Hoping for an Intellectual Recovery

Gold Money published an article two days ago about two important papers that I hope will bring reform in central banking and the monetary system of the world. I am referring to the papers that just recently came out from the Bank for International Settlements (BIS) and from the Britain's Adam Smith Institute. These papers confirm the message of the Austrian Business Cycle Theory. I wish that this is just a beginning of intellectual recovery that Murray Rothbard told us in his essay, Economic Depressions: Their Cause and Cure:

“Once again, the money supply and bank credit are being grudgingly acknowledged to play a leading role in the cycle. The time is ripe for a rediscovery; a renaissance of the Mises theory of the business cycle. It can come none too soon; if it ever does, the whole concept of a Council of Economic Advisors would be swept away; and we would see a massive retreat of government from the economic sphere. But for all this to happen, the world of economics and the public at large, must be made aware of the existence of an explanation of the business cycle that has lain neglected on the shelf for all too many tragic years” (“The Austrian Theory of Trade Cycle and Other Essays”, 1978, p. 91).

Let me just share three important paragraphs from Gold Money:

"Within one month of the Fed raising the Fed Funds rate by a miniscule 0.25%, it seems the whole world is falling apart. The usual market cheerleaders are now on record of expecting a global crisis to develop, the signs being too obvious to ignore. Markets are over-valued relative to deteriorating economic prospects. Collapsed energy and commodity prices tell their own story. Shipping rates and the share prices of US utilities (including rails and freight) are falling. The days of blaming China for a contraction of world trade are over: the downturn is now far larger and more widespread."

". . . the banking crisis of 2008 was a prelude, rather than the crisis itself. The Fed will almost certainly reduce interest rates back to zero, and reluctantly will have to consider imposing negative rates."

"The Keynesians will blame the Fed for a complete policy failure. They will argue in retrospect, as they did following the banking crisis, that the financial and economic crisis of 2016 was made immeasurably worse by the Fed raising the Fed funds rate and not pumping yet more money into the economy at such a crucial time. It's like saying alcoholics must drink more to be cured."

ABCT Reaching Mainstream Economists

It is good to know that the Austrian Business Cycle Theory has finally reached mainstream economists. The response varies. Thanks to 2008 global financial crisis. To me this is an indication of the fulfillment of a foresight.

Beginning 2010, I have been encountering in the web that existing economics will undergo transformation. Mainstream economists can no longer afford to ignore the voice of the Austrian school.

A paper written by Jerry H. Tempelman is an example of the influence of such voice. His topic is the “Austrian Business Cycle Theory and the Global Financial Crisis: Confessions of a Mainstream Economist”. He wrote it in 2010.

The paper is structured around three parts: the identity of those who oppose the business cycle theory, the summary of the theory, and the influence of the theory on several mainstream economists. I just want to follow this order in sharing my own understanding of Tempelman’s paper.

Opponents of Austrian Business Cycle Theory

Milton Friedman tops the list of those who oppose the Austrian Business Cycle Theory. For Friedman, the theory does not provide an accurate explanation of economic recession. It lacks verifiable evidence in actual practice.

Unfortunately, Friedman was not able to witness the 2008 global financial crisis. He passed away in 2006. He was no longer there to witness the specific fulfillment of the theory.

Allan Greenspan is another key personality that opposed the Austrian school. He is a Keynesian. Due to his influence, the voice of William R. White, an Austrian influenced economist was ignored.

Prior to 2008 crisis, White predicted an economic crisis that would result from real estate bubble. His warning was not seriously taken. He actually identified central banks as primary responsible for the crisis due to monetary easing policies. The response to White changed when his prediction happened.

Overview of Business Cycle Theory

Tempelman acknowledged that among several schools of economics, the Austrian school is now considered the most reliable source of interpretation of the 2008 global financial crisis with its business cycle theory. He gave an overview of this theory. It is good that he distinguished between two types of economic booms – sustainable and unsustainable. I find it very helpful.

An economic boom is considered sustainable if it is an outcome of escalation in investment funded by growth in saving. On the other hand, it is unsustainable if the resulting escalation in investment is derived from credit expansion by monetary authorities. This kind of economic boom will certainly end in bust.

Ordinary people find it difficult to identify the dynamics that follow after credit expansion. They include lending money at low interest rates, distortion of vital economic information, negative impact on entrepreneurial decision, and unproductive use of capital. The end of the process is economic decline.

