To The Austrian School (And Others) I Take Exception

[peristaltor.livejournal.com]

In one of the many recent money and finance posts and comments recently, I got a link to the Austrian business cycle theory. At first, it makes sense, echoing much of what I've been writing about, all this bank money creation and government money creation. Some points with which I am in general agreement:

Banks expand credit . . . often supported or encouraged by the setting of low interest rates by a central bank. This additional credit flow into the economy from increased borrowing for capital projects stimulates economic activity. Projects which would not have been started before, seem now profitable, creating malinvestment. They increase demand for production materials and for labor and their prices rise, which, in turn, leads to an increase in prices of consumption goods. If the banks would stop the extension of credit, the boom would be rapidly over. To prevent the sudden halt of this boom (and the resulting collapse of prices), the banks must create more and more credit, and the prices will rise even more.

But this expansion of credit cannot continue forever.

First, observant readers will note that I will in no way touch the Austrian concept of "malinvestment." Why is simple: I don't believe it exists. What people find worthy of their investment dollars is now and will always be what people find worthy of their investment dollars. Now, do I think some of those are insane as investments? That's a different question for a different day.

To rephrase the above intro to a business cycle, banks lend money into existence, which is spent on assets. Some of those assets yield profitable returns or resales; these assets are the subject of further investment. More and more borrow to themselves invest in these assets; the continuing increase in the money supply makes the continuing asset price rise possible. This continues until either the credit extension or the price rise balk.

With this I would agree.

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That agreement doesn't, like a credit expansion, go on forever. First, note in the quoted block above an ellipsis. Here is the phrase I removed: ". . . well beyond their own assets and by the funds of their clients." Uh, what?

If a bank is under a strict gold standard that statement might be true. Most banking systems, though, count viable assets (such as the collateral used to secure loans) as legitimate backing. To reiterate the last crisis, let's use houses for an example. As long as the houses maintain their resale value, the bank is safe lending, since it can simply sell the foreclosed house after a default. Furthermore, as long as the bank maintains the required fractional reserve, the central bank will back any short-term shortfalls in currency assets that might occur if depositors make a "run" on the bank. The bankers might have to liquidate some assets to carry them over the hump of a run, but for the most part these panics are short-lived if they are backed by the central authority and some kind of insurance.

Therefore, the phrase "well beyond their own assets and by the funds of their clients" has little if any meaning. Let's continue from where I left off, shall we?

But this expansion of credit cannot continue forever. There is no additional capital or labor; there is only more money (and debt). The means of production and labor which have been diverted to the new enterprises have to be taken away from others. Society is not sufficiently rich to permit the creation of new enterprises without taking away from others.

I have a wee but significant problem with this description. Why? As long as there are un- and underemployed people in the society willing to work and able to do that work, most societies can expand their economic activity. I've worked in factories before. Most run one or two shifts; when business gets hopping, they run three. The argument that society "is not sufficiently rich to permit the creation of new enterprises without taking away from others" ignores under-utilized labor and another very, very important one: Mechanization.

---

When one of us does a job, we very seldom actually do the job. For example, this morning I took about 180 people to and from work (mostly, I assume, to). I must be a brute to lift all these people on my shoulders, what? No, I just drove the bus. (Actually, I "operated" the bus; "drive" is a word English speakers carried over from what we teamsters used to do with harnessed animals.) That 60-foot wheeled diesel machine did all the work. As long as tasks can be mechanized, and — here's the really important bit — as long as we can fuel those machines, we societies can indeed "permit the creation of new enterprises without taking away from others."

I was thinking about this point after I read beyond the introduction I'm quoting and found this tantalizing sentence: "The regularly occurring booms and and busts were observed from approximately late eighteenth century, along with the start of the Industrial Revolution." Aha! The era of steam brought with it an era of, er, expansion, which in turn led to an era of booms and busts unlike those from previous eras. Those eras, too, did have their financial disasters. Recall the tulipomania in Holland or the South Sea Company bubble in London. Both of these preceded the age of steam, true. But both of them resulted from the sudden injection of wealth made possible by harnessing energy with another technology, wind that filled the sails and drove (there's that misapplied word again!) ships filled with booty from far-away lands.

