world resource-usage-preferences phenomenon, and the second is a real-world phenomenon that is then added to by concern for political and other additional risks. It is only that on top of these that concern for movements in purchasing power is added. The day to day movements of market interest rates are then caused by the changes in weighted-average natural rates aggregated across all individuals, plus people acting for reasons other than price-based investment decisions, plus the influx of new money from gold finds that haven't yet spread out through the whole pricing structure or efflux of money because people decide they want more gold-bearing products.

Moreover, interest rates are independent of what money supply is made up of. The same natural rates would prevail in the same economy were the money supply exclusively non-fractional specie versus the were money supply specie plus fractional money. Just as there is no permanent relationship between interest rates and the quantity of money, there is no concrete relationship between the rates of interest and the reserve ratio either. It is only when the money supply changes that interest rates change. It is only when banks reduce their minimum reserve ratios and engage in extra lending out of the now-deemed excess that interest rates fall. Once the markets have absorbed this expanded level of money and credit interest rates will return to where they were before, though added to by an increased risk premium because the stability of the banking system has gone down.

Say in a laissez-faire economy, without fractional-reserve banking, to eliminate all those complications. Would a gold find lower the prevailing interest rates, and would a poorer-than-expected year of gold production raise them? If yes, why?

Temporarily, yes, until the new situation with the money supply is understood by all and the core reasons for interest rates are pre-eminent again. The change in gold stocks wont permanently change rates.

JJM

[Capitalism Forever]

The short and long-term money creation can be up or down, which leads to four possibilities. For instance, the Fed can pump in short term money, while selling securities, thus mopping up longer term money. In fact, this has been the Feds approach to the current downturn. They call it "sterilizing" -- i.e. they're trying to keep the total money supply from growing too much, even while they pump short-term money into the system. So, your notion of one affecting money and the other affecting short-term interest rates is actually applicable in that scenario.

Right, and that is why the dollar has been relatively strong recently while interest rates have been low. Now, the question to the advocates of the Austrian business cycle is: Will this trigger a boom-bust cycle?

[Capitalism Forever]

If on the other hand you are keeping $500 in accounts but wouldn't keep that much in coin if cheque accounts did not exist then you are correct to point out that it is functionally equivalent to holding the same in liquid securities, where you're just getting the bank to do it for you. But, there is one big assumption most overlook when judging that functional equivalency - fair financial weather. If that does not hold then the equivalency breaks down. In a crisis the fractional system will cause the money supply to be reduced, itself making things worse until the reserve fraction rises to an acceptable level, while in a proper system of individuals non-fractionally owning liquid securities there is no threat to the money supply. I noted to Agrippa that if a market were sufficiently free then even a fractional system can proceed happily without incident.

Well, my answer to that is: the market should be sufficiently free!

I've already said that the natural rates of interest in a settled economy are independent of the size of the money supply.

The size, yes, but are you saying that they are dependent on the growth rate of the money supply?

[adrock3215]

Let me try to approach this entire issue more simply.

The economic purpose of financial markets is to transfer wealth from net savers to net borrowers. Interest rates are the price mechanism by which these transformations are made. In a fiat system, interest rates are determined by a central authority. Given these premises, do you really think that it is totally implausible that interest rate fixing is the source of business cycles?

Remember that almost every school of modern economic thought (not just Austrian) thinks that monetary policy is either the most, or one of the most significant contributors to output fluctuation.

[John McVey]

Well, my answer to that is: the market should be sufficiently free!

That still doesn't make fractional banking okay, as the issue of the misallocation remains.

The size, yes, but are you saying that they are dependent on the growth rate of the money supply?

It - and more precisely the expectation of it - is one of the major determinants, but it is not the only one.

Nor is there any set relationship between the growth rate in the money supply and the reduction in interest rates. If people become increasingly adept at predicting the growth of the money supply and its effects on prices (which includes consideration of the other determinants, too), they will incorporate that effect into their expectations of inflation and increase their required rates of interest to compensate. What the effect any particular rate of growth of the money supply will be on interest rates will be the product of people's thoughts and their ability to act upon them, not exclusively purely physical factors such as quantities of dollars.

JJM

[Capitalism Forever]

The economic purpose of financial markets is to transfer wealth from net savers to net borrowers. Interest rates are the price mechanism by which these transformations are made. In a fiat system, interest rates are determined by a central authority. Given these premises, do you really think that it is totally implausible that interest rate fixing is the source of business cycles?

Remember that almost every school of modern economic thought (not just Austrian) thinks that monetary policy is either the most, or one of the most significant contributors to output fluctuation.

Oh, I certainly do agree that the Fed's actions have a lot of impact on the economy--I just don't share the Austrian view of what the exact mechanism is and what actions have what consequences.

How would you answer the question I asked in my reply to softwareNerd: What will the effects on the economy be if the Fed keeps interest rates low and the dollar (relatively) strong, as it seems to be doing right now?

[Capitalism Forever]

That still doesn't make fractional banking okay, as the issue of the misallocation remains.

But why is there misallocation if I keep $500 in a fractional account, but not if I keep it in a bond? I don't consume anything in either case as long as I keep the money there, and when I do withdraw money from the account, I withdraw capital from the economy in pretty much the same way as when I sell a bond.