The Austrian Business Cycle Theory described above was proven true in the 2008 economic crisis. The credit expansion and mal-investment that characterized the years prior to 2008 was the primary cause for the decline both in financial market and the total global economy.

The Influence of Business Cycle Theory on Mainstream Economists

The names of mainstream economists mentioned in the paper include William Dudley and Paul Krugman. The Economist is also mentioned. Other mainstream economists using different methodology and whose economic researches are classified as “on the cutting edge” are also identified.

Tempelman noted William Dudley’s analysis of the Federal Reserve has many features common in the Austrian school. Paul Krugman also voiced out his criticism of the Fed for its ability to create boom and bust, an idea borrowed from the Austrian school. TheEconomist even cited the analysis of Ludwig von Mises criticizing the Fed’s monetary stimulation policy. The economic website also recognized that numerous qualities from Austrian business cycle theory characterized the economic decline both in the US and Japan.

Mainstream economists who utilized different methods include Taylor (2007), Jarocinski and Smets (2008), Smithers (2009), and Vogel (2010). All of them, though they used different approach arrived to a conclusion almost similar to the ideas of the Austrian school. Taylor for instance identified the correlation between the Fed’s monetary policy and the boom in the housing industry. Jarocinski and Smets confirmed this findings using “Bayesian vector auto-regression”. Furthermore, Smithers identified the connection between the irresponsible action of central bankers and global financial crisis. Finally, Vogel observed a sequence of events leading to financial crisis. It all started with the Fed’s monetary policy followed by 2001 economic recession leading to house bubble, which collapse finally resulted to the global crisis.

Tempelman mentioned three among cutting edge mainstream economic research. The first type of research focused on financial leverage and liquidity. Someone mentioned in the paper that a growing body of literature has been focused on this important subject. The works of Tobias Adrian and Hyun Song Shin (2009) is just one example of this type of research. Again the works of these scholars appear to be an echo of the message of Austrian business cycle theory.

Another type of research resonates the voice of the Austrian school is simply focused on liquidity. Brunnermeier (2009) argues that the face of macroeconomics will certainly change and a new economics will emerge considering the contribution coming from the macro, the micro, and financial economics.

The third type of cutting edge research concentrates on behavioral interpretations of business cycle. This one is considered complementary to Austrian Business Cycle Theory.

Conclusion

Tempelman wrote that since 2008 crisis, Federal Reserve officials have shown some “positive signs” acknowledging the mistake of their monetary policy. They admitted that low interest rates for too long does not really help, but has made the crisis more severe.

Some ideas for monetary reform are now considered. Unfortunately, in spite of the accuracy of the Austrian school, its proposal is still considered too radical and therefore rejected. The proposal includes closure of central banks, return to gold standard, free banking, and monetary competition.   

Personal Response

Immediately after the crisis, central banks escaped public blame. All fingers are pointing to free market capitalism. That’s the power of mainstream media. Statist interventionism is doing its best to find a scapegoat.

Thanks to alternative media and bloggers. Thanks also to the influence of Ron Paul. Central banks now are exposed. In time, the role of statist interventionism on the global crisis will also become part of mainstream consciousness.

Regarding the paper, I observe that despite the fact that core features of Austrian Business Cycle Theory were fulfilled in 2008 crisis, mainstream economists are still hesitant to acknowledge the direct influence of the Austrian school in their economic interpretation. This is my personal impression after reading the paper. I think this observation also applies to Templeman’s position. Even though he was in favor of the Austrian school, somehow he remains reserve in the way he presented his material.

As a whole, I appreciate the fact that the Austrian Business Cycle Theory is making an impact among mainstream economists. How I wish that such impact would lead to a thorough study of the Austrian school of economics and the abandonment of the Keynesian economic framework. I also wish to see the fulfillment of George Reisman’s vision in our generation: the spread of Austrian economics literature into the library of universities worldwide. I believe that such education would enable economists to see the real colors of dominant ideologies behind our present political and economic turmoil around the world. I am hopeful that the exposure of the schemes of socialism and statist interventionism would lead to a new appreciation of genuine free market capitalism. And this would mean a better future for global economy based on personal liberty, honest money, and private property.

Disproportionality Doctrines as Explanations of Business Cycle

This is the last article in our study of Chapter 20, Section 9 of Human Action. We end here our discussion about the impact of business cycle on the market. And we will focus our attention on the charges against free market advanced by nonmonetary theorists of business cycle known as “disproportionality doctrines.”