So, continuing after "along with the start of the Industrial Revolution," we read: "Sudden economic crisis, when some king made war or confiscated the property of his subject were known; but there was no sign of the modern phenomena of general and fairly regular swings in business fortunes, of expansions and contractions." Didn't I just list two such crises? Ah, but these are one-off blips in economic weirdness, not "fairly regular swings in business fortunes."


Stephenson's Rocket, the first
practical steam locomotive, 1829.
When we got to the Industrial Revolution, changes that would have taken a century with mechanized help from wind transport started to take but decades; the rapid accumulation of change would have in turn affected the banking cycle of lending and the monetary creation implied therein. More wealth means more collateral means more lending.

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From here on, though, the exceptions I take get drastic. Continuing, this time with emphasis:

As long as the expansion of credit is continued this [shifting of resources] will not be noticed, but it can't be pushed indefinitely. The inflation and the boom can last only as long as the public thinks that the prices will stop rising in the near future. When the public becomes aware, that there the inflation will not end, and that prices will continue to rise, panic sets in.

Here the Austrian School is talking out of its collective asses.

Think about it. You are an investor. Why are you an investor? Because inflation is constantly eating the value of your bank- and mattress-deposited cash. You seek an asset that has been lately increasing in value (or, even better, you think will do just that in the future). You buy it. That house is all yours. A prominent article featuring your neighborhood gets published and it's off to the paper equity races.

Others hoping to ride this bonanza take out bank loans for their own up-and-coming fixer. The price skyrockets, buoyed not just by the enthusiasm houses have fired, but by the increase in dollars floating about looking for purchases. If enough enthusiasm flames for long enough, even bankers will forget prudent lending standards and issue loans to questionable lenders using their iffy houses closing for double-you-tee-eff prices.

As long as the resale prices continue to rise, or as long as bankers continue to honor the resale value of these houses with collateral status, inflation will continue, which, unlike what the Austrian School maintains in the selected quote, is exactly what the investors hope will happen. Once a house fails to resell or, more likely, once a buyer goes delinquent on his or her loan, though, the party is just about over. It is inflation's end, not the threat of its continuance, that panics investors. Finally:

Eventually, people may give up the currency and rush to exchange money for goods, buying things they have no use for, just in order to get rid of the money (the so-called "flight into real values.")

In case you think that might be a typo, here they repeat the theme. Why in the living hell we call banking would they do that?!? As bank debts backed by falling house prices continue to default, the remaining money in circulation becomes more valuable! Things of value are hoarded, not abandoned!

I do think there is a lot of buying and selling as a bubble deflates, but that is probably just the fire sale following a crash. People may have lost value in their house, yes, but that doesn't end the contractual obligation for them to repay the loan that bought that house. Liquidating other assets might be the only recourse they have. Oh, and let's not forget that, unlike the Austrian concept, no one gets "rid of the money" when we buy and sell. It goes from one hand to another. The only main destroyer of money is deflation; the main cause of deflation is a loan default and collateral value collapse.

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I should specify that I have nothing against the Austrian School of economics. Nothing personal, that is. I invite those who claim allegiance to Mises and Hayek and the rest to correct me as they feel needed. Better yet, go back to the source material and see if the Mises Wiki is wrong at all. As long as the Austrian School of Economics hopes to be considered in any way scientific, however, diversions from empirical reality such as those I outlined above must be abandoned, or at the very least amended to conform to empirical tests.

After I read this entry a week or so ago, I started to ponder what a "theory" actually was, especially a scientific theory. Empirical testing is but one element of a theory. I'll ponder what other benefits a theory must have later.

Comments

[a-new-machine.livejournal.com]

Not much of a reply, but in general a theory is both explanatory and predictive. It tells us why X is the case, and tells us what will happen to X if Y occurs.

[peristaltor.livejournal.com]

Absolutely, with emphasis on "both." I'd go into more detail, but that will be the next magnum opus.

