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Source link: http://archive.mises.org/10012/correcting-quiggin-on-austrian-business-cycle-theory/

Correcting Quiggin on Austrian Business-Cycle Theory

May 25, 2009 by

Because of the popularity of the Austrian message mainstream economists are taking the time to explain why (in their opinion of course) the Mises-Hayek theory is nonsense. In the past I’ve answered Tyler Cowen and Paul Krugman’s objections, but today’s focus will be the recent critique penned by Australian economist John Quiggin. Quiggin’s piece deserves careful scrutiny. In the interest of brevity, I am going to dive right into his objections. FULL ARTICLE

{ 96 comments }

Liberty Australia May 25, 2009 at 8:08 am

Very nice!

“If you need a more introductory exposition of Austrian business-cycle theory (ABCT), try this collection or, if you prefer a PowerPoint presentation, check out Roger Garrison’s amazing creations.”

The link to Garrison’s PP presentation is broken. Anyone got a link?

Jeffrey Tucker May 25, 2009 at 8:18 am

It seems like it is just Auburn’s servers. I’ll see about putting that up on the mises servers.

just doug May 25, 2009 at 8:26 am

One point on rational expectations that I’ve never seen mentioned is that even if an individual businessman knows ABCT, knows what the “real” market interest rate would be, and knows that the customer walking in the door is paying entirely with money created out of thin air by fractional reserve shenanigans, what is he going to do? Tell the customer to get lost?

When the bubble is unwound things don’t return to the prior state of affairs, therefore even in the ideal case of perfect ABCT knowledge the businessman has no way of knowing whether the bubble fed demand will remain or vanish in the bust. The close relation between high tech and bubbles is one example from the last few cycles.

About the best that can be done at the level of the individual is to be very gun shy about spending on plant and equipment in a mature industry when a bubble is in progress. Unless you are too big to fail of course.

DS May 25, 2009 at 9:20 am

“Overall, the US was much closer to free banking throughout the 19th century than in the period from 1945 until the development of the largely unregulated ‘shadow banking’ system in the 1990s, but the business cycle was worse then (how much worse is a matter of some controversy, but no serious economist claims it was better).”

I dispute almost this entire system, including the implication that the business cycle was worse in the 19th century. You certainly couldn’t call the period from 1861 through 1879 “free banking” – in any event, the massive wartime inflation of fiat greenbacks and the subsequent return to the gold standard were certainly not a time of laissez-faire capitalism or free banking. The US had a de-facto central bank for most of the first 30 years of the 19th century including most notably the panic of 1819.

There was a tremendous crash after Andrew Jackson de-commissioned the Bank of the U.S. – the money supply was increased tremendously in the last gasps of Biddle’s monstrosity, leading to a great crash in 1837. But after that time, the period from 1838 until the Civil War was time of stable, real economic growth with little government interference, no central bank. Fractional reserve banking was in existence but without a lender of last resort no sound bank would leverage up anywhere near the standard 10:1 of today.

The other thing people don’t understand is that in the 19th century the economic downturns resulted mostly in the ruination of speculators and financiers, the common man was not affected to the extent that they have been in the 20th century. There was no comparable period in the 19th century where unemployment was over 15% for more than a decade. The “great depression” before the Great Depression was in the 1890′s and it lasted about 4 years without bread lines, mass unemployment, starvation or massive government take-overs of huge swaths of the nation’s resources.

In contrast, the 20th century was no economic panacea. The Great Depression aside, there was a period after world war 2 where the United States was the only industrial economy left on the earth and the US enjoyed an unprecidented, un-sustainable and un-repeatable period of prosperity where America was the manufacturer and financier for the world. We had 80% of the world’s gold and produced 50% of the world’s goods. This was an unsustainable situation of which the government and central bank did not produce, but were simply along for the ride. What the government and central bank did produce was the inflation of the 1970′s and subsequent de-industrialization of America. This was hardly any kind of victory for central banking and big government.

Murphy hits the nail on the head when he says that ABCT theorizes that Fractional Reserve Banking is responsible for the business cycle, not central banking per se. Central Banking’s sole purpose is to prop up the FRB system.

fundamentalist May 25, 2009 at 9:38 am

“If investors correctly anticipate that a decline in interest rates will be temporary, they won’t evaluate long-term investments on the basis of current rates.”

This kind of statement from mainstream economists is commone and always makes me laugh. What they refuse to see is that mainstream econ teaches that temporary changes in the interest rate won’t have the effects that Austrians claim they will have. Mainstream econ teaches that manipulation of interest rates never has harmful effects under any circumstances. So even if businessmen understand that low interest rates are temporary, they will listen to mainstream economists tell them to go ahead and borrow at the low rates because nothing harmful will happen.

Mainstream econ needs to ask why the Feds reduce interest rates to ridiculously low levels. I honestly don’t believe there are any businessmen existing who don’t understand that very low rates are temporary and that at some point the Feds will have to raise rates. You would have to be particularly ignorant to not understand that.

An important point to keep in mind is that most businessmen don’t get sucked into the Fed’s spider web. That should be clear because even in the Great D, most businesses did not fail. A lot of businesses failed, but the majority survived. Unemployment reached 30%, but it never approached 100%. Business failures were high, but never even close to 50%, let alone 100%. Failing businesses are always a minority of businesses even in the very worst depressions in history.