If people become increasingly adept at predicting the growth of the money supply and its effects on prices (which includes consideration of the other determinants, too), they will incorporate that effect into their expectations of inflation and increase their required rates of interest to compensate.

And that would mean that an increase in the money supply would mean a rise in interest rates in such a well-working economy, wouldn't it? Not a decline!

[adrock3215]

Oh, I certainly do agree that the Fed's actions have a lot of impact on the economy--I just don't share the Austrian view of what the exact mechanism is and what actions have what consequences.

How would you answer the question I asked in my reply to softwareNerd: What will the effects on the economy be if the Fed keeps interest rates low and the dollar (relatively) strong, as it seems to be doing right now?

The dollar has been in a bear market since the early 70's. All these 1-2 year bounces since then are just bear market rallys. The dollar will be strong for a year or two, then it will be right back down making new lows. The Fed does not have the ability to keep the dollar strong. In fact, the current dollar strength has nothing to do with the Fed, it has more to do with the enormous amount of deleveraging occuring in the financial system. People are selling out all of their positions all over the world and buying dollars to fund redemption requests.

America is a service based economy that doesn't produce much in the way of actual goods. We import most of our manufactured goods, i.e. cars, toys, steel, oil, etc. When Americans buy imports, we pay foreign firms in dollars. This means that dollars are sent abroad. But foreigners have nothing to spend them on, because Americans don't produce any goods that they need. That's why there are foreign nations sitting on mounds of US dollars, and trying to find ways to deploy them. They'll buy real estate here, or equity stakes in US firms, simply because there is nothing else for them to use the dollars for. There aren't many manufactured goods that they can buy from us, so there is nothing for us to export to them. What happens is that the foreign firms will just sell their dollars and convert them to a useful currency. This selling pressure is nothing but bearish for the dollar in the long-term, and it's the reason the dollar continues to lose value. It's because of our enormous trade deficit.

The Fed has no control over this. So long as Americans continue consuming indefinitely, and don't begin saving, investing, and producing goods that people want and exporting them, the dollar will continue its long-term slide.

Edited December 15, 2008 by adrock3215

[John McVey]

But why is there misallocation if I keep $500 in a fractional account, but not if I keep it in a bond? I don't consume anything in either case as long as I keep the money there, and when I do withdraw money from the account, I withdraw capital from the economy in pretty much the same way as when I sell a bond.

It's not the keeping that's the problem, it's the building up and drawing down, which over time will be more up than down because more gold will keep on being mined and partially monetised. The difference is that buying a bond does not increase the money supply as a fractional deposit does, nor does selling a bond lower it as drawing against a fractional account does. The variations - particularly the magnification that takes place on the back of the growth in specie - mess with the money supply beyond the travails of gold mining and increase the 'noise' content in the signal that is the price of credit.

That is all that fractional banking achieves - an increase in the noisiness of the credit-price signal, and so causing misallocation of capital beyond mere error in business judgement. That increases general risk, and hence people's risk premiums, which raises the cost of capital generally, which lowers the grand total amount of capital people are willing to provide. In a free economy the magnification effect is there though somewhat minor (but still not worth a tinker's curse), whereas in an unfree economy it is magnified to great extents (and thus a major threat to our well-being).

And that would mean that an increase in the money supply would mean a rise in interest rates in such a well-working economy, wouldn't it? Not a decline!

After people make their judgements, yes - which is why the Fed has to accelerate its expansion of the fiat money supply to maintain an under-market price of credit. However, there is still the gap between the time that credit is expanded and the time when people either notice that directly or figure it out from backwards-looking statistics. Without government to magnify the whole process to gigantic proportions, the response is quick and golds's check-against-expansion mechanism works fast, but even in a free economy it is not instantaneous. People will always have to take the time to get the facts and make their judgements accordingly, and therein lies the opportunity for what was initially fraud and now is just ignorance and delusion (and pitiful financial education).

JJM

[Capitalism Forever]

The difference is that buying a bond does not increase the money supply as a fractional deposit does

Suppose Jack has 500 gold dollar coins that he wants to keep in reserve indefinitely. His options are:

1. To keep the 500 coins under his pillow, or equivalently, in a safe deposit box or non-fractional account provided by a bank. The effect of this is to withdraw $500 from circulation for as long as Jack keeps it there.

2. To invest the money into a bond. The effect then depends on what the issuer or seller does, but if we suppose that it is a freshly issued bond of a productive corporation, most of the $500 will be spent on productive effort, and thus stay in circulation.

3. To put the money into a bank that maintains a 50% reserve policy. The effect will then be to withdraw $250 from circulation for as long as Jack keeps the money on the account, in much the same way as under #1; the remaining $250 will be invested by the bank into ... let's say, a portfolio of bonds being issued by AAA-rated corporations, so that it will stay in circulation in much the same way as under #2. The $500 worth of paper or electronic money held by Jack as a token of the bank's liability to him will not be circulating as long as Jack maintains his $500 balance, which we supposed he wants to do indefinitely.