[johnny9fingers.livejournal.com]

You have become an extremely good communicator of ideas. And a great communicator of great ideas. The rumour was that Keynes had his work "sent up for good" more than any other pupil ever at Eton, which is a signal honour, as the school keeps records, some ancient indeed.

You began this path some time ago, declaring your reading and showing your analysis. There are a few folk here on this comm and on LJ who have made themselves expert on various matters: you have become one, and appear to have a real feel for this.

[Tips Hat and tugs forelock.]

[peristaltor.livejournal.com]

I say to you, kind sir, a sincere "Ah, shucks."

[anfalicious.livejournal.com]

I agree. Easy to read, yet not dumbed down. I saw the mass of text and almost thought tl;dr but it was easy enough to skim that I ended up reading it all. Good use of paragraphs and page breaks too.

[peristaltor.livejournal.com]

Thanks! I am constantly befuddled by those who value "content" over "style." If your content is buried in bad style, how are people supposed to access it?

[jerseycajun.livejournal.com]

"First, observant readers will note that I will in no way touch the Austrian concept of "malinvestment." Why is simple: I don't believe it exists. What people find worthy of their investment dollars is now and will always be what people find worthy of their investment dollars."

I read malinvestment as being a disparity between what an investor's basis for investment is, and the reality of the situation, which may be very different. I read what you said here as (and you can correct me if I'm wrong) treating investment worth in a bubble in which the world outside the human mind need not be considered and so the concept of malivestment is purely subjective, when it is only half-subjective. The half that relies upon human perceptions and expectations. The other half is the feedback we get from the environment telling us how close or far-apart those perceptions are from reality.

[peristaltor.livejournal.com]

Well put.

[sophia-sadek.livejournal.com]

I believe the Austrian school considers malinvestment to be capital consumption rather than capital investment.

[meus-ovatio.livejournal.com]

The problem with Austrians is the problem with neo-classicals. They're all rather stubbornly loyal to their 1930s mindsets.

[peristaltor.livejournal.com]

Oh, while I agree — more on the neoclassicals later, I promise — I would have to say those mindsets go back quite a bit further than the mere '30s.

[meus-ovatio.livejournal.com]

It annoys me that economics get treated like a natural science, as if human economic systems are generalizable or robust across large spans of times such that we can just use theoretical constructs (like a theory of gravitation or something) regardless of the reality of human culture. I mean, shit, there is so little actual empirical similarity left between when these theories were made, and the way the world is now, that it's just silly. Economics is not a natural science. It doesn't have eternal theoretical rules and validity like physics. FFS.

[anfalicious.livejournal.com]

I've always thought of it as more akin to a social science (and indeed, we teach economics here in high school out of the Humanities faculty). I've got a couple of degrees in a few areas of the social sciences and we change our mind about shit all the time; because the context is constantly shifting.

[anfalicious.livejournal.com]

And I think this is why Marx went to such pains to point out that Dialectical Materialism was a theory of History; and I think there is something to the point that all stratified societies have a struggle between the haves and the have nots. Maybe even in all societies. This is why Das Kapital is worth the read as a theory, but The Communist Manifesto is more of either an anachronism or background to get a context to understand the 20th Century. It has no relevance as handbook.

[johnny9fingers.livejournal.com]

Have I "friended" you lately. :)

This comment is worth its weight in gold.

[meus-ovatio.livejournal.com]

Yeah, communism has a little too much of that fervent "we can predict the future" because Enlightenment, mentality going on. All kinds of crazy shit cropped up under the aegis of "modern reason", and most of it is as problematic and superstitious as those things it intended to replace.

[peristaltor.livejournal.com]

I would agree. From what I'm reading now, Marx was the last good classical economist who modeled the economy better than just about every economist practicing today (with exceptions), though no one outside the philosophy department seems to know that and no one in the econ building would even entertain the evidence.

[gunslnger.livejournal.com]

I will in no way touch the Austrian concept of "malinvestment." Why is simple: I don't believe it exists. What people find worthy of their investment dollars is now and will always be what people find worthy of their investment dollars.