In the previous article, we mentioned that nonmonetary theorists of the business cycle explain an inherent contradiction within the free market as the real cause of business boom and bust. They identified it as the “disproportionality in the size of investments made in various branches of industry” (p. 582). And the two most popular disproportionality doctrines are “durable goods doctrine” and “acceleration principle.” Let us give a brief definition of each of them.

Durable goods doctrine is an economic belief that:

“…goods retain their serviceableness for some time. As long as their life period lasts, the buyer who has acquired a piece abstains from replacing it by the purchase of a new one. Thus, once all people have made their purchases, the demand for new products dwindles. Business becomes bad. A revival is possible only when, after the lapse of some time, the old houses, cars, refrigerators, and the like are worn out, and their owners must buy new ones” (p. 583).

Acceleration principle on the other hand is:

“A temporary rise in the demand for a certain commodity results in increased production of the commodity concerned. If demand later drops again, the investments made for this expansion of production appear as mal investments. This becomes especially pernicious in the field of durable producers’ goods” (p. 584).

Responding to the first accusation against free market, Mises argued:

“There are, to be sure, always promoters who in a mood of deceptive optimism are prone to over expand their enterprises. In the pursuit of such projects they snatch away factors of production from other plants of the same industry and from other branches of industry. Thus their overexpansion results in a relative restriction of output in other fields. One branch goes on expanding while others shrink until the unprofitability of the former and the profitability of the latter rearranges conditions. Both the preceding boom and the following slump concern only a part of business” (p. 584).

Mises’ response shows that the accusation is unsound for in the trade cycle, not only part of a business is affected. In fact, almost all entrepreneurs suffer financial lost. Durable goods doctrine cannot provide a reasonable explanation for this economic phenomenon.

Responding to acceleration principle, Mises explains that:

“The fundamental error of this doctrine is that it considers entrepreneurial activities as a blindly automatic response to the momentary state of demand. Whenever demand increases and renders a branch of business more profitable, production facilities are supposed instantly to expand in proportion. This view is untenable. Entrepreneurs often err. They pay heavily for their errors. But whoever acted in the way the acceleration principle describes would not be an entrepreneur, but a soulless automaton” (p. 584).

Mises then goes on to describe the character of a real entrepreneur as speculator. By this, he meant the quality of an entrepreneur to have an “anticipative understanding.” This quality is basically instinctive and cannot be learned in school. No existing rules could assess the presence of this entrepreneurial quality. An entrepreneur according to Mises is not guided by what was and is, but by how he sees the future.

Concluding his refutation of disproportionality doctrines, Mises claims that even if the arguments of nonmonetary theorists are accepted as valid, still they could not sufficiently explain how businessmen could proceed in expanding their business apart from credit expansion caused by increase in money supply. Only monetary credit theory of business cycle could provide reasonable explanation for business expansion caused by credit expansion.

Impact of Business Cycle

Let us now proceed to Chapter 20, Section 9 of Human Action. The central idea discussed under this section is about the impact of business cycle on the market.

Reading the previous post should make it clear by now that increase in money supply promoting credit expansion is the real cause for business fluctuations. These fluctuations are popularly known as “boom” and “bust” of business.

Mises appropriately describes the “boom” aspect of business cycle as “delusive prosperity.” It is an economic illusion not based on real data. It is an artificial wealth. No corresponding increase in production is taking place with the increase in money supply. This increase in money supply also called as inflation is mistakenly identified with economic progress. Such an artificial boom therefore is already doomed from its very source. It is the real culprit. It is the disease caused both by inflation and credit expansion.

The “bust” side of business is dreaded by politicians, bankers, economists, and the public. But in reality, economic depression is the way of the free market to restore health back into the economy. It is an act of economic recovery. Mises states: “we must call the boom retrogression and the depression progress” (p. 575).

The business cycle has several serious impacts on the market. In reality, business boom is a waste of economic resources through bad investments and decreases the quantity of goods through overconsumption. Its inescapable outcome is impoverishment.

The material impoverishment that follows after economic prosperity is a little consequence in comparison to the mental and psychological damages resulting from economic depression. People would turn despondent, dispirited, and frustrated. People would lose their “self-confidence and the spirit of enterprise to such an extent that they even fail to take advantage of good opportunities” (p. 578).  “The more optimistic they were under the illusory prosperity of the boom, the greater is their despair and their feeling of frustration” (p. 576).

The unthinkable part among the impact of business cycle in the market is the public longing for more inflation and credit expansion. For Mises, this proves the incorrigibility of the people. For the public, “more inflation and more credit expansion are the only remedy against the evils which inflation and credit expansion have brought about” (pp. 576-577).