If you compare the options, you will see that the relative effect of both #2 and #3 on the supply of circulating medium, as compared to #1, is upward, and that #2 in fact has a stronger upward effect than #3. (And keeping $250 under his pillow and $250 in a bond would have an effect equal to that of #3.)

So while fractional reserves do leave more money to circulate and to bid up prices than 100% reserves, they are no more inflationary than investing part of your money into liquid bonds. They are really just a way of doing the same thing through an intermediary.

Should Jack eventually decide to lower the amount of liquid reserves he kept and spend his $500 on consumable goods, the effect under each scenario will be:

1. The $500 worth of specie will re-enter the supply of circulating medium.

2. The buyer of the bond, who is obviously someone who has just produced $500 worth of wealth and wants to keep it in reserve, will in effect swap places with Jack, letting Jack have the $500 worth of freshly-produced wealth. The original $500 of specie that paid for the bond will continue circulating as it always has been.

3. (Supposing Jack withdraws all the $500 in specie:) $250 will come out of the bank's vault and re-enter circulation in much the same way as under #1. $250 will come from the sale of the bond portfolio, with the effects described under #2. The $500 in paper/electronic token form that was held by Jack will cease to exist.

[John McVey]

Suppose Jack has 500 gold dollar coins that he wants to keep in reserve indefinitely.

We could go into a major discussion on what Jack’s actual intentions are and hence whether this is a rational action, but we’ll just run with it instead. We will further assume that if Jack deposits money to a fractional account he does so knowingly. If he doesn’t, then to that extent Paul (and others) is correct to condemn the bank’s action as fraud.

1. To keep the 500 coins under his pillow, or equivalently, in a safe deposit box or non-fractional account provided by a bank. The effect of this is to withdraw $500 from circulation for as long as Jack keeps it there.

The consequences of Jack’s actions don’t end with just a pile of coins sitting around. Circulation has reduced, as you note, but how you put it leaves much out. What happens is that spending is decreased. All those who would normally trade with Jack feel the pinch first, and the influence spreads out broader (and thinner) from there, until the markets stabilise again at a point were all prices have fallen. This is the standard effect of an increase in the demand for money, which is what Jack has done.

Moreover, what Jack has done is not equivalent to a reduction in the money supply. The total money supply remains the same, because the pile of coins is still able to be spent at a moment’s notice. Instead, what has happened is that Jack’s increased demand for money has lowered the velocity of circulation. I could explain that further, but it’s a side issue compared to the present discussion.

I will note, however, that this is not a fair baseline for comparison of what happens in non-fractional banking with what happens in fractional banking. In a fair comparison the demand for money is unchanged, so there is no change in transactional velocity to account for. That is, people are choosing between an already-existing holding of money kept aside or being put into a non-fractional account on the one hand (banks as storehouses) versus into a fractional account on the other (banks as debtors). One then looks at the effects the latter has in comparison to the former. A proper #1 scenario would be where Jack already holds $500 aside, not that he decides to add a new lot of $500 to his holdings of money. We'd then show that keeping it in a non-fractional account achieves the same thing as keeping in a deposit box or under the mattress.

2. To invest the money into a … freshly issued bond of a productive corporation, most of the $500 will be spent on productive effort, and thus stay in circulation.

Correct, as far as it goes. What you’re missing is the actual nature of investment. It is not money that is invested, it is the resources that could be bought with them that are invested. Money is nothing more than a medium of exchange. What Jack had was an asset (the money) that people will trade away physical goods and services in return for. It is Jack’s ability to obtain those goods and services and use them as means to further production (whether on his own part or getting another to do the physical parts of it) that is the actual investment. When he buys a new bond what he’s trading is the ability to obtain goods now for the ability to gain a larger quantity of goods later, where the extra goods arise because the borrower will act to produce them.

Getting back to the money part, in both #1 and #2 Jack retains an asset of equal value in the present. For Jack, the difference with #1 is that he now has the chance of getting a return in the future but at a higher level of risk. For the economy, the difference with #1 is that, because circulation is maintained in #2, total spending is maintained. What happens then is that the various prices of different actual resources will increase and decrease, arising from Jack’s change in spending habits. That change in composition of spending is what’s supposed to happen, because those signals will then make producers change the composition of purchases and production various goods accordingly.

3. To put the money into a bank that maintains a 50% reserve policy. The effect will then be to withdraw $250 from circulation for as long as Jack keeps the money on the account, in much the same way as under #1; the remaining $250 will be invested by the bank into ... let's say, a portfolio of bonds being issued by AAA-rated corporations, so that it will stay in circulation in much the same way as under #2. The $500 worth of paper or electronic money held by Jack as a token of the bank's liability to him will not be circulating as long as Jack maintains his $500 balance, which we supposed he wants to do indefinitely.

First up, if the banking system has a 50% reserve policy then the result will be that the system will have all $500 sitting in vaults. In addition, the system will have $500 worth of loans (total book assets $1000), then have deposit to the total of $1000 (total book liabilities $1000). The extra deposit liabilities will arise because of the decreasing loans made out of the original $500 deposit and repeatedly coming back as deposits when the borrowers spend it. Lend out $250 and all of it comes back as more deposits, then lend out $125 and that too comes back, until $250 + $125 + $62.50 + $31.25 … = $500.