And the businesses that fail tend to be the most highly leveraged ones. This is common knowledge to all bankers and businessmen. It is the reason the debt ratios are one of the most frequently watched businesses indicators. A minority of businessmen ignore the dangers of high leverage when the Feds reduce interest rates and for a variety of reasons. Sometimes, they are just desperate for money to finance their dreams. Sometimes they just focus on the short run and like Keynes figure we’ll all be dead in the long run. But the really important thing to remember is that the Fed depends upon the frailty of human nature and short run thinking in order to accomplish its goal of stimulating the economy.

Without these frailties in human nature, the Fed’s plans would never work. And it’s clear that the Feds depends upon these frailties because it reduces interest rates in steps. The Feds always reduce rates and then wait to see if anyone is gullible enough at those rates to borrow. If the Feds get too few suckers, they reduce interest rates again and they keep reducing interest rates until they have enough suckers borrowing money to stimulate growth.

Jeremy May 25, 2009 at 10:25 am

Fundamentalist – good points. And there are the huge numbers of IPOs of businesses that won’t survive the bust but which allow their founders and Wall Street to extract large amounts of wealth from.

There are also many short sighted top managers of public companies who make malinvestments to create the appearance of wealth, extract it through bonuses mainly in the form of stock options (inflated further by the corresponding boom in the stock market, itself fueled by cheap money), and then walk away.

Both such CEOs and the people behind IPOs can be very rational and know that their companies will fail or do very poorly in the years to come, while walking away with millions. All it takes is the assumption that investors are not rational to show why ABCT could work even with rational expectations of entrepreneurs and management who don’t own their businesses but instead sell them to investors.

BioTube May 25, 2009 at 11:01 am

I noticed nobody touched on his Jackson reference. From what I can figure, the cause of that mess was Jackson pulling all the government’s funds from fractional reserve banks, rather than anything the Fed could’ve fixed.

Inquisitor May 25, 2009 at 11:32 am

Why doesn’t Quiggin just refer to Krugman or DeLong or Cowen’s writings on the topic? He adds nothing new and repeats their ignorant arguments.

s burgess May 25, 2009 at 12:31 pm

ive looked hard to find a good argument against the atbc i realy have.im still looking.

Beta Hater May 25, 2009 at 1:22 pm

“If investors correctly anticipate that a decline in interest rates will be temporary, they won’t evaluate long-term investments on the basis of current rates”

It’s interesting that macro-economists don’t make a similar argument about price controls in the micro sphere. Market prices allocate goods just like interest rates allocate investable resources. If such macro-economists were consistent and applied this reasoning to price controls in the micro sphere, then they would have to argue: “if suppliers and demanders correctly realize that the regulated price is not the free market price, shortages or surpluses won’t t arise.”

It’s best to listen to Garrison’s lecture and follow along with his slides.

Lecture: http://media.mises.org/mp3/MU2008/8_Garrison.mp3

Slides: http://www.auburn.edu/~garriro/lvmi.htm

Stephen Grossman May 25, 2009 at 1:25 pm

Animals have rights.
Business cycles are caused by capitalist animal spirits.
Therefore, capitalists have rights.

Michael A. Clem May 25, 2009 at 3:02 pm

The Fed was created in 1913. There were booms and busts in the decades before the Fed. These booms and busts are often cited as the alleged reason for the creation of the Fed. And yet, while the Fed didn’t exist before then, there WAS a federal banking system that existed, from after the Civil War up to the creation of the Fed, and this system, while not quite as centralized as the Fed, was still capable of contributing to the cycles of this period.
Unfortunately, if mainstream econs can’t even acknowledge the boom and bust cycle of the 1920s/1930s as a consequence of the Fed’s policies, they surely would be unable to acknowledge the earlier cycles as a consequence of the federal system. But it would be nice of them to at least admit the existence of the federal system of banking in late 19th century America.

filc May 25, 2009 at 3:54 pm

I concur with Stephen. Be ware of the animal spirits!

Harry Valentine May 25, 2009 at 4:10 pm

Its important if not crucial that theories expounded by economists like Cowan, Krugman and Quiggin be refuted and debunked . . . . governments ultimately formulate economy policy based on their advice. When things go wrong as they inevitably would, the pro-statist economists invariably seek to absolve themselves of responsibility and seek scapegoats . . . . like Alan Greenspan blaming Asian saving for having precipitated the latest economic slowdow.

John Quiggin May 25, 2009 at 4:35 pm

No time for a full-scale response now, unfortunately. But I would like to respond on the question of fractional reserve banking. You place a lot of emphasis on this, but the respondents to my original post who seemed most reasonable to me (Steve Horwitz) for example, denied that opposition to FRB was central to the Austrian case. Garrison (cited above) certainly downplays this element, and my understanding of Hayek is that his proposals for free banking don’t include any restriction on FRB.

In any case, I’m not really concerned to determine what is the orthodox Austrian line on this matter, but to ask a more fundamental question. As far as I can see all banking is FRB (this seems to be true even of the fabled Bank of Amsterdam for most of its life, but in any case, I don’t think pre-1800 experience is of much relevance here).

And since banking is essential to capitalism , it seems to me that the FRB version of the Austrian theory shows that the business cycle is inherent in capitalism.

