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Source link: http://archive.mises.org/7045/why-dont-entrepreneurs-outsmart-the-business-cycle/

Why Don’t Entrepreneurs Outsmart the Business Cycle?

August 28, 2007 by

A common argument against Austrian theory, writes Brian Stanley, is that entrepreneurs are too smart to be fooled by Fed intervention. The argument claims that entrepreneurs recognize the Fed actions and ignore the Fed by proceeding as if the interest rates were where they would be if they were set by the free market and not by Fed intervention. If this contention is true, the business cycle theory is wrong in its conclusions about what causes the boom and bust cycle. In fact, it isn’t possible to determine what the natural rate should be. Small businesses particularly can’t be expected to recognize and react to Fed intervention, and there is no evidence that even large, sophisticated businesses can perform any relevant and meaningfully accurate calculations and forecasts. FULL ARTICLE

{ 138 comments }

Thomas Benjamin September 10, 2007 at 3:03 am

To ktibuk and fundamentalist: Thanks also for your comments. They were very helpful. Fundamentalist: I will look up the writings of the authors you mentioned–these should be very interesting. My question to you both (and to Yancey as well for he hasn’t answered it yet…) is this: given that credit expansion (and the authorization it gives to increase the fiat money supply) is stealing some capital goods from someone and giving them to someone else, does having the authority to create credit out of thin air give those who have such authority de facto control over the means of production? On a similar note, does the imposition of a fiat money system on a society as the only legal tender give those who control the supply of that fiat money de facto control over that society’s means of production and make that society de facto socialist (or mutualist) with individuals merely having an aggregate of rights which are ‘guarenteed’ and ‘protected’ by government with respect to those means of production?

ktibuk September 10, 2007 at 5:40 am

“does having the authority to create credit out of thin air give those who have such authority de facto control over the means of production?”

Not a total controlö, as in deciding what goods would be produced in what quantities. That is up to the market.

However, since this theft actually manipulates interest rates and interest rates are about time preference, this manipulation causes businesses to invest in relatively long term investments rather than relatively short term investments.

This is called malinvestment. But in the end since this credit expansion is not sustainable, these malinvestments gets to be liquated sooner or later when the credit supply contracts.

But the net winners, meaning the thieves are always the banks and governments.

Banks earn interest out of thin air, and governments get a free source of credit.

Anthony September 10, 2007 at 7:27 am

Ah, you misunderstood Mises. Austrian economics stipulates that markets are dynamic, and not automatic processes like some neoclassical models paint them to be. Mises contended that the entrepreneur played a vital role in the market economy. It is with entrepreunerial intiative that efficiency prevails.

I don’t understand what you mean by perfectly efficient. It is a relative concept.

Yancey Ward September 10, 2007 at 7:50 pm

Thomas,

Yes, goods are the prices for other goods, however, money is the exchange mechanism and the way to assign prices to goods so that you don’t have to figure out that a pound of bananas is equal to a two loaves of bread by systematically going from bananas to pears to shoes…. to bread.

Without an exchange mechanism capable of serving this function, then we are limited to barter transactions.

And, yes, the problem with your system is the “freeriders”, though, in all honesty, I see no reason to call them that since they are doing exactly what the system is designed to do. Human beings will, on average, tend to do the minimum amount of work to accomplish a particular goal.

And when I talk about your system becoming inflated, it is not a society-ending disaster. Your system would be quickly abandoned for a true commodity money.

Thomas Benjamin September 11, 2007 at 12:56 am

Anthony, here is what I mean by perfectly efficient (in Mises’ own words, HUMAN ACTION, pg 328), “In an economic system in which every actor is in a position to recognize correctly the market situation with the same degree of insight, the adjustment of prices to every change in the data would be achieved in just one stroke”. This, at least to my understanding, is the way classical economics defines market prices. This assumption would make time series of prices “random walks”. What concerns me is the application of Say’s Law to the free market envisioned by Mises (and I believe Mises is correct). In an economic system where demand does not immediately catch up to supply there would be an increase in the purchasing power of the medium of exchange of choice until the supply of the medium of exchange of choice was sufficiently increased. If the rate of increase of the medium of exchange of choice outstripped the rate of increase of supply there would be a decrease in the purchasing power of the medium of exchange of choice until the supply of goods and services sufficiently increased. The question I ask regarding this is, why does a great supply of the medium of exchange of choice chasing goods not act as a signal for producers of producer’s goods to increase production to such an extent that inflation would eventually ‘go away’. This question is for ktibuk as well.

Thomas Benjamin September 11, 2007 at 1:20 am

ktibuk, So what you are saying is that the central deceit of the ‘banking cartel’ (since they control the supply of fiduciary money) is to fool entrepreneurs into thinking that long-term projects are feasible when in fact they are not and because the ‘banking cartel’ controls the supply of fiduciary money (and therefore the assignment of prices i.e. the standard of value) it is impossible for entrepreneurs to outsmart the bankers? Also, how do bankers earn interest out of thin air when they did not loan it into existence in the first place (or did they…)?