A popular argument in favor of more credit expansion upholds that more credit would enable the entrepreneurs to expand production, the unemployed to find jobs, and consumers to purchase products. It is argued that refraining from more credit would sink the economy into a prolonged depression. It is an erroneous analysis. In fact, this longing for more credit expansion only interrupts and prolongs the curative process resulting from depression. It could create a new boom resulting to deeper economic depression. This failure to learn the lesson from depression would keep the old story of boom and bust in repeating itself.

The prevailing erroneous opinion and response to economic depression is a result of the influence of the nonmonetary explanations of the trade cycle and the advocates of inflation and credit expansion. Only the monetary credit theory has clarified the notion about the neutrality of money and has provided also reasonable explanation about the cause of business cycle.

However, those motivated by political bias would certainly persist in nonmonetary explanation of the cyclical trade fluctuations despite of evidence. Mises identified them as the Marxians, non-Marxian socialists, and the interventionists.

The Marxians uphold that business boom and bust are inherent flaws in capitalism. The primary concern of non-Marxian socialists and interventionists is to exploit the alleged weakness of free market in order to destroy it and establish statist omnipotence. As a whole, the nonmonetary theorists of the business cycle receive inspiration from the Marxian and explain the trade cyclical fluctuations in terms of “disproportionality in the size of investments made in various branches of industry” (p. 582). They see it as inherent contradiction within the free market economy.

To explain these disproportionality doctrines in detail is the subject of the next post.

The Monetary Credit Theory of Business Cycle

The knowledge of Austrian economic way of thinking is a basic requirement in the education of an informed entrepreneur. Financial education and personal development are insufficient. They failed to supply the necessary knowledge to understand inescapable realities that all entrepreneurs face. Understanding of the increase in money supply, credit expansion, and business cycle are relevant economic realities that a responsible entrepreneur cannot afford to ignore without serious negative financial consequences.

Our goal in this article is to share our personal understanding on the writings of Ludwig von Mises about business cycle. And we will start with Chapter 20, Section 8 of Human Action where Mises discussed about the monetary credit theory of business cycle.

This business cycle is popularly known as business “boom” and “bust.” Understanding the cause of this cycle serves as necessary information for those who made the decision to enter into the world of entrepreneurs.

Chapter 20, Section 8 of the book provides two major explanations of business cycle: direct exchange theory and monetary credit theory. The first explanation is the dominant one and the second is coming from the Austrian school.

In the study of modern capitalism, it is popularly accepted that progress and depression characterized its history. Investigating this economic phenomenon, one can discern a general connection among the increase in the amount of capital, visible prosperity, and economic decline. The efforts of statistician to go beyond the general connection into details of business fluctuations with statistical methods are useless and futile due to the misdirection caused by mainstream interpretation.

It is evident that the Austrian school does not have the monopoly in explaining business fluctuations. Other schools of thought have their own version of business “boom” and “bust.” An example of this is the British Currency School.

The explanation of the British Currency School about business cycle is unsatisfactory in two ways: it failed to see the role of bank deposits in credit expansion and it limited its explanation of economic crisis to external source. As such, it failed to analyze the connection between money supply, lower interest rate, and credit expansion and their relationship to economic boom and bust.

Interest rates are anathema in the eyes of the public. It is considered a great barrier to production. For critics of free market, high interest is perceived as a tool for economic exploiters. Such mindset is a favorite dominant social theme for the interventionists. The state is seen as the savior from economic woes through either lowering or totally abolishing interest rates. Mainstream publication praise constant credit expansion as necessary to economic prosperity and advocate lower interest rates. Money’s neutrality is accepted as given assumption.

The above trend results into misleading analysis of economic crisis and business cycle using the theory of direct exchange. The monetary credit theory has therefore faced two primary obstacles: erroneous economic theory providing alternative and misleading explanation of economic crisis and business fluctuation and political bias.

The monetary credit theory therefore provides an explanation how the increase in money supply, lower interest rates, and credit expansion affect the trade cycle. Business fluctuation is the unavoidable consequence of credit expansion resulting from the increase in money supply and lower interest rates. The boom created by credit expansion would naturally result into bust, and nothing can be done to avoid such a collapse. The only alternative is either to accept the crisis sooner by abandoning further credit expansion or by delaying the crisis through continued credit expansion that would ultimately result into the collapse of monetary system.