N. Joseph Potts May 25, 2009 at 5:15 pm

John Quiggin -
Good chain of logic re “the business cycle” is inherent in capitalism. Can’t see a way out of that one.
But I CAN see a way out of concluding that ABCT is invalid. Since business fluctuations are NOT cyclical in any sense of a fixed or repeating period of time, let’s refer to them as “business fluctuations.”
Business fluctuations are in fact inherent in business, and would be present even without FRB. FRB, like all sources of credit and objects of investment, provides a source of business fluctuation.
Now, add the central bank (and fiat money legal tender) to the mix. Now, adjustment to REAL fluctuations (e.g., invention of electricity) is hampered by coercive manipulation. And what do you get? BIGGER fluctuations.
Central banking and FRB go together like a horse and carriage – into the ditch. And FARTHER than either might go without the other.

Michael A. Clem May 25, 2009 at 5:20 pm

“All banking is FRB” – That’s like saying that all roads are public roads, and thus, private roads are impossible. There is debate about whether or not FRB is simply out and out fraud, or if it would simply be at a competitive disadvantage in a free market, but it seems a little simplistic to say that non-FRB banking is impossible–it may simply be impossible or at a disadvantage because of the current banking rules and regulations. One point that Austrian economics stresses that a lot of mainstream economists seem to downplay or ignore is the impact of politics and the legal system on the economy. If a government tariff or a minimum wage law is so obviously an interference in the free workings of an economy, how much more so are the laws that control what banks can do or not do?
But I’m just an armchair philosopher and economist–perhaps I should leave it to the professional economists like Murphy to answer.

Jonathan Finegold Catalán May 25, 2009 at 5:29 pm

John Quiggin,

I would suggest reading Huerta de Soto’s Money, Bank Credit and Economic Cycles. He does a good job explaining the history of fractional reserve banking, and shows how during the Roman Empire property rights on demand deposits were respected under law. Banks which operated with fractional reserves normally failed, and the businessmen who owned them were tried as criminals.

No Austrian economist, except when making a compromise, suggests that there should be restrictions on how banks should operate. For what it’s worth, Austrian economists believe in complete deregulation (Huerta de Soto writes from the perspective of a lawyer, and so his book is an attempt to show how fractional reserve banking is not legally justified; so, his book proposes a system in which government regulation is present), and so fractional reserve banking would certainly be possible.

The argument is not what a bank can theoretically do, but what a bank will have to do to stay in business. Huerta de Soto makes a good case on how banks have not been able to historically survive on fractional reserve banking schemes, since most of the time they cannot meet the demand for people’s money. So, it’s similar to this example: I can shoot myself in the foot, but it won’t necessarily do anything constructive.

The Austrians do not claim that business failures are not inherent in a free-market; they explain the reasons behind collective failures.

Alex May 25, 2009 at 5:30 pm

“As far as I can see all banking is FRB … And since banking is essential to capitalism , it seems to me that the FRB version of the Austrian theory shows that the business cycle is inherent in capitalism.”

Wouldn’t Austrians argue, however, that since the central bank controls the monetary base, it controls the amount of bank credit and deposits and hence the magnitude of the business cycle under FRB?

P.M.Lawrence May 25, 2009 at 6:59 pm

“…banking is essential to capitalism…”.

That isn’t actually true, unless you are either further defining capitalism as something which includes banking or merely making an observation about historical examples of capitalism. But clearly capitalism as ordinarily understood could function without banking – banking isn’t part of the essence of capitalism, something without which it wouldn’t be capitalism.

Eric May 25, 2009 at 7:10 pm

John Quiggin says that capitalism is unstable because FRB occurs in all modern countries.

When Austrians analyze Capitalism, they do so in 2 parts. Part A (e.g. see Rothbard in Power and Market) is capitalism in a free market, and part B is capitalism in a non-free market.

It is useless to speak of capitalism without making this distinction. It’s like explaining the effects of gravity without considering whether one is on the ground or orbiting in space.

If we include FRB into the definition of capitalism, then capitalism is certainly flawed and contains the seeds of its own destruction. Austrians prefer to consider FRB a corruption of capitalism – and so they analyze it both with and without FRB.

But to blame the free market (variety of capitalism) for creating the institutions of force and fraud that corrupt it is similar to blaming motherhood for sexual perversions.

Tomás May 25, 2009 at 7:47 pm

I understand the dangers of FRB, but how does a bank operate without it? How can it be 100% reserve and yet still give interest in people’s accounts AND make a profit for themselves?

To me right now, Central Banking is the real curse and not necessarily FRB; though the both of them together is devastating.

I’d really appreciate feedback as I have been reading Mises & LRC regularly for awhile, but Selgin/Free Banking crowd seem to make a lot of good points that I just haven’t found answers for yet.

matskralc May 25, 2009 at 7:58 pm

I understand the dangers of FRB, but how does a bank operate without it? How can it be 100% reserve and yet still give interest in people’s accounts AND make a profit for themselves?

I think one easy way would be to not allow interest-bearing accounts to be withdrawn on demand, similar to a certificate of deposit. You give them your money for a year at 3%, they turn around and lend it out for a year at 6%. During that year, you can’t demand your money. The bank essentially plays the middle man here.