Thomas Benjamin September 11, 2007 at 1:50 am

Yancey, You say that it is human nature to do the minimum amount of work needed to accomplish a certain goal. In terms of the difference between the value of the price paid (the costs incurred–in this case work) and the and that of the goal attained (the goods desired), i.e. the profit it seems to me you are saying human beings are seeking to ‘maximize profit’, an assumption that Mises’ conception of the free market (at least as I understand it) would find unnecessary. If the actors in my toy economic system did not behave this way, i.e. produced more in order to keep inflation from occurring, would that make them “Angels” (this term from Hoppe’s paper “How is Fiat Money Possible?–or, The Devolution of Money and Credit”, pg 62)? Would it make them ‘altruists’? Would it make the society in which my toy economic system exists a ‘Mutualist’ society? Please let me know….

Fundamentalist September 11, 2007 at 9:51 am

Thomas: “This assumption would make time series of prices “random walks”

You’re right about that. Random Walk theory depends upon every player knowing everything. But as Mises and Hayek point out, that is impossible. In the Random Walk and “perfection competition” models of mainstream econ, the Austrian view of econ is not efficient. But the Random Walk and perfect competition models are impossible to achieve, but even if they were possible, they would not be desirable because the “perfect competition” model actually destroys competitiveness by eliminating every tool of competition but price. I think the Austrian definition of efficiency would be that markets are unhindered by the state and no coercion is involved in trading.

Thomas: “What concerns me is the application of Say’s Law to the free market envisioned by Mises.”

Keep in mind that Say’s Law applies only to a regime with a constant money supply. Where Say’s Law fails is when the money supply is artificially increased through credit expansion. When that happens, the supply of consumer goods temporarily falls below demand and prices increase.

Thomas: “…why does a great supply of the medium of exchange of choice chasing goods not act as a signal for producers of producer’s goods to increase production to such an extent that inflation would eventually ‘go away’.”

The “great supply of the medium of exchange of choice chasing goods” causeS prices to rise and does cause increased production. But that signal to increase the production of consumer goods is part of the business boom that causes the bust. In the Austrian business cycle, prices rose because the lower interest rates spurred investment in basic industries (mining, equipment manufacturing, etc.) first, not consumer goods industries. The increased investments in the basic goods industries increases employment and therefore demand for consumer goods at a time when production of consumer goods hasn’t increased. Wages lag behind price increases, so the price increases cause profits to jump. At that point, businessmen decide to produce more consumer goods using more labor because it is cheaper than buying new equipment. The basic industries find themselves competing with consumer good producers for scarce labor and input materials, and the basic industries lose out, causing business failures and lay-offs. The reduced employment in the basic industries reduces demand for consumer goods at a time when production of consumer goods is increasing, and causes prices to fall, or not rise as much.

In a constant money regime (that is, the stock of money remains fixed with no increase or decrease in supply or flow of money), you wouldn’t find the basic industries stimulated by artificially low interest rates, and prices would fall at the same rate that production increased. Even without a constant money regime, but one where the money supply increased only at the same rate as the increase in production, you wouldn’t have artificially low interest rates and therefore no business cycle and no price inflation.

If the increased investment in basic industries happened because of increased savings, instead of artificially lower interest rates, then basic industries would not compete for resources with consumer goods industries, because saving is just another term for reduced consumption. Reducing consumption frees resources in the consumer goods industries that the basic industries can employ. Prices of consumer goods then fall slightly, due to the decreased demand and lay-offs, but as soon as the labor transfers to the basic goods industries, the demand picks up and prices return to normal levels.

Anthony September 11, 2007 at 10:59 am

Good reply Fundamentalist.

Fundamentalist September 11, 2007 at 1:03 pm

It just occurred to me that Thomas may be asking why production doesn’t catch up with the expanding money supply and thereby stop price inflation. There are a couple of reasons for this. One answer is that production can expand in the long run only on real savings. Otherwise, if expansion is based on credit expansion alone, then basic industries and consumer industries compete for the same scarce labor/material resources. That’s the main reason. The other is that just at the time that the real economy is cleaning up the mess the credit expansion caused, that is, in the recession, and returning a balance to production, the Fed gooses the money supply again. In other words, producers can never keep up with credit expansion. Finally, when consumer prices first rise, profits rise, too. But later, the prices of inputs (labor and materials) rise also, reducing profits, and killing incentive to invest. So while consumer prices may keep rising, businessmen don’t increase investment to meet demand because profits have fallen.

Naturally, the economy will at about 3.5% annually; that includes 2.5% for productivity growth and 1% for population growth. That’s also based on the current level of US savings and foreign savings invested in the US. But the Fed expands the money supply at about 8-10% annually.

Jason Cawley September 11, 2007 at 2:36 pm

Pardon me for coming late to a useful discussion. I have comments on several of the arguments presented.

First, one fellow wondered about the independence of interest from the real productivity of capital. This was well discussed in Bohm Bawerk, as one of the previous theories of the origin of interest that can be shown to fail on logical grounds. Essentially, the physical productivity theories all implicitly assume that the same physical quantity of the same good, has the same value at all times. But there is no reason for this implicit assumption.

In the case of the 2% growing tree, the choice it presents is to have say 100 board feet of lumber now, or 110 board feet of lumber 5 years from now. But which of these two is more valuable? That has nothing to do with the physical productivity “on offer”, and everything to do with how much more useful in consumption terms lumber now is compared to lumber 5 years hence.

Now, the value of anything varies with the quantity of it available. If lumber now is infinitely more useful than any amount of lumber later, it is pointless to save trees for later use. But more realistically, some portion of available trees will be used now, and others left for later. Varying the quantity used for each will vary their marginal utility, until the two uses coincide. Naturally, shifting quantities from one use to the other will also change their prices – the price of trees will move with time.