All those deposit liabilities are now part of the money supply because Jack et al can do transactions with them, so Jack’s $500 in gold has been turned into $1000 in fiduciary media by the banking system. What Jack’s non-spending achieves economically is the same as in #1: a reduction in the velocity of circulation.

As it happens, you’ve picked a reserve ratio that works out to the banking system’s actions being functionally equivalent (as far as the economy is concerned) to Jack making the loans himself – so long as Jack doesn’t change his mind. If a different ratio were at work there’d be different circumstances, but we’ll go with your 50% to start with. Now, as Jack calmly views his constant bank balance, in the mean time what is the difference between #2 and #3 to the economy? The total spending is the same as before because Jill et al spend the proceeds as they would still do, the same amount of loans are made as before, and the same quantity of resources invested as before. Net benefit: none. But what else has happened? The fact that Jack can still withdraw every dollar when he so chooses has created additional risk to the economy. You’re assuming he doesn’t change his mind about spending, but if he does then two alternative things can happen.

The first is that he spends money by say an EFTPOS transaction against his account. The result of that is extra spending total in the economy for that time period. Since the total amount of physical resources is unchanged, this extra spending cannot do anything except raise prices and mess around with people’s plans. Most people will identify this, or the effects of this, because they will know it will happen beforehand or will see an increase in variations of prices (including rates of return). This means an increase in risk and an increase in risk premium when people identify it. Benefit to the economy: none. Detriment to the economy: present to a degree that varies proportional to how strongly people react to the potential for Jack to change his mind.

If the ratio were higher, say 75%, then there is less nominal lending and less nominal spending. In this case, all we have is a blend of #1 and #3. The total effect would be partly the neutral one from #1 and partly the detrimental one from #3. If the ratio were lower, say 25%, then there is more nominal lending and more nominal spending. In this case we have a blend of two detrimental effects, that of partly the risk generated as per #3 and further an immediately felt rise in general prices because there’s more money being spent on the same goods and services as always. No matter how you rearrange things, it remains that fractional banking adds NOTHING but more risk and, except in rare circumstances you’ve accidentally hit upon (the combination of the right ratio and the right demand for money), more inflation.

If you compare the options, you will see that the relative effect of both #2 and #3 on the supply of circulating medium, as compared to #1, is upward, and that #2 in fact has a stronger upward effect than #3.

Completely wrong. In #2, total spending and the total money supply remain constant where all that changes is the composition of spending. In #3, the money supply has increased by $500, and spending will increase by whatever amount Jack chooses to spend via some non-specie transaction.

1. The $500 worth of specie will re-enter the supply of circulating medium.

More precisely, transactional velocity goes up. That then has effects on prices until the effects are absorbed and spread out, in reverse to #1 above.

2. The buyer of the bond, who is obviously someone who has just produced $500 worth of wealth and wants to keep it in reserve, will in effect swap places with Jack, letting Jack have the $500 worth of freshly-produced wealth. The original $500 of specie that paid for the bond will continue circulating as it always has been.

Leaving aside a bunch of other assumptions that take us far afield (Jack’s sale competing with other’s new issues), that’s pretty much as correct as #2 above.

What would be more instructive is to look at what happens when the bond matures and Jack decides not to renew it, but we’ll leave it at that for the time being.

3. (Supposing Jack withdraws all the $500 in specie:) $250 will come out of the bank's vault and re-enter circulation in much the same way as under #1. $250 will come from the sale of the bond portfolio, with the effects described under #2. The $500 in paper/electronic token form that was held by Jack will cease to exist.

If we are supposing Jack withdrawing the lot, then the bank is required to take out all $500 in its vault, not $250, when Jack makes his demand (hence the term demand deposit). The bank then has no reserves left over for the other $500 in deposit liabilities! If it has a 50% ratio policy then it must either inject $250 in equity or long-term debt issue, liquidate some of its loan assets until it receives the needed $250, or not make any loans at all from new deposits in until reserves rise to meet the required ratio. That requires others to deposit in aggregate to deposit $500, replacing Jack’s withdrawal.

In the meantime, loans mature and expire. If a bank is cutting back its lending activity because of the need to rebuild reserves then businesses (whether individually or in aggregate) are no longer getting the new loans they need to maintain their present level of business activity. This then means they can only produce less, or not at all, because they can less afford to buy the input resources they need. None of this would happen were Jack's account not fractional, because the banking system would never have made those extra loans in the first place (it would have made loans funded by equity or formal debt instruments, NOT out of deposits). It is this granting of improper loans that later cannot be renewed that is a major element in the boom-bust cycle, and reflects the fact that people don't actually seek to invest for the proper time frame as borrowers are lead to believe.

Further, if the bank has reducing deposit liabilities the total money supply is also falling. Yes, $500 in fiduciary media will cease to exist. And that then gives a similar effect as the original #1 right at the very top, with the added kicker that it is happening at the same time as businesses' lines of credit being yanked as described in the previous paragraph. As I said before, the non-occurrence of the assumption of fair financial weather makes functional equivalencies break down, usually causing economic distress to some degree in the process.

Sorry to leave it at that, but it's been a long day and I need to get to bed. I wont be able to reply for a few days at least, too, probably not until after Christmas.