I imagine that withdrawal-on-demand would be more similar to a safe-deposit box, where you actually pay the bank a small fee in order for them to safely guard your money. The bank can then take those fees and lend those out if they choose.

I’m sure some smarter people than me can come up with better ways.

Eric May 25, 2009 at 8:13 pm

matskralc,

No need to imagine….

In the past (as when I was a kid) demand accounts (checking) didn’t pay interest and required that you pay a fee for the service.

On the other hand, the fine print at the back of my savings deposit booklet said that if I wanted to withdrawal funds, I may be required to give them a 90 day notice. This was in the 1950′s – not THAT long ago.

John Quiggin May 25, 2009 at 8:16 pm

To clarify, I’m talking about “actually existing capitalism”. If FRB-free banking is a feature of some hypothetical form of capitalism, it’s necessary to explain
(a) why has this form never emerged anywhere in the past
(b) how do you propose to get there from here

Happy to take pointers on this. As regards the post, I don’t find the explanation “governments always allow suspension of payments” satisfactory. First, they don’t always. In some cases, FRB banks fail permanently – this has much the same effects as a suspension since there’s not enough money to pay the depositors. Second, if you want to argue that some sort of bailout has always happened, it’s going to be v hard to set up institutiosn that will create conviction that no such bailout will occur in the future.

That leaves the possibility of prohibiting FRB altogether. That seems to me to be extreme version of the kind of stringent prudential regulation I’ve regularly advocated, designed to prevent banks getting into a position where they face default. So, I assume anti-FRB Austrians would favor tighter prudential regulation as a step in the right direction. Is this correct?

DS May 25, 2009 at 8:43 pm

John Quiggen,

“You place a lot of emphasis on this, but the respondents to my original post who seemed most reasonable to me (Steve Horwitz) for example, denied that opposition to FRB was central to the Austrian case. Garrison (cited above) certainly downplays this element, and my understanding of Hayek is that his proposals for free banking don’t include any restriction on FRB.”

I am responding under the assumption that you have come here to learn, not simply to restate your opinion.

You seem to be confusing and intermingling two concepts here. For lack of better terms I will call them “observational” and “prescriptive”. One is the observation of basic laws under which economies behave, the other is a debate about what to do about business cycles – and indirectly what government should or shouldn’t do about them.

Central to Austrian Business Cycle Theory is the idea that Fractional Reserve Banking (FRB) is the fundamantal, root cause of the business cycle – it is not the sole unitary cause (the fortunes of individual businesses can vary greatly, sometimes these variations can be in sync, sometimes out of sync. But for those fluctuations to move in unison is a low probability occurance and evidence of some extraordinary circumstance, most likely caused by government interference), but certainly the dominant one. Amongst Hayek, Mises, Rothbard, their predecessors, students and followers there is very little disagreement on that subject – in fact I’m not aware of any. If you have come to some other conclusion you are mistaken. Again, there is almost no controversy about this subject amongst Austrians.

Where various Austrians have some disagreement is in the prescriptive realm: what is to be done about business cycles and the moral issues as to whether FRB is fraud.

Side Note: most Austrians are libertarians by nature and do not think that the government should do anything to manipulate the economy, but center almost exclusively on what the government should refrain from doing.

Murray Rothbard certainly thought FRB was fraud, others view it not as fraudulent but an unfortunate government supported practice that could not exist in a free market. The latter believe that in a true free market – one where governments do not support FRB by allowing suspension of payments or in the extreme case create a central bank to act a lender of last resort – no private business practicing FRB can stay in business for very long except with extremely conservative pyramid ratios – nowhere near the standard 10:1 that is commonplace for central bank supported institutions.

The real issue comes down to a moral one: as libertarians most Austrians do not believe that the government should dictate the use or lack thereof of FRB, or the extent to which is should be used. But both sides agree that any bank that cannot redeem it’s liabilties in real money on demand should be bankrupted and cease doing business, just like any other business that cannot meet its liabilities. Again, I don’t think you will find much disagreement on the last point, nor do I think you will find any serious adherent to the ABCT advocating that FRB is a good practice or one that should be supported or expanded by government or the legal system in any way.

Personally, I fall in the latter camp (many others will join in and present the Fraud case, so will not make any further attempts). In a true free market with no government interference, FRB would be a very precarious business strategy because it is inherently unstable due to the difference between the time structure of liabilities and assets. FRB rests on the observation that only a fraction of people will want their money at a given time period, which is true most of the time but tragically not true on occassion. The only way around that problem is to fractionally lend a very small portion of your assets, thus reducing the odds of a run down to infinitesimal levels. In such a world banks would compete based on their soundness, their transperancy (there is no need for teh SEC in a true free market) and in effect on the conservatism of their pyramid ratio. The free market would quickly drive the ideal ratio close to zero. This was how banking functioned in between the end of the Bank of the US and the Civil War, quite well.

Central banks are the apex of the Rube Goldberg contraptions invented over the years by governments to try and artificially prop up this unstable practice – mainly because every central bank in the world is used by its host government as a way to fund its expanding welfare and warfare without directly taxing its citizens.