If overall time preferences reflect an interest rate of zero – all goods at all times equally valuable – then trees should be left standing. If they instead reflect a 5% rate of discounting, then lumber will have to rise in price by 3% per year, for it to be profitable to leave trees standing. Until they are rising that fast, it would be profitable to use up more of them now.

Thus the rate of interest is set prior to consideration of how to use the trees, by independent time preferences. All the physical productivity does, is allocate resources between present and future uses, according to a schedule of usefulness, from high usefulness to low.

IR discounting and physical productivity interact to determine what quantity of resources should be allocated to which use (in the single asset example, use trees now or use them later – realistically, a whole schedule of investment alternatives with all gradations of time of use).

I’ll address my next subject as a separate post, as some may be less interested in the above.

Jason Cawley September 11, 2007 at 3:04 pm

Next to the key issue of credit expansion. It is rightly raised by Thomas’ thought experiment of sight drafts. The comments made on his idea strike me as unsound, because they overlook the very real possibility that anyone who wishes may simply refuse some people’s sight drafts, while being perfectly willing to accept those of others. Sight drafts are simply credit, pure and simple. They contain no element of coercion, no implication of forced circulation, no implication of government backing of any kind.

To Ktibuk, sorry, banks are not thieves, and credit is not theft. If you think their gig is so great, you are perfectly free to join them, and put your reserve balances in bank stock instead of bank deposits. Almost needless to say, doing so would have done far better under fiat money than either holding fixed denomination debt, or formally monetary metals.

You are correct that banks create credit out of thin air. All credit is thin air. Strangely enough, this does not make all credit unsound, and therein lies the rub. Some credit certainly is, however. The error lies in the implicit assumption that no accepter of a credit should bear any risk, or that whatever asset is used as a medium of exchange can or ought to be riskless.

There is simply no such animal. Every good is fully enmeshed in the entire market and subject to all its vagaries. There can be better and worse forms of monetary standard, certainly. But no riskless ones.

Nor can credit be outlawed without abolishing freedom itself, entirely. The frequent lines about coercion one finds in Austrian discussions of banking and the cycle dodge the key point, that there is in fact no way short of the most draconian coercion, to abolish the possibility of credit freely contracted and given.

That governments have tried to grant special rights over credit expansion, in the course of trying to institutionalize frankly haphazard controls over it, and that unsound governments have also used and misused credit placed in them or in institutions they have manipulated or controlled, may of course be granted. But none of that makes government action the essence of credit or credit expansion. It existed before governments got into the biz and will continue to exist under any form of monetary system, in which there is the slightest freedom left to merchants and entrepeneurs.

Government regulation of credit has focused on means to limit the rate at which it occurs, because abolishing it is impossible, and also would not be worth choosing. This is a legitimate aim and one they have frequently failed to achieve. But the complete absence of regulation in the matter yields Thomas’ thought experiment, not perfectly sound money. And the most rigid gold standard imaginable would not stop credit expansion – in case everybody forgot, we left such systems by an endogeneous process of credit expansion around and away from the closely regulated base money.

We still do. When the Fed controls bank balance sheets, banks turn to off balance sheet debt creation through collateralized securities and the like. As the economic historian Kindleberger put it, “the process is sisyphean” – financiers invent new forms of credit, regulators close up the loopholes those exploited, and financiers then come up with new ways around the new rules.

The underlying reality driving credit creation is that banks actually have real economic credit, in the sense that their debts are in fact accepted by most as money, and would be independent of any government stipulations in the matter.

As Thomas’ example shows, in order to maintain the continued acceptance of one’s sight drafts as money, one has to limit their issuance. Banks do. The sort of regulations they follow are in their own interests; at most they address the collective action problem of some getting too frisky and making trouble for the rest.

In the past, those were simply allowed to fail in the bust ensuing any prolonged overexpansion. Now instead, with the Fed and government committed to preventing bank failures, the banks don’t fail but also can’t create credit quite as easily. So they have partners who aren’t as regulated, and can still fail. Meanwhile, bank deposits have been made riskless enough that they return zero in real terms, without actually becoming riskless.

The credit mechanism is inherently unstable. The Austrians are right to tie the trade cycle to instabilities in credit expansion. They are incorrect in the association of credit expansion exclusively with government action. And they are incorrect that any regime consistent with economic freedom can abolish the instability in question.

Better and worse regimes or management can indeed limit the amplitude of cycles, and avoid major policy mistakes that can amplify them enourmously. But the bare cycle itself comes from the freedom to err that is involved in freedom itself. We cannot abolish it and should not attempt to do so.

In my next I will address the issue of short and long goods, where I think the Austrians have been incoherent, precisely as Eric sensed. Without it involving them being wrong about the overall causes of the cycle, their actual arguments on the point were blatantly false.

Jason Cawley September 11, 2007 at 3:52 pm

Now to Eric’s question and the argument from higher and lower orders, as actually presented by e.g. Mises in the Theory of Money, and reiterated by Hayek in correspondance with Keynes.

The basic motivation is sound enough – both are looking for ways to explain why falsifying market signals about time preferences are a bad idea, and why overinvestment in the boom can have negative consequences. But the arguments Mises in particular deployed to address it are just hopeless.