JJM

[Capitalism Forever]

A proper #1 scenario would be where Jack already holds $500 aside, not that he decides to add a new lot of $500 to his holdings of money.

Well, I never said that he didn't already have the $500. Although I realize that one could easily think that I implied so from the way I put it. What I wanted to focus on was the difference between #1 and the other two options for achieving the same end, not the effects of #1 as compared to some unstated #0.

First up, if the banking system has a 50% reserve policy then the result will be that the system will have all $500 sitting in vaults. In addition, the system will have $500 worth of loans (total book assets $1000), then have deposit to the total of $1000 (total book liabilities $1000). The extra deposit liabilities will arise because of the decreasing loans made out of the original $500 deposit and repeatedly coming back as deposits when the borrowers spend it. Lend out $250 and all of it comes back as more deposits, then lend out $125 and that too comes back, until $250 + $125 + $62.50 + $31.25 … = $500.

This makes the additional assumption that the successive recipients of the $500 are also going to opt for fractional accounts. I don't mind that assumption, but then we have to apply an analogous assumption to the direct bond investment option as well. A single-individual hypothetical is too limited for that, so let's extend the whole exercise to an entire economy:

1. Baseline scenario: We have an economy consisting of 1000 producers (and no unproductive consumers). The money supply consists of 200,000 gold coins denominated at $1. There are no bonds or fractional accounts; everyone keeps all his money in his wallet. The cash holdings of each of the 1000 producers vary between $100 and $300, averaging $200 over time. The average spending is $200 per quarter, which means that the velocity of the 200,000 gold coins is 4 per year. Another way of looking at it is: there is $100,000 actually circulating, with a velocity of 8 per year, plus $100,000 sitting still as reserves in people's wallets, with a velocity of 0. Whichever way we analyze it, the figure relevant for determining the price level, MV, is going to be $800,000.

2. Bonds scenario: We still have 1000 producers and $200,000 in gold, but each of the producers invests the static portion of his liquid holdings into bonds. To continue the assumption that the static portion is 1/2 of the average holding, we have to make the $200,000 of total gold play the role the $100,000 actually circulating played in #1, and set the figures thus: Individual liquid holdings vary between $200 and $600, $200 of which is bonds and 0 to $400 gold. The average spending is $400 per quarter, making V = 8 and MV = $1,600,000. If this economy produces the same amount of goods per year as the baseline one, its price level is going to be twice as high--but, of course, it could also well be that it produces twice as much, selling everything at the same price. The total investment into bonds is $200,000.

3. Fractional banking scenario: We still have 1000 producers and $200,000 in gold, but each of the producers keeps all his money in a fractional account backed by a 50% reserve. The result, of course, is that all the $200,000 is sitting in bank vaults. The banks owe each individual a sum that varies between $200 and $600, and totals $400,000 for the economy. We have an average spending of $400 per quarter, meaning that the money supply of $400,000 is spent 4 times a year, and thus MV = $1,600,000. Again, this could mean the same output as #1 at twice the price level, or twice the output at the same price level (etc.). The total of fractional-banking-induced loans on the asset side of the banks' balance sheets is $200,000.

Comparing #2 with #3, we find that the relevant figures are exactly the same--the only difference between the two is that the banks act as a middleman for investing the $200,000 in the latter, while they have no such function in the former. Having a middleman has its costs, but also its benefits, and the benefits sometimes do outweigh the costs. In addition to the probably more expert investment decisions made by banks, fractional banking also has the benefit of providing a more convenient form of making payments.

Now, what if "the weather turns bad" and there is a decline in production, or an increase in consumption needs? If it hits all the 1000 producers at the same time, the result is going to be the same under all three scenarios: prices are going to increase. If it affects only an isolated individual, we may safely assume that it is going to be a regular occurrence in the economy, and make it a built-in part of each scenario. Let's say, one poor old fellow in each quarter who has to spend his $100 (#1) or $200 (#2, #3) of reserves in addition to his regular spending, but is balanced by one promising young gentleman per quarter who freshly builds a $100 or $200 reserve, respectively. Under #1, this will involve the transfer of $100 of specie held in reserve from the former to the latter (and a countervailing transfer of consumable goods, making MV = $8,000,400 per year); under #2, the unfortunate man will sell the bond and the successful producer will buy it, allowing the former to buy $200 worth of consumable wealth ultimately produced by the latter (resulting in an annual traffic of $16,000,800 of specie against goods); under #3, the bank balance of the reserve-depleter will decrease by $200 and that of the reserve-builder will increase by $200 (also bringing MV to $16,000,800). So again, we have the same figures for #2 as for #3, but while the afflicted gentleman will have to go through the process of selling a bond before he can buy what he needs with #2, he can simply write a check or go to the ATM under the #3 scenario.

I wont be able to reply for a few days at least, too, probably not until after Christmas.

I won't be logging in much in the near future, either. I'll do some more skiing around New Year's (I guess you must be doing very different kinds of things this time of the year down under! ) and will be back sometime after January 4. Until then, have a merry Christmas, and be sure to celebrate it properly, by exchanging a lot of the stuff that ought to be gold!