Central banks, because they are so universal in the economies of the world and because they are so powerful and destructive, much Austrian time is spent discussing their effects. But don’t misunderstand that the existence of a central bank is not the only characteristic between a free market and an un-free market and central banks by themselves do not cause the business cycle. They simply magnify the destructive effects of FRB to absurd, world destabilizing levels. Central banking is not the key, Fractional Reserve Banking is.

Abolishment of central banking is the first step, not the last, towards an economy free of drastic, destructive business cycles that have been commonplace in the FRB era.

Lowell Sherris May 25, 2009 at 8:47 pm

Tomás

I understand the dangers of FRB, but how does a bank operate without it? How can it be 100% reserve and yet still give interest in people’s accounts AND make a profit for themselves?

I am not that old, but my first checking account paid no interest. There was a monthly fee and a percheck charge of $.25. The bank made money on its checking accounts by charging fees for its service. There was a strict differentiation between checking and savings accounts.

Savings accounts actually had a requirement to give 30 days notice before making a withdrawal. This requirement was not enforced, but it legitimately gave the bank 30 days during a bank run to come up with the money before being in default.

Without fractional reserve banking the purpose of a bank is essentially to safeguard your cash. If you want to earn interest, you would need to be willing to have your money tied up for a period of time, as in a CD or bond.

The banks have been giving away their services essentially for free. They can do this since they make so much money multiplying deposits via fractional reserve banking.

Huerta de Soto’s Money, Bank Credit and Economic Cycles explains this much more elegantly than I could ever hope to. Wouldn’t you be willing to give up these free banking services in return for a stable currency where your savings will not be made worthless by inflation?

Tomás May 25, 2009 at 9:06 pm

Wow, thanks Lowell! (and Eric & matskralc too)

That really cleared things up, I imagined the current scenario I’ve grown accustomed to was not always the case.

It’s funny, I had actually bought de Soto’s Money, Bank Credit and Economic Cycles back at the 2004 Freedom Fest in Las Vegas, BUT was convinced to resell it by the friend I had gone with the next year. It was before I realized how different the divisions were in the libertarian movement, and how biased my friend was at the time by his internship with the STATO–oops, I mean the CATO Institute.

Oh well, thank goodness for Amazon Marketplace!

Bob Murphy May 25, 2009 at 9:48 pm

Dr. Quiggin,

Thanks for posting your thoughts here. First, I’m sorry that it must be difficult for an outsider to judge “the” Austrian theory of the business cycle, when we don’t all agree on it.

The reason I generalized it to FRB, is that Mises in The Theory of Money and Credit says something about FRB containing the seeds of its own destruction. And as far as Rothbard’s explanation for how “government intervention” caused the business cycle even before central banking, it seemed to me the most succinct way to explain it was that private banks engaged in FRB and then the government absolved them of their contractual obligations when they got into trouble.

You’re right, in a sense, that the boom-bust cycle is inherent in a market economy. In a perfectly unregulated (by government) banking system, I think it’s possible you’d see FRB. But because of competition, the threat of runs, etc., I think you might see a risky bank keeping only 90% reserves, and a nutjob bank keeping only 85% reserves. And so the booms and busts would have a much smaller amplitude than they do now, and they would have a much smaller frequency as well because the reckless banks would really take a beating relative to the more cautious ones, every time the bust hit.

I do encourage you to skim my formal model [.pdf] where I recast ABCT in a straight-up neoclassical model where the agents obey rational expectations.

Last point: If you write a rebuttal (rejoinder? counterreponse?), I left myself wide open. I said that you were being unfair for accusing the Austrians of worshipping Mises and of disagreeing with each other. The implication I made was that a religious group couldn’t have such disputes.

But obviously that’s wrong; there are all sorts of different sects who (say) worship Jesus and yet disagree strongly with each other.

If you work with it, you could really zing me on that one.

George May 25, 2009 at 10:05 pm

About the best that can be done at the level of the individual is to be very gun shy about spending on plant and equipment in a mature industry when a bubble is in progress. Unless you are too big to fail of course.

Or go find non-recourse money to expand with…

John Quiggin May 25, 2009 at 10:07 pm

I had precisely that zinger in mind, but I thought I’d stick to the high road to start with and now you’ve beaten me to the punch :-) .

I agree with the view that the worst case is banks that are guaranteed but weakly regulated. I’ve proposed that banks be given the choice between much tighter regulation and freedom from regulation combined with a guarantee that government won’t rescue free banks or let them be helped by guaranteed/regulated banks.

But, based on my reading of history, I think that such a choice would produce a system in which the core banking functions were performed by the guaranteed institutions.

I’ll take a look at your model.

ABOM May 25, 2009 at 11:04 pm

I’m concerned no Austrian has confronted JQ’s very reasonable point: If Austrians know that FRB is so damaging to the economy, and that genuine free competition is banking is a long way off (or even hypothetical given in the corrupt real world it’s been around for over 200 years), are Austrians OK with strict government regulation of banking as a second best alternative?

As an Austrian, I must I am OK with this proposal. FRB is FRAUD so government regulation is better than a central bank supporting the madness until the cancer kills the whole economy.

Some Keynesians and some Austrians could come together on this issue.

Do any other Austrians want to confront this issue?