He claims at one point that investments with the shortest lifetimes always have the highest returns, and that longer date investments are only made after all shorter ones are exhausted. This is false on its face. It is clearly motivated by analogy to standard Ricardo marginalism, trying to get the schedule of investments (by return, and therefore urgency) to match up to the schedule of extensions involved in having more capital overall.

There may also have been an intuitive sense involved, that Mises was thinking of the most urgent needs e.g. for water or food (imagine a Crusoe economy), imagined as pressing but low return, compared to less urgent but perhaps more lasting activities.

But it won’t work. Very soon in his activities Crusoe will make himself a weapon, which may last him several months. And not long after he will make himself a shelter of some kind, that may last him years, if not (with improvements) his lifetime. All shorter turn around investments will emphatically not have been exhausted by the time he does so.

The reason is clear enough – even if his capital is so limited that the value of income a single period in his future, or a few, is still paramount, there may be long dated investments whose returns even in their first few periods is so high, that they beat out other short turn around investments.

Even if these long dated investments *also* have a very long tail of usage returns to offer, stretching out through a long period of time. In other words, the return schedule (including allowance of risk etc) at an appropriate discounting rate is the sole discriminator among competing uses of the available capital. And there is absolutely no necessity that short uses by filled first, and in fact they will not be.

Nor is there any logical connection between capital intensity and capital life. A gem trader may have neglible labor costs and very short turnover periods and still require substantial circulating capital, by value. Or a power company may have very capital intensive and very long dated assets. A canal might be constructed through the most labor intensive efforts with little use of anything else, then return a long stream of usage incomes. Or present labor and little else might yield present goods and little else, at say a coffee shop. There is simply no necessary relationship between the mix of labor vs. capital being used, and the lifetime of the stream of services that result.

There is a second fallacy involved in the standard Austrian argument about long dated capital. They implicitly treat the *value* of capital available as a fixed result of past savings. Clearly, the physical quantity of capital cannot be put into a meaningful relation to prior income limits without passing through valuation. But just as clearly, once capital is instantiated and exists, its *value* in future periods after the initial saving, need bear no systematic relationship to the amount originally saved.

Instantiated capital rises in value and falls in value with every change in the conditions of the whole market system. When entrepeneur expectations are not met, the total value of available capital falls, and past savings having been entirely adequate to finance the original investments is of no help in preventing this. When entrepeneur expectations are exceeded, the total value of available capital rises, and even if some of those initial investments were financed originally with gratuitous credit expansion, that credit will turn out to be wholly sound, after the fact.

The real issue is whether changing signals and conditions cause the entrepeneurs to miscalculate. They always can, and large systematic monetary disturbance is almost certain to bring about such miscalculation. But it is the miscalculation and misallocation that is doing the damage. And while there may be a tendency in that direction and it may be realized in the extreme cases with very high probability, there is no logical connection between a prior mismatch between savings and investment, and the subsequence returns realized from those investments disappointing the expectations present when they were made.

The one who came closest to getting these issues right was Hayek, when it spoke about some sets of future projections or plans, on the part of all the disparate economic actors in a given market situation, sometimes being mutually compatible, and at other times not being so. Even mutually compatible expectations *can* be disappointed – by real changes e.g. But mutually incompatible ones *must* be.

Why do the longer orders show up more in the resulting difficulties? Because their values are more sensitive to changes in the rate of interest, naturally. This is just standard DPV analysis and is not due to any exhausting of all short investments before long ones.

A house that will return a live in value of 1 per period forever is worth only 10 present value if the real rate of discount is 10% (1/ .1), and is worth 20 if the real rate of discount is 5% (1/.05). A good with a lifetime of a month is still affected, but its present value changes only from 1.004 to 1.008.

If the production price of a new house with present factor costs were 15, then it would look like a worthwhile investment under one prevailing interest rate assumption, and would turn out not to be, with a loss of a third of the invested capital, if that rate expectation is falsified. The short investment is subject to a similar sort of error, but the change in its present value is immaterial.

Errors of allocation through time are what IR uncertainties cause, and those errors are the real cause of loss through the cycle. Long dated assets are where the values are most sensitive to IRs, and therefore where misallocation of resources will occur, when one IR is expected to prevail through the life of an asset, and instead some other rate does prevail.

What is relevant about capital lifetimes, in other words, is simply that the first partial of value with respect to interest rates is higher for long dated assets, and therefore the error in their valuation due to errors in rate forecasting swamps any error in the demand or price expectations for simpler, short goods.

Forecast errors are emphatically still possible for short period consumer goods – a grocer can stock the wrong goods and get stuck with an inventory problem or have to sell them at a loss. But rate uncertainty specifically will not drive such errors. The cycle might still do so, indirectly, by inducing the entrepeneur to misforecast overall demand or its direction toward luxuries vs essentials, etc.

In sum, the Austrians are right that credit expansion drives the cycle, wrong that it can simply be eradicated by a few regulations or a different monetary system. The Austrians are right that real misallocations cause the losses involved in the cycle, wrong that misallocations can be eradicated. They are right that misallocations specifically to long date assets are the characteristic driver of the cycle, wrong about why that is the key sector (the real reason being IR-forecast value-sensitivity).

One man’s opinions…

Jason Cawley September 11, 2007 at 4:02 pm

One additional point. Mises speaks of stopping the cycle by forbidding credit expansion, but he also at other times argues that the right target for monetary policy is to maintain the exchange value of money as nearly as possible unchanged, in order to avoid falsifying calculation by monetary factors. He does not seem to realize that the two aims are mutually incompatible.