Of course. Which is why "malinvestment" is defined as an investment that people wouldn't ordinarily invest in, but they do because of an out of the ordinary incentive that doesn't line up with its actual value. It's not a moral judgement of the investment.

As long as there are un- and underemployed people in the society willing to work and able to do that work, most societies can expand their economic activity.

Up to a limit. That's all the description is saying. There's also a time issue besides; the economy is not infinitely flexible.

[mikeyxw.livejournal.com]

"the economy is not infinitely flexible"

The flexibility of the economy is usually not the problem. Finding people "able to do that work" is the tough part. It doesn't do much good to have unemployed carpenters if you need brain surgens, or vice versa. It takes a while to train your carpenters to be brain surgens or your brain surgens to be carpenters.

[gunslnger.livejournal.com]

That's part of what I'm referring to with that shorthand.

[anfalicious.livejournal.com]

We've been having a series of skills shortages in Australia for the last 15 years. It's an interesting aspect of an economy in transition from manufacturing to service and farming to mining.

[mikeyxw.livejournal.com]

The US has been suffering from skills shortages in some areas for decades and will for the forseeable future. A good engineer may not be hard to find, but if you need a couple hundred, you better go to India or China.

[anfalicious.livejournal.com]

That was how I understood malinvestment.

[peristaltor.livejournal.com]

I see a lot of Austrians throwing around loaded terms like "actual value" and "free market." These terms imply a perfect set of circumstances where values are known by all and markets are unimpeded by (fill in derogatory thing here).

That's the problem. Outside of the theory mill, we humans have only each other to deal with, only our perceptions to help us evaluate value.

I prefer to let people be people. The values and markets might not be perfect in any way, but then again neither are the participants — nor can they ever be.

[gunslnger.livejournal.com]

Consider it more of an ideal to strive for than a theory describing how things are.

[mikeyxw.livejournal.com]

"Here the Austrian School is talking out of its collective asses."

Well, yes, but not for the reason you are giving. There is a difference between an asset bubble and a credit bubble. Credit bubbles cause inflation which then causes the price of credit to rise and therefore deflates the bubble... at least so the theory goes. Why keep your money in the bank at a low interest rate when you get a better return on putting that money in blue jeans and cat food today rather than collecting interest and buying them as you need them?

An Asset bubble, like the one around home prices, is completely different. Credit bubbles are self-limiting, there is a point where people will stop buying blue jeans because their prices are have gotten too high. If houses go up in price, or even better, stocks, then they just become more desirable. You aren't buying a stock to wear it or because you have cats to feed after all. Most people who buy stocks never even see the stock they bought, the only reason they bought it is to sell it higher at some point in the future. If stocks keep going up, there is no point where someone will say, wow, stocks are too expensive, I'm going to buy bonds instead. If a pair of blue jeans costs $20 and will cost $25 next month, you figure it's on sale and buy it. If a pair of blue jeans costs $2,000 and is expected to cost $2,500 in a month, you've made a good case to buy dockers instead. If a stock is going to go up by 25% in a month, it's a good buy regardless if it's $200 or $2,000.

There are two reasons why the Austrian School is talking out of its collective asses. First, if business cycles were so predictable, mutual funds could simply track the ups and downs, buying tech on the ups and cyclicals on the downturn. Second, the Austrian's theory would have some types of employment going up during recessions, which doesn't happen. This theory was pretty well discredited when I was in college.

[gunslnger.livejournal.com]

This theory was pretty well discredited when I was in college.

Perhaps you could post some reference to where/how this was discredited so the rest of us could learn.

[mikeyxw.livejournal.com]

Hm, well, my memory was more of the prof acting like the Austrian guys were Flat Earthers in a geology class... in a very polite way of course, but here's some stuff that was online:

Paul Krugman's take:
Here's the problem: As a matter of simple arithmetic, total spending in the economy is necessarily equal to total income (every sale is also a purchase, and vice versa). So if people decide to spend less on investment goods, doesn't that mean that they must be deciding to spend more on consumption goods—implying that an investment slump should always be accompanied by a corresponding consumption boom? And if so why should there be a rise in unemployment?
http://www.slate.com/articles/business/the_dismal_science/1998/12/the_hangover_theory.html

Milton Friedman's take:
"The Hayek-Mises explanation of the business cycle is contradicted by the evidence."