ABOM May 25, 2009 at 11:07 pm

“free competition in banking…” Yes JQ, I’m still drinking, but only Macallan 18 year old and only occasionally…

ABOM May 25, 2009 at 11:11 pm

“I must say I am OK with this proposal”. I’m sorry for the typos – I’m so nervous siding with a Keynesian my hands were shaking!

newson May 26, 2009 at 12:15 am

to abom:
actually frb dates back a lot longer than 200 years. carlo cipolla details one instance in “The Monetary Policy of Fourteenth Century Florence”. and huerta de soto deals with instances dating back to antiquity where the temptation became too much, and deposit accounts deceitfully became loan accounts (in the good old days this was a serious offense).

but to be clear, the 100% reserve brigade only insists that the normal penal sanction against fraud be applied (as it is to other fungible commodities such as warehoused wheat). providing depositors were treated as such, and not bank creditors (which they really are today), there would be no need for dedicated banking legislation.

obviously quiggan is absolutely correct in abhorring the privatization of profits and the socialization of losses that we witness today.

ABOM May 26, 2009 at 12:27 am

Yes, newson, I agree. Mises actually talked about monetary debasement and (related) FRB activities destroying the Roman Empire (copper corrupting silver etc etc).

Even the Ancient Egyptians complained of money changers (who may or may not have been engaging in FRB-like activities). The profession of the shyster – embezzlement (often under the guise of religion or government) – is as old as prostitution.

I was really referring the post-BoE modern incarnation of “systemic” FRB, where illiquid banks are periodically “saved” from bank runs by co-ordinating collusive actions of other banks in co-operation with a central bank. This co-ordinated sophisticated monetary fraud was really refined by the absolutely corrupt Bank of England in the early 1700s after it was legally established in 1694. It’s similar to herding sheep – spewing gold (“loaned” from the vaults of “good banks”) out of a “bad” bank in order to save the rest. The Mafia is a pathetic joke compared to the BoE’s history.

I know the history.

My point is that Austrians hate both FRB and government. But which is worse? I hate FRB so much I’d prefer “Nugget” Coombs to “easy” Al.

You seem to be saying the same thing.

Could other hardcore Austrians please comment? This is a key issue to confront right now.

ABOM May 26, 2009 at 12:42 am

And if the Austrian response is “FRB and government are related – FRB only survives through government sanction and support through a central bank”, then I have a further quesion:

If corrupt FRB and corrupt government go together and they have the guns, and have used them repeatedly to entrench their power, what practically can be done to reach a stable, genuine free market? Won’t the free market be pulled down again by the corruption?

And if that is the case, can’t we support the (argh!) Keynesian case for greater regulation of the financial services industry as a second best alternative, before a genuine free market in money is born? Do we have to wait for absolute anarchy before we get a free market in money? What are our PRACTICAL steps to get from here to there?

JQ has asked some very reasonable questions which need answers.

Anonymous May 26, 2009 at 12:47 am

John Quiggin,

FRB increases the amount of property titles in existence without increasing the amount of property. In all other cases this is a fraudulent activity. For instance, creating additional property titles for a car would be fraudulent. Why should creating additional property titles for a sum of money be legal?

Ben O'Neill May 26, 2009 at 1:42 am

Quiggin: “As far as I can see all banking is FRB…”

FALSE – There currently exist institutions which will act as a bailor for gold holders (e.g. BullionVault). These institutions effectively operate as banks for gold, which is itself a form of money. They operate by charging commission payments on transactions and charging a storage fee to their depositors. They do not pay interest on accounts because they are not FRBs.

It is only because we are used to calling fiat currency “money” and gold a commodity, and because we are used to thinking of banks as FRBs paying interest, that we do not see these institutions as banks. But in fact, they are effectively banks which operate with 100% reserves. That is, they are institutions which hold deposits of money (gold) and issue certificates of account for this money to their depositors, which can be redeemed for the deposited money (gold) on demand.

The assertion that there cannot be 100% reserve banking or that this does not currently exist is nonsense. If banking means the holding of money for a depositor, with access to that money on demand (and I can’t think what else it should mean) then any institution which does this, and does not lend out the money deposited, is a bank with 100% reserves. Bailors of gold, silver and other monetary commodities fit the bill nicely. It is only be preempting the question and regarding “banking” as meaning FRBs which pay interest, that one can ignore the many institutions which already operate as 100% reverse banks for silver, gold and other forms of enduring money.

Conza88 May 26, 2009 at 3:19 am

AOEM,
-”Could other hardcore Austrians please comment? This is a key issue to confront right now.”-

Why do you need the hardcore? Ron Paul basically addressed this in 1999. (Ron Paul Was Right About “Deregulation” in 1999, Too – http://www.lewrockwell.com/blog/lewrw/archives/023595.html)

-”And if that is the case, can’t we support the (argh!) Keynesian case for greater regulation of the financial services industry as a second best alternative, before a genuine free market in money is born?”-

Nope. The answer is not to support it, but to denounce the root cause of the problem. To do otherwise, is to sell out / compromise. “We” shouldn’t clamor for more regulation, ever. (Disregarding, “Let’s regulate the Federal Reserve” rhetoric. Hehe)

Instead, the real issue should be addressed. Rothbard has outlined this well in his numerous papers on strategy. Yet in the corrupt system, Ron realised the “deregulation” would make things worse, so he voted against it. It does not follow that because he voted against deregulation in a specific instance, that he then supports regulation in the wider sense.