[John McVey]

The key problem you’ve very clearly displayed in this post and others – a problem in which you’re far from alone in having, I must add – is the failure to heed the advice I have been saying repeatedly in almost every post I have ever made on this subject. Always remember that the physical world, and our beliefs about, our responses to and preferences for the physical world, are paramount in human affairs.

You – and not only all others who have no objection to fractional reserve banking but also all those whose objection is based on claims of fraud – will never understand why the practice is worse than worthless until you fully reduce all concepts back to the physical world and see how all the physical elements subsumed by those concepts interact with each other. Until and unless you’re willing to do that then any discussion on the matter is a waste of time. Without such understanding a discussion would be rationalism, and I believe that is where this would be going, just as Dr Peikoff once described the inevitable terminus of rationalism: into ever more detailed discussion of and deduction from minutiae without reference to principles grounded in observation of and induction from physical reality. Here is the case in point with your latest scenarios:

1. Baseline scenario:

- 1000 producers

- $200,000 gold coins denominated at $1

- no bonds or fractional accounts

- average holding of money is $200

- average preferred minimum holding for money is $100 (the “static portion”)

- average spending is $200 per quarter, which means velocity is 4 per year

- result is MV = $800,000 per year.

I know you don’t realise it, but the whole essence of your problem is right there – not in what you’ve stated (which is mathematically – ie rationalistically – ‘sound’), but in what you have not. What’s glaringly absent is any consideration for who is spending how much on what and why. That flaw is fatal.

The ‘how much’ part is your failure to distinguish between the ‘who’s relative spending preferences to buy consumer goods so as to the fruits of their labours now versus buying investments now so as to consume more in the future.

The ‘on what’ part is your failure to distinguish between the supply of consumer goods on the one hand and the supply of inputs to production (land, labour and capital) on the other so as to physically enable the two elements in the ‘how much’ part for the benefit of the ‘who.’

The ‘why’ part is your failure to realise that:

- a given level of total physical production requires the input of given quantity and structure of physical capital along with a certain amount and structure of labour;

- the physical capital goods involved must constantly be replaced;

- the larger part of total spending in an economy must be directed towards purchasing and installing those replacements just to maintain the same level of production;

- people adjust their spending in the ‘how much’ part above by using the physical-world consequences of the above physical actions as evidenced to people in the form of their comparisons of the prices of consumer goods and the potential returns for labour on the one hand against the cost in time and effort for working and the cost of not consuming the fruits of that work now on the other.

Here’s the physical reality. If people want to consume more now, they can only do so at the price of spending less on capital replacements and so must be content with consuming less later. On the other hand, if they want to consume more later then they must first direct spending to the purchase of more capital items than merely necessary as replacements, and so must be content with consuming less now. That is the bottom line.

The physical reality of that consumption timing decision is put into effect via people acting in the finance world by using money and financial instruments as proxies. The signalling effect provided by the price of capital – not just rates of interest but all rates of return across the entire investment spectrum from bills to ordinary stocks – are the means by which people determine with reasonable precision what part of their claim to resources goes to present consumption and what part of their claim to resources goes to investment for future consumption. Remember that people’s core preferences for these are physical world phenomena, originating OUTSIDE the realm of finance. All this is made possible by the fact that a prime purpose for the use of money is that it is a unit of account, a single common value used as a basis on which to calculate all other values. People spend money to buy investments because they want to consume more in the future, where that spending is a financial-world proxy for the want of allocation of physical resources towards the production of what people will want in the future, where the financial world as intermediaries then goes on to pass the money on to businesses who actually buy and use the requisite physical resources.

The validity of all the calculations involved depend on there being a definite and identifiable link between the real world of the physical resources used in business and the financial world that proxies that physical world in business. The value of a unit of money in terms of what it can buy relative to the value of the physical effort required and time constraints borne to earn a unit’s worth of that money is the link between them. The increase in the quantity of proxies – be that in the form of fiat-money expansion or credit expansion – cannot increase the real quantity of available resources for which they are proxies. All that happens is the link gets screwed with and the proxies are no longer valid tools of calculation until people properly identify the new nature of the link.

The essence of the Austrian theory of the business cycle is that increasing the fractionality of the money supply acts only to distort that link. The reason why it distorts that link is because it is allowing both types of spenders to spend more money to purchase the same resources. This cannot do anything except cause the general prices of resources and products to rise and cause the structure of those prices to deviate from what people’s physical preferences would have them be. The result is the standard business cycle:

- the boom phase is when the first recipients of extra spending mistakenly think they are the beneficiaries of real changes of preferences in their favour and begin allocating too much resources and of the wrong type to their lines of production

- the peak is when the truth starts hitting people in the face through the structure of prices in the marketplace beginning to be forced back into line with what everyone’s aggregate real preferences actually are, and so the recipients of extra spending are no longer paying the low prices they once did for their various inputs

- the decline phase is when people cease investing because they can no longer accurately calculate values for shorter and shorter time frames, which phase will be exacerbated by the link itself being redistorted in the opposite direction because of reductions in the money supply as the reserve ratios are raised again or banks fail

- the depth of the bust is when the physical results of the mistaken beliefs are being undone through liquidation sales and scrapping unviable capital goods for saleable and/or recylable content

- and the recovery phase – if there is one rather than merely a new boom phase – is when people begin to sort out what the new link between the real world and the financial world actually is.