No credit expansion would lead to a continual increase in the exchange value of money, as productivity improves. One might wish to advocate this, but it is clearly a monetary policy of conscious and deliberate deflation, and not a policy aimed at the stability of the exchange value of money.

In modern economies under fiat money, and with the instability of the credit mechanism already discussed above, it is clear that the goal of price stability would involve continued credit expansion. It would proceed at slower rates than we see in practice, but it would be non zero.

The price level has risen 3-4% per annum since WW II, which is not price stability. But the money supply has risen more like 6-7%. In more recent times, the former has run 2% core to 4% overall, and the latter in the historical range – with occasional faster periods.

Mises gives excellent arguments that price stability is a better aim for monetary policy than either inflation or deflation. But the practical consequence of accepting those arguments is to allow continual credit expansion at a non zero rate. We have erred on the side of inflation and too rapid credit expansion in recent history, certainly. But zero credit expansion, even could it be achieved without abolishing free markets, would not be choiceworthy, even on his own arguments.

Anthony September 11, 2007 at 5:54 pm

Jason, money is meant to be a commodity serving as the medium of exchange to overcome the inherent inefficiencies entailed in barter. Production must occur to trade a certain amount of goods for a certain amount of money. From what I could tell, individuals could merely issue sight drafts in Thomas’ system without engaging in any productive activity whatsoever. Could this possibly be similar to either a free paper banking system or a commodity system?

Also,

“The credit mechanism is inherently unstable. The Austrians are right to tie the trade cycle to instabilities in credit expansion. They are incorrect in the association of credit expansion exclusively with government action. And they are incorrect that any regime consistent with economic freedom can abolish the instability in question. ”

So what do you think is the most appropriate banking system to adopt a) in a pure free market b) in the present system, in order to minimize the problems experienced under the current order?

Thomas Benjamin September 11, 2007 at 8:58 pm

To Fundamentalist, Anthony, and Jason Cawley, thanks for your insights and comments. In my toy system, as I conceive it, consumers print sight drafts (priced at current prices) to obtain consumer goods. The producers of consumer goods then calculate the cost of producer’s goods they need to satisfy the orders then write sight drafts for that amount at current prices to the producers of producer’s goods. The producers of producer’s goods then (if possible– and here is where the catch may be according to Fundamentalist, if I understand Fundamentalist correctly…) produce the amount necessary to fulfill the orders, the producers of consumer goods produce enough to satisfy the orders, and there is no excess–in theory (of course reality is not so pretty…). However, if one starts with basic industries, why doesn’t a heavy influx of sight drafts (assuming they are written for small amounts) to the producers of producers goods create such a glut of producer’s goods that the price of such goods stay low enough so that producers of consumer goods can keep their prices low as well, thus staving off inflation? The problem of free riders in my system seems to be essentially the same as the problem of welfare in a liberal democracy. Giving, say, food stamps to poor people would necessarily increase prices but in my system it might be deemed a necessary evil to stave off, say, social instability. Because everyone is free to do the same, it might solve more problems than it creates since it may keep the necessarily unproductive and the unproductive by choice out of the way of the productive so that those who choose the life affirming path of productive effort may be free to associate only with those who share their values while leaving the rest free to live and possibly choose to be productive (I hold that productive effort is valuable in and of itself to maintain the proper mental health of man…). Also, why can’t the ‘excess funds’ be swallowed up in R&D, hopefully creating the discoveries necessary to be able to increase production n-fold so that inflation would not occur?

ktibuk September 12, 2007 at 2:33 am

Jason: To Ktibuk, sorry, banks are not thieves, and credit is not theft. If you think their gig is so great, you are perfectly free to join them, and put your reserve balances in bank stock instead of bank deposits. Almost needless to say, doing so would have done far better under fiat money than either holding fixed denomination debt, or formally monetary metals.

You are correct that banks create credit out of thin air. All credit is thin air. Strangely enough, this does not make all credit unsound, and therein lies the rub. Some credit certainly is, however. The error lies in the implicit assumption that no accepter of a credit should bear any risk, or that whatever asset is used as a medium of exchange can or ought to be riskless.

There is simply no such animal. Every good is fully enmeshed in the entire market and subject to all its vagaries. There can be better and worse forms of monetary standard, certainly. But no riskless ones.

Nor can credit be outlawed without abolishing freedom itself, entirely. The frequent lines about coercion one finds in Austrian discussions of banking and the cycle dodge the key point, that there is in fact no way short of the most draconian coercion, to abolish the possibility of credit freely contracted and given.”

I wouldnt join them since my moral code doesnt permit me and I couldnt join them since everywhere banking is more or less a closed industry.

But that is besides the point.

Fractional reserve banking and fractional reserve banking with a fiat currency are both theft or fraud, whatever you wish to call.

Fractional reserve banking under 100% free market money (like golld), is like real estate agents renting your house out without telling you and collecting the rent himself. They can do this with money since money is homogenous but homogenouity doesnt change the fact that they are the same thing.

There is not transfer of titles of property and banks are safekeepers. But they take the money and lend it out and make good profit from your money. And this is not just theft but it also creates boom bust cycles since it increases the credit stock artificially.

Fiat money system where credit is created out of thin air by a central bank is worse because the creation helps the banks, and hurts the rest of the money holders since purchasing power of their money is lowered as a result of the credit creation.