I was looking for something to expand on this, Friedman is not as prolific online as Krugman for obvious reasons, here's a good summary: http://theincidentaleconomist.com/wordpress/is-austrianism-serious/

Also, here's one about the problem of the predictibility that the Austrians expect to see in business cycles, starting on the bottom of page 76: http://mises.org/journals/rae/pdf/RAE2_1_4.pdf

[peristaltor.livejournal.com]

I just read the Krugman link, where he says, "They can and should be fought, not with austerity but with liberality—with policies that encourage people to spend more, not less."

"Encourage?" When a bubble is deflating, the money supply is contracting, leaving everyone with less cash. Are we to simply encourage people to take out debt they can't afford? This would just shift the pain from the previous investors to the recovery borrowers.

I'm sorry, but as much as K. is right about the Austrians, he seems woefully uncertain about the actual cause of slumps — "A recession happens when, for whatever reason, a large part of the private sector tries to increase its cash reserves at the same time" — which leads him here, apparently, to recommend solutions that won't fix the problem except temporarily.

He must address the debt overhang with a solution that does not beget more debt. To do that, he must recognize the debt as part of the problem; and to do that, his modeling must include debt's true impact.

Once he does that, I can accept his analysis.

[anfalicious.livejournal.com]

Some of you never will.

[peristaltor.livejournal.com]

There is a difference between an asset bubble and a credit bubble.

I would disagree. Once one inflates the money supply, the existing money holders need a place where their money will not devalue through inflation. Since one inflates the money supply through loose lending, the initial credit bubble causes the flight to assets, which in turn draws many to speculate on the assets, perhaps by borrowing money, which inflates the money supply. . . . Rinse, repeat.

Credit and speculative assets: the two are like the legs of a compass.

Sadly, the current raft of economists with any say seem to not appreciate the role of lending in inflating the money supply. For that reason, they miss the positive feedback loop action of credit/asset bubbles, choosing instead to separate the two. Like you have. I'm not knocking you personally; just pointing out that the references you gave Gun below all come from neoclassical economists, the most common kind. The book I'm reading right now exposes their blind spot to speculative lending's feedback effect on the money supply, which is why Bernanke, et. al. missed the housing crisis. More on that later.

[mikeyxw.livejournal.com]

"the current raft of economists with any say seem to not appreciate the role of lending in inflating the money supply"

I would disagree. This is economics 101 stuff, I expect any professional economist is very aware the role that lending plays on the money supply. They just reach a different conclusion than you do.

[peristaltor.livejournal.com]

Until I started digging into this stuff, I would have agreed with you as well. The number of quotes from prominent neoclassical economists, though, from Friedman to Greenspan to, even, Krugman, speak to a blind spot in the model they use to make predictions. Unlike your conclusion, I think this stuff is Finance 101 material, and may not be covered in economics courses. Steve Keen notes that is was the case for him. He did not discover the money creation through lending mechanism until after he got his econ PhD.

Even Yves Smith, whose book EConned I really, really found insightful, suffered from this blindness. (I note her blindness in the first section of this post (http://talk-politics.livejournal.com/1349697.html).) I can't blame her, though, simply because she spent 25 years as an investment banker, and thus can be forgiven for not knowing the nuances behind commercial banking.

[anfalicious.livejournal.com]

You might enjoy the Etymology of drive. (http://www.etymonline.com/index.php?term=drive&allowed_in_frame=0) It's earliest roots go back to "pushing from behind".

[sophia-sadek.livejournal.com]

As in: "The businessman with an ambitious wife exhibits a great deal of drive."

[kylinrouge.livejournal.com]

Austrians don't really bring anything to the table. They just go around telling everybody that nothing can be measured and then sit down and wait for gold to rise in value.