The structure will initially change depending on who exactly gets the money first, but even so in aggregate all businesses will be tempted into borrowing more because the cost of borrowing will go down. However, because all money soon makes its way into the hands of consumers who are also initially made to think that happy times are here, and because consumer borrowing goes up for the same reason that producer borrowing does, consumer spending goes up and so the retail frontages get the lion’s share of the benefits at the expense of the manufacturing businesses. That effect gets worse the further away from retail supply a business is, because the retail shops are in a better position to compete for the scarce business resources (primarily labour), which pulls the prices of labour up. The continued consumer spending boom allows the retailers to offer ever higher wages, which the manufacturers find it harder to match. Thus one of the markers of a peak (more or less, there are complications) is a continuing retail boom while manufacturing is reporting bottlenecks and shortages that it cannot afford to cover.

2. Bonds scenario:

Still 1000 producers and $200,000 in gold, but static portion of liquid holdings invested in bonds. To continue the assumption that the static portion is 1/2 of the average holding, we have to make the $200,000 of total gold play the role the $100,000 actually circulating played in #1, and set the figures thus:

- 1000 producers

- $200,000 gold coins denominated at $1

- no bonds or fractional accounts

- average holding of money is $400

- average preferred minimum holding for money is nil (the “static portion” is all in BAB’s)

- average spending is $400 per quarter, which means velocity is 8 per year

- result is MV = $1,600,000 per year.

Firstly, your changing of numbers served no purpose whatever, and acted only to invalidate what you set up as a baseline as comparative. A proper continuation would have meant that the money supply, average holdings, and velocity all remained constant from #1. You then should have said people spent their “static portions” on buying the bonds instead. Had you done that, figured out what would motivate such an action under those conditions, and then followed what would happen to the economy both physically and financially starting from #1, you’d find that this action had set in motion a chain of events whose importance is greater in the physical world than the financial.

Secondly, you’ve made it very clear that you don’t know what velocity of money actually means and why a given number eventuates. That is, you have no clue why the average holding is what it is. The real reasons are things that exist in the physical world. One part you have heard of – the demand for money – but the other influence is dollar-weighted average time-period between various pay-cycles of all entities in the economy. For example, some people get paid weekly, others fortnightly, businesses remit invoices monthly, bondholders get paid half-yearly, taxes get paid on their own various schedules, and so on, and then also all manner of random possibilities for those without regular pay cycles. Once again, that is independent of what happens in finance, and it does not change either with any great speed or to any significant degree. Since this is the case, your decision to increase the velocity was totally arbitrary, done solely to make the numbers convenient for yourself rather than to represent reality, and so was completely without justification.

Thirdly, your reference to people seeking to hold their “static portion” in bonds reveals your ignorance about what the demand for money is. The reason why people have a demand for money is that they are preparing for unexpected expenditure requirements, any of which could occur immediately. Suggesting that people would be buying bonds with their minimum preferred holdings of cash is ludicrous, because one cannot get one’s money back on even the world’s most liquid bond all that quickly (this includes bills, for that matter). Buying any investment at all defeats the purpose of having that ‘static portion’! If people actually wanted to invest for the future then they’d consciously do exactly that without ever thinking in terms of a “static portion” of cash, knowing full well that what they bought would not do for any spending needs that had to be met in a hurry.

All you’ve got is a system of numbers you plucked out of nowhere and on no basis but convenience and rationalist-deductive connection, with nothing but a token reference to physical goods that isn’t actually taken anywhere important. By focusing solely on the financial numbers and calculations you’re completely missing what those numbers actually mean and why the numbers you picked are ridiculous. The result is that all you have to show for your efforts is a mathematical castle in the air.

If this economy produces the same amount of goods per year as the baseline one, its price level is going to be twice as high--but, of course, it could also well be that it produces twice as much, selling everything at the same price.

Sorry Cap, but this casual glossing over of the physical world and what it means for calculation in the financial world is totally unacceptable.

3. Fractional banking scenario:

- 1000 producers

- $200,000 gold coins denominated at $1

- fractional accounts at 50% reserve ratio

- all coins in banking system; 50% ratio sees money supply = $200,000 / 0.50 = $400,000

- average holding of money is $400, all in bank notes or demand deposits

- average preferred minimum holding for money is not mentioned

- average spending is $400 per quarter, which means velocity is 4 per year

- result is MV = $1,600,000 per year.

Comparing #2 with #3, we find that the relevant figures are exactly the same--the only difference between the two is that the banks act as a middleman for investing the $200,000 in the latter, while they have no such function in the former.

A feat you’ve arbitrarily achieved because you picked velocity numbers to suit. In the real world, if the velocity without fractional banking is X then the only reason it will change is because of a change in the demand for money or in the average length of pay cycles. But as noted the latter doesn’t change very much, and your scenario #3 is keeping the former constant as per #2. Thus your halving of velocity does not stack up in the real world, because to have that eventuate everyone and every business would have to double every single pay cycle length! That’s just not going to happen. So, instead, if X were 8 as per #2, then the shift from non-fractional to fractional banking as per #3 would mean that X stay at 8 and result in MV shooting up by 100%, taking all prices with it. As that colossal inflation actually progressed over time it would cause massive upsets in every single market in that economy in a manner that goes beyond just what these aggregates describe.