I would love to give you one billion dollars of credit. Even on a 1% annual rate. I dont have 1 billion dollars worth of savings but that doesnt matter in fiat money. O could just punch in some numbers in a computer and transfer it to you.

But I can’t. I am not the fed or central bank of some country.

So you don’t need to spend the created money, just the interest is enough.

So when a banks gets a loan with and interst f say 3% from a central bank and gives it out with an interest of 6% and if this operation causes the purchasing power of the currency to drop.

Then this profit that the banks are making are actually theft. They are not making anything productive like lending out the savings of others.

They are stealing the wealth of the rest of the people whoo have to hold cash.

Fundamentalist September 12, 2007 at 7:58 am

Thomas: “The producers of producer’s goods then …produce the amount necessary to fulfill the orders, the producers of consumer goods produce enough to satisfy the orders, and there is no excess…”

Yes, that would work on paper. But you run into the problem of scarcity. Unless the increased investment in basic goods comes from reduced consumption of consumer goods (savings), you’ll have basic goods and consumer goods industries competing for scarce resources.

Thomas: “Also, why can’t the ‘excess funds’ be swallowed up in R&D, hopefully creating the discoveries necessary to be able to increase production n-fold so that inflation would not occur?”

Because the funds invested in R&D go to people as wages, who then spend most of their wages on consumer goods. Whether investing in R&D or increased production, the result is greater employment and therefore greater demand for consumer goods. If the new employees are busy with R&D, no one is producing the consumer goods to meet the new demand and prices will rise.

Fundamentalist September 12, 2007 at 6:51 pm

Jason: “Mises speaks of stopping the cycle by forbidding credit expansion, but he also at other times argues that the right target for monetary policy is to maintain the exchange value of money as nearly as possible unchanged, in order to avoid falsifying calculation by monetary factors. He does not seem to realize that the two aims are mutually incompatible.”

Mises was smarter than you give him credit for being. Credit expansion does depreciate the value of money, but a gold standard, as Mises advocated, would come very close to maintaining the value of money at a constant level because the increase in gold production would match increases in production in general.

Jason: “But the money supply has risen more like 6-7%.”

It’s closer to 12%.

Jason: “He claims at one point that investments with the shortest lifetimes always have the highest returns, and that longer date investments are only made after all shorter ones are exhausted.”

Read it again. Mises does not write that. He shows that when interest rates are lowered artificially, that the shorter term investments earn the highest rate of return. Smart investors and businessmen go for the highest rate. It’s very basic math.

Jason: “Nor is there any logical connection between capital intensity and capital life.”

Who said there was? Capital intensity increases wages by improving their productivity. That’s all.

Jason:”They implicitly treat the *value* of capital available as a fixed result of past savings.”

Please read the material again. The changing value of capital due to changing interest rates and changing demand is key to Austrian analysis.

Jason: “But it is the miscalculation and misallocation that is doing the damage.”

Are you trying to absolve the Fed of its errors? Who makes the first error? The Fed does by artificially lowering interest rates and pumping money into the economy. If the Fed would stop committing its crimes, the business people would make fewer mistakes.

Jason: “The one who came closest to getting these issues right was Hayek, when it spoke about some sets of future projections or plans, on the part of all the disparate economic actors in a given market situation, sometimes being mutually compatible, and at other times not being so.”

You forgot the part where Hayek writes that future plans will be imcompatible because of the Fed’s monetary pumping. If new investment came from savings, far fewer projects would become incompatible. The number of incompatible projects increases exponentially because basic industries are competing with consumer goods industries for scarce resources as a result of the Fed’s monetary pump.

Jason: “Errors of allocation through time are what IR uncertainties cause, and those errors are the real cause of loss through the cycle.”

If investors and businessmen made mistakes on their own, the mistakes and successes would be randomly distributed across time and industries. The volume and size of mistakes would cancel out the volume and size of successes and there would be no business cycle. A business cycle exists because the mistakes aren’t randomly distributed, but follow a strong pattern. What causes businessmen to fail and succeed at the same time? Only Austrians have an answer: the Fed sets them up to fail when it artificially lowers interest rates.

Jason: “But zero credit expansion, even could it be achieved without abolishing free markets, would not be choiceworthy, even on his own arguments.”

Nonsense. Dr. Reisman demonstrates in “Capitalism” that mild deflation would be better for the nation than mild inflation. Inflation hurts savers and rewards debtors; deflation rewards savings and discourages borrowing. Inflation destroys wages because wages never keep up with inflation; deflation would reward workers; they would never have to ask for a raise.

Creating mild deflation would involve nothing more than limiting the increase in the money supply to a rate lower than the increase in the population and production, or going back to the true gold standard.

Fundamentalist September 12, 2007 at 6:51 pm

Jason: “Mises speaks of stopping the cycle by forbidding credit expansion, but he also at other times argues that the right target for monetary policy is to maintain the exchange value of money as nearly as possible unchanged, in order to avoid falsifying calculation by monetary factors. He does not seem to realize that the two aims are mutually incompatible.”

Mises was smarter than you give him credit for being. Credit expansion does depreciate the value of money, but a gold standard, as Mises advocated, would come very close to maintaining the value of money at a constant level because the increase in gold production would match increases in production in general.

Jason: “But the money supply has risen more like 6-7%.”

It’s closer to 12%.