“It’s pretty amazing that Ron Paul was this prescient. Wiesberg even cited LTCM as his canary in the gold mine but Paul (again amazingly) addressed it 9 years ago and cited it as a moral hazard in a corrupt pseudo deregulated system.”

Here’s the speech to Congress: (http://www.house.gov/paul/congrec/congrec99/cr110899-glb.htm)

“Madam Speaker, today we are considering a bill aimed at modernizing the financial services industry through deregulation. It is a worthy goal which I support. However, this bill falls short of that goal. The negative aspects of this bill outweigh the benefits. Many have already argued for the need to update our financial laws. I would just add that I agree on the need for reform but oppose this approach.”

Inquisitor May 26, 2009 at 3:54 am

If Quiggin tried to liken Austrianism to religion one could just do the same to Keynesians and Keynesianism and positivist economics more generally… or indeed, anything. Perhaps “critics” of Austrian econ should silence themselves on the whole “religion” analogy because it can blow up in their faces, and usually does (what defines a religion that does not define a scientific community? trying to choose internal agreement/disagreement as the criterion is at vague.)

newson May 26, 2009 at 3:55 am

to abom:
the comparison of nugget coombs to greenspan is not helpful in the sense that coombs was in a bretton-woods world, where there was a modicum of restrain by virtue of the usd/gold link. greenspan ruled a goldless monetary system.

providing merely depository services for current-account holders, and intermediary services for borrowers and lenders would mean banking is far less profitable than is presently the case. and politicians would have to front the electorate with overt tax rises, rather than use the covert means of inflation to fund expenses.

the vortex of decline of paper monies worldwide will at least get people talking about what needs to be done to restore monetary order. whether or not some nations reform along sensible lines remains to be seen. my feeling is that this is a runaway train.

John Quiggin May 26, 2009 at 4:11 am

“If Quiggin tried to liken Austrianism to religion …”

But since I didn’t, everything that follows is kind of irrelevant. Is it too much to ask that you should read the original piece as well as the critique before commenting?

ABOM May 26, 2009 at 6:25 am

I agree it’s a runaway train, a sinking ship…use whatever analogy you want. Decades of monetary corruption heaped on top of decades of monetary corruption. Massively distorted price signals. Farming destroyed for residential housing in California that is now itself being demolished by the banks. A nuclear bomb would have done less damage. Tragic-comic.

We are undoubtedly on the verge of the “crack-up boom” Mises warned about – the final catastrophic deflationary/stagflationary implosion of the credit-based fiat-money “dark star”.

But do we just sit around drinking ourselves to death waiting for monetary anarchy and government bankruptcy, or do we advocate concrete steps to try to ameloriate the tragedy that we see coming for our societies?

I see the disaster coming, but I desperately want to turn the ship away from the iceberg. Don’t you?

DS May 26, 2009 at 6:31 am

“And if that is the case, can’t we support the (argh!) Keynesian case for greater regulation of the financial services industry as a second best alternative, before a genuine free market in money is born? Do we have to wait for absolute anarchy before we get a free market in money? What are our PRACTICAL steps to get from here to there?”

In my mind there are no halfway steps. “Regulation” is a very broad term, but we have regulation of the banking system by government now, banking and finance are currently the most regulated and least free buisnesses anywhere on the planet. The idea that we don’t have enough regulation is rather odd.

The problems are several:

- Despite the idealized, 7th grade civics class notions about government regulation, government regulation is and has always been instituted to favor certain businesses over others, not as a way for the people to restrain the actions of businesses (not that I would advocate that either). The regulated banking system today regulates it’s members in order to force them all to hold HIGHER reserve ratios and operate more dangerously than they otherwise would in order to keep them from competing with each other on the basis of the soundness of their balance sheets (if that sounds like a cartel then you are on to something). That is precisely why the Federal Reserve system was founded by the bankers (not a grass roots demand from the people), and why ALL central banks exist. Central banks are sold to the public as precisely the opposite – institutions that are supposed to limit the amount of risk these institutions produce and limit the inflation they create. The reality is precisely the opposite.

- Supposing that the goal of regulation would be towards the 7th grade civics class ideal of regulation (to restrain and limit the fraud of institutions) this supposes that government has some special knowledge of the markets that can be used to regulate the banks for the good of society. This is ONE of the fundamental flaws of the Fed: even if you believe that its mission is to provide low inflation and unemployment by manipulating the money supply, the information problems make that impossible. True “regulation” of the economy (or anything) requires that the regulator be able to accurately measure the current status of the system in real time, be able to accurately predict the effects of its interventions and be able to implement the right corrections in real time in order to have the desired effect. But the government and the Fed can not hope to meet any of these conditions.

And again, this assumes that the “regulators” at least have noble goals, another rarity in history of government.

fundamentalist May 26, 2009 at 6:57 am

Quiggin: “And since banking is essential to capitalism , it seems to me that the FRB version of the Austrian theory shows that the business cycle is inherent in capitalism.”

I think the Bank of Amsterdam is a better example than people like to admit. It practiced some limited frb secretly, but not all along and not to the degree that other banks do. Frb started long before anyone would date the origins of capitalism. It began in medieval Venice when gold merchants began loaning money to customers by adding to their accounts in the merchants’ books. The first business cycle probably occurred in the 13th century according to Braudel.