To make matters more interesting, if the inflation proceeded fast enough then people will start taking an active desire to get rid of money by buying stuff ASAP. This - which is a collapse in the demand for money, called the flight to values - then sees the velocity of money go up, not down. When people stop accepting the money in payment at all, the demand for it has finally hit zero, velocity is "infinite" and prices cease to have any meaning at all. All trade is then conducted either in another form of money or by barter - assuming anyone's still alive.

Having a middleman has its costs, but also its benefits, and the benefits sometimes do outweigh the costs. In addition to the probably more expert investment decisions made by banks, fractional banking also has the benefit of providing a more convenient form of making payments.

One, don’t talk down to me, dammit.

Two, the modern financial world has no need whatever of recourse to fractional reserve banking to provide us with the full panoply of financial and monetary services. The services you mention – brokerage, lending, financial planning services, funds transfers, ATM systems, credit card systems, and so on – can occur perfectly efficiently without resorting to, and whose practices have nothing inherently to do with, fractional reserves and credit expansion.

Three, stand back and realise what you are actually saying about the financial system. The provision of equity and credit is a market just like any other, and whose sole purpose is to facilitate the provision of physical resources under certain legal conditions. The proper market prices for those resources under those conditions are set by the physical-world considerations that underlie all minimum required rates of return (of which interest rates are one subset). By saying that fractional banking adds something what you’re really saying is that the free markets are fundamentally incapable of bringing together those with more physical resources than they know what to do with and those who have more ideas for physical resources than they actually have, and fundamentally incapable of readjusting prices to match people’s relative preferences for consumption now versus consumption later – that is, you are saying that markets cannot clear - without resorting to credit expansion. That is one helluva charge, especially from one who accounts himself a capitalist! It is also one that does not stack up in a real world when there are no minimum wage laws, licencing laws, union powers, price controls, and so on. Again, the only reason why fractional reserve banking and credit expansion appears to be beneficial is because the consequent inflation is used as means to skirting around the barriers that those programs put up to market clearing.

Sorry Cap, but I’m not going to answer any more of your questions or deal with your scenarios until it looks as though you’ve made a decent effort at trying to understand the physical-world roots of capital, interest, and every other financial-world concept you are depending upon. Feel free to ask about how to go about reducing and integrating those concepts, of course.

Until then, have a merry Christmas, and be sure to celebrate it properly, by exchanging a lot of the stuff that ought to be gold!

Gold-foil-wrapped chocolates will have to do

Thank you, season's greetings to you too, enjoy your trip, be safe on the slopes, and see you when you get back!

JJM

ps: yes, I have been skiing before, and yes, in Australia.

Edited December 24, 2008 by John McVey

[John McVey]

Two changes...

- people adjust their spending in the ‘how much’ part above by using the physical-world consequences of the above physical actions as evidenced to people in the form of their comparisons of the prices of consumer goods and the potential returns for labour on the one hand against the cost in time and effort for working and the cost of not consuming the fruits of that work now on the other.

Uy that part is ugly! Change it to read:

- people adjust their spending on the 'how much' part above based on their estimation of: the number of dollars they can expect to get for a given amount of effort; the value of a dollar today; the value of a dollar tomorrow; and what sort of investment returns they can get; all of which judgements include physical estimations and so are heavily influenced by the physical consequences of prior spending.

Secondly, you’ve made it very clear that you don’t know what velocity of money actually means and why a given number eventuates. That is, you have no clue why the average holding is what it is.

I made a typo. It should be "no clue why the velocity is what it is", not average holding.

JJM

[Capitalism Forever]

Thank you, season's greetings to you too, enjoy your trip, be safe on the slopes, and see you when you get back!

Thanks, I'm sure I'll enjoy it!

I agree that it is futile to discuss economics as long as we have conceptual, and ultimately, epistemological differences. Concepts such as capital, money, and investment are indeed crucial for getting economics right, but I don't look to Austrian economics for their definition and discussion; I think the correct definitions are to be found in the writings of Say, and in works yet to be written by people like Richard Salsman and other future Objectivist economists.

Also, the rejection of my numerical demonstration as "rationalistic" suggests that beyond the disagreements on economic concepts, we also have a very different approach as far the methodology of economics is concerned. As a case in point, I hold that simplified models of an economy, or a part thereof, are useful tools of abstraction and can help shed light on the essence of certain relationships and laws by focusing one's attention on just the relevant aspects--while the Austrians seem to have a distinct aversion toward such models and prefer to make their point using verbose paragraphs of often difficult-to-follow prose. They even reject the use of equations as such; e.g., von Mises dismisses the Equation of Exchange as "mathematical economics"--while I, on the other hand, consider it to be indispensable for understanding the interaction of production, money, and prices.

The purpose of this thread was to answer adrock's question about what disagreements I have with Austrian economics; I think it's fair to say that it has served its purpose well and provided a good glimpse of the scope, nature, and extent of my disagreements.

So now, I'm off to skiing!