Jason: “He claims at one point that investments with the shortest lifetimes always have the highest returns, and that longer date investments are only made after all shorter ones are exhausted.”

Read it again. Mises does not write that. He shows that when interest rates are lowered artificially, that the shorter term investments earn the highest rate of return. Smart investors and businessmen go for the highest rate. It’s very basic math.

Jason: “Nor is there any logical connection between capital intensity and capital life.”

Who said there was? Capital intensity increases wages by improving their productivity. That’s all.

Jason:”They implicitly treat the *value* of capital available as a fixed result of past savings.”

Please read the material again. The changing value of capital due to changing interest rates and changing demand is key to Austrian analysis.

Jason: “But it is the miscalculation and misallocation that is doing the damage.”

Are you trying to absolve the Fed of its errors? Who makes the first error? The Fed does by artificially lowering interest rates and pumping money into the economy. If the Fed would stop committing its crimes, the business people would make fewer mistakes.

Jason: “The one who came closest to getting these issues right was Hayek, when it spoke about some sets of future projections or plans, on the part of all the disparate economic actors in a given market situation, sometimes being mutually compatible, and at other times not being so.”

You forgot the part where Hayek writes that future plans will be imcompatible because of the Fed’s monetary pumping. If new investment came from savings, far fewer projects would become incompatible. The number of incompatible projects increases exponentially because basic industries are competing with consumer goods industries for scarce resources as a result of the Fed’s monetary pump.

Jason: “Errors of allocation through time are what IR uncertainties cause, and those errors are the real cause of loss through the cycle.”

If investors and businessmen made mistakes on their own, the mistakes and successes would be randomly distributed across time and industries. The volume and size of mistakes would cancel out the volume and size of successes and there would be no business cycle. A business cycle exists because the mistakes aren’t randomly distributed, but follow a strong pattern. What causes businessmen to fail and succeed at the same time? Only Austrians have an answer: the Fed sets them up to fail when it artificially lowers interest rates.

Jason: “But zero credit expansion, even could it be achieved without abolishing free markets, would not be choiceworthy, even on his own arguments.”

Nonsense. Dr. Reisman demonstrates in “Capitalism” that mild deflation would be better for the nation than mild inflation. Inflation hurts savers and rewards debtors; deflation rewards savings and discourages borrowing. Inflation destroys wages because wages never keep up with inflation; deflation would reward workers; they would never have to ask for a raise.

Creating mild deflation would involve nothing more than limiting the increase in the money supply to a rate lower than the increase in the population and production, or going back to the true gold standard.

Yancey Ward September 12, 2007 at 11:24 pm

Jason Cawley,

A very nice series of comments.

And Jason is correct, you cannot stop credit expansion without resort to draconian measures of state control. To do so unjustly limits people’s right to contract- but we have had that discussion on this site so many times that I have lost count. Libertarians should stand for free money and banking concurrent with the right to failure without access to a national treasury.

Thomas Benjamin September 13, 2007 at 2:02 am

Fundamentalist, Do you believe in ‘the limits to growth’? If I understand the definition of scarcity, that is, a good is defined as scarce if and only if when the price of that good is zero, demand exceeds supply; then economic goods are scarce, ceteris paribus i.e. ‘other things being equal’. What are these ‘other things being equal’ that cause a good to be scarce? One thing of course is the cost of transforming the raw material into the desired good (eg. gold and silicon–silicon is supposed to be the most abundant element on this planet, yet the silicon needed for the electronics industry is ‘scarce’, just like gold…). Another ‘thing being equal’ is the actual limit of the raw material (like oil, for instance) yet if the price of oil becomes greater than the cost of producing, say, biofuels, hydrogen, solar or other alternative fuels, then those alternative fuels will be chosen. If labor shortages cause inflation (with the money supply increasing), as you suggest, then it is an opportunity for some entrepreneur to develop cheaper alternative labor like robots, for example. The point is (As Ayn Rand correctly pointed out) production is “the application of reason [generally speaking, the human mind--my comment] to the problem of survival”, the purpose of which is to reduce the scarcity of economic goods i.e. to make economic goods as ‘free’ as possible, thus allowing the entrepreneur to have a large amount of exchange opportunities, that is, real wealth. What keeps things ceteris paribus is the limits within the human mind. We should never forget that the ultimate resource is the creative human mind and that the free market alone can unleash the creative human mind to its highest potential. All other systems potentially (and in reality actually) limit it. End of sermon….P.S. Perhaps instead of the notion of ‘scarcity’ the more general notion of ‘value’(value defined as that for which action (conscious or unconscious) is required to achieve and/or maintain it; ‘economic’ values are defined as that for which conscious action is required to achieve or maintain them) would be more useful for economics. It would at least be more in tune with the ‘logic of human action’, economics being derived from such a logic….

Fundamentalist September 13, 2007 at 12:28 pm

Thomas: “Do you believe in ‘the limits to growth’?”

I like your definition of scarcity. Growth isn’t limited in the long run because, as you write, we’re limited only by our imagination and intelligence. I might add that we’re limited by popular socialism, too. Regulation, taxation and inflation are major hindrances to long term growth.

In the short run we are limited. Hayek and Mises have some interested material on the interest rate break on technology implementation. We’re limited to the rate of savings and productivity improvements, which have to do with technology.