100% reserve banking is possible, but not likely. Hayek in “Monetary Theory and the Trade Cycle” pretty much gave up on any attempt to get rid of frb and conceded that it could actually cause new technology to be implemented sooner than 100% reserve banking. Of course, in the 1970′s Hayek endorsed free banking as the only means to restrain banks from inflating without restrictions.

Mises and Hayek believed that business cycles inherent in frb could be dampened if the public were educated enough on the dangers, as Washington Irving tried to do in his essay in 1820 on the Mississippi Bubble. But that will never happen as long as mainstream econ denies the existence of the problem.

So what would happen if we simply accept frb as part of capitalism and, as Mr. Quiggin suggests, that the business cycle is inherent in capitalism? We would merely need to accept free banking as necessary to capitalism to control the business cycle and try to educate people about the dangers. It certaintly doesn’t argue for more state intervention in the economy. The state has proven what a mess it makes of things. I can’t believe anyone would be proud of the Federal Reserve’s records and hold it up as an example.

In addition, insurance could solve a lot of the problems caused by frb. Banks could insure against default and customers could buy insurance against losses if they wanted. Insurance companies would need to know the financial condition of banks in order to price insurance and the premiums would signal the soundness of the banks.

Free banking with private bank insurance sounds like a good combination to me.

Steve Horwitz May 26, 2009 at 7:23 am

DS writes:

“Central to Austrian Business Cycle Theory is the idea that Fractional Reserve Banking (FRB) is the fundamantal, root cause of the business cycle – it is not the sole unitary cause (the fortunes of individual businesses can vary greatly, sometimes these variations can be in sync, sometimes out of sync. But for those fluctuations to move in unison is a low probability occurance and evidence of some extraordinary circumstance, most likely caused by government interference), but certainly the dominant one. Amongst Hayek, Mises, Rothbard, their predecessors, students and followers there is very little disagreement on that subject – in fact I’m not aware of any. If you have come to some other conclusion you are mistaken. Again, there is almost no controversy about this subject amongst Austrians.”

As the kids today say: FAIL. :)

There is ALL KINDS of controversy among Austrians about whether fractional reserve banking is the root cause of the business cycle. I refer you to a thread on this very blog: http://blog.mises.org/archives/009973.asp .

I think it would be fair to say that Austrians agree that INFLATION is the root cause of business cycles and that we agree that government central banks are the source of inflation. However, there are plenty of Austrians (and I submit a majority of them, if one is talking about PhDs in economics who do work from an Austrian perspective) who are perfectly find with fractional reserve banking and do not see it alone as a cause of inflation and cycles.

Gasman May 26, 2009 at 8:12 am

FRB can expand and contract and when gold was the medium of exchange it always contracted back to the (gold) base. The size of the boom/bust cycle depended on how big the synchronized bank system was (town, region, country, and now world). Adding in world fiat currency fundamentally changes the system. It is no longer capitalism. What shall we call it?

See this post:-
http://www.freemensch.com/2009/05/mises-money-gold-and-gibsons-paradox-part-iv.html

Michael A. Clem May 26, 2009 at 9:35 am

ABOM, there are no easy answers to get from where we are now to where we want to go. But surely the first step is to fully recognize those two steps. Quiggan is concerned with “actually existing capitalism”, or capitalism that is heavily politically-controlled and regulated. Clearly understanding the impact of politics on the economy is a necessary first step towards doing something about it.
Understanding what a free market is and how it works is the first step towards getting there.
Getting mainstream economists like Quiggan to a better understanding of economics, including ABCT, Capital Formation Theory, and other such things is an important step so that they give better advice to government officials. Whether officials accept it or not is another matter, but if the majority of economists disagree with government actions or policies, support for those policies will be harder to maintain.
Sure, simple things like government not bailing out failing banks, getting rid of things like the FDIC, will help. With higher reserves, the alleged necessity of such government support is reduced. Tighter regulation? It’s not necessarily the amount of regulation that matters, but the type of regulation. Banks are private institutions, and are fully entitled to run their businesses as they please, as long as they are not initiating force or fraud on their customers. If FRB is fraud, then government should outlaw it, not allow it or require it.
You don’t have to be a full-blown cynic to recognize that some corruption is going to occur. Like Zimbabwe, governments want their central banks to inflate the money supply, and are most likely unwilling to give up inflation, much less do away with their central banks. So the last, but not least problem is helping ordinary people to get a decent grasp on economics, as well, so that they recognize the economic problems that governments cause, and are willing to be skeptical of government regulation and whether it is good or bad regulation.
None of this is likely to be easy, but we start with education and understanding. If Quiggan understands, then he, too, can figure out what “reasonable measures” should be taken without our having to tell him.

Alex May 26, 2009 at 9:54 am

“I think it would be fair to say that Austrians agree that INFLATION is the root cause of business cycles and that we agree that government central banks are the source of inflation. However, there are plenty of Austrians (and I submit a majority of them, if one is talking about PhDs in economics who do work from an Austrian perspective) who are perfectly find with fractional reserve banking and do not see it alone as a cause of inflation and cycles.”

Bingo! In a fiat money system, with fractional reserve banking or not, the amount of money creation is determined solely by the central bank.

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