Jason Cawley September 13, 2007 at 2:13 pm

Anthony,

I understand how you took the proposed sight draft money thought experiment. But as I tried to stress and perhaps need to stress more, someone being free to issue a sight draft in no way obligates somebody else to take that sight draft.

If some particular issuer only ever writes new sight drafts and tries to exchange them for (other, non-money) goods, and never performs the reverse operation of accepting sight drafts from others in exchange for his own other, non-money goods, then everyone who knows about it will simply refuse his sight drafts – the same way you refused any bankrupt’s promissary notes. He can write all he likes, but taking them is voluntary to his counterparty.

You might then suppose the danger of this is so high that no counterparty will take anyone’s sight drafts. But this is not the case. If a merchant of excellent reputation says he will pay you with his bill now, and when his ship comes in you can pay for an equal value of his goods with your own sight draft, there is no reason to prefer another money medium to this arrangement. And if both parties have general enough dealings, the bills of either may circulate as money, without directly crossing. Or they may arrange to clear them by mutual cancelling.

Bills of exchange worked essentially in that way, and were far more efficient than commodity money, from the middle ages to the development of modern deposit banking. It is true they benefitted from an underlying money for clearing, in wider use, whereas the thought experiment involves only sight drafts and various forms of barter.

Of course, if the items being bartered are notes, loans, stock certificates etc on one side of each transaction (“money substitutes”), then most of the gains of avoiding bulk commodity barter are already achieved. The additional qualities of money that make it still more useful are its uniformity and consequent highest liquidity. There may also be a widespread impression that money rather than substitutes involves no risk, but this is a fallacy (money illusion, in fact).

This also illuminates the error, or at least a presumption of it, involved in describing ordinary modern banking as fraud. Leaving aside for a second government stipulations – which are incidentally readily circumvented if people care to, more on that below – there is nothing forcing people to accept the debts of modern banks as money. Any more than the sight drafts of the thought experiment.

If someone does so voluntarily, it is because they in fact benefit by the transaction. They might wish they benefitted even more in some other way, or that other men did not benefit in some way they do, from the practice, but these are “just jawing” – wanting a deal one has already agreed to as profitable to oneself, to have even better terms.

Someone who honestly believes that using bank money does not benefit him, stress on honestly believes, simply would not do so. The pragmatist Peirce taught us that the evidence of belief is the willingness to stake much on a proposition, not the willingness to verbally deliver glib paradoxes. We can watch what men do, and infer what they really believe, in action.

One might object that government requirements e.g. in payment of taxes, require use of modern bank money. But any group with the slightest organizational ability could readily circumvent this in trivial ways. Just have a lawyerly escrowing service that liquidates real property in whatever form is preferred, as needed, to meet tax obligations and only those. It is not like the banks can make the real property actually held instead of money, become not-valuable.

What is really going on is that some are ideologically opposed to modern banking but nevertheless find it beneficial to themselves and engage in it anyway.

As for the claim that banking is a closed industry, it is absurd. You can go buy bank shares in minutes for as little as $50 and presto you are a partner with the banks. They aren’t expensive. As for the claim that one is too ethical to engage in banking, one immediately wonders whether those pretending so have any credit cards or ever write checks. If they do, then they issue gratuitous credit themselves.

Credit is not fraud. If you issue so many IOUs that you can never make them good, go bankrupt, and somehow keep the real assets that flowed to you in return for your paper pledges, then yeah that is fraud. But banks as such do not go bankrupt.

I am well aware that the Austrian charge is that the mere ability to bid for resources without prior savings, itself constitutes a form of fraud, but I utterly deny it. Every entrepeneur does that, whatever form of substitute financing or promises he issues to mobilize resources on his behalf. And when it is successful it is of great public benefit.

Yes it means trading on other people’s trust and turning the strength of one’s word with other people into a real command of real goods, to which no prior service to anyone by anyone (“saving”) corresponds. But that doesn’t make it fraud. Bold, sometimes dangerous, occasionally unsound, involving possible loss to the community as a whole as well to oneself, certainly – but not fraud. It is just the underlying phenomena of real credit, and can no more be abolished than property or profit or interest.

In the era of gold standard money of which Mises was thinking when he wrote the Theory of Money, banks that issued lots of gratuitous credit regularly did go bankrupt in crises – their bankruptcy depending essentially on their promise to repay, on demand, and in gold coin, any of their debts. Typically they were illiquid rather than insolvent, and did possess other goods (money substitutes mostly) that could cover their claims in liquidation – and as a result, even in bank failures many of their creditors could be made whole. But some obviously were not, particularly lenders to the least sound.

Hmm, are lenders to unsound enterprises, financial or otherwise, at any risk in other circumstances? Gee, sure. The illusion is that “depositing money in” a bank is supposed to be riskless and that it isn’t. But that is because (1) nothing is and (2) the actual operation is lending to the bank, and commodity metal money has been exchanged for a bank debt money substitute. The exchange ratio between them need not remain 1.

Anthony reasonable asks what monetary system I think preferable, credit being necessarily unstable but essential to economic freedom. I think there are several workable systems that acknowledge those facts. I am not a perfectionist. I am not advocating free banking, though I do advocate freedom generally. The scale of credit issuance needs to be prudently controlled, but there are multiple ways of trying to reach prudent control over it, institutionally.

A gold exchange standard with credit allowed but prudentially controlled by leading bankers is a possible system. It will involve crises and bank failures, however. I don’t think modern peoples would put up with those, so I don’t expect to see them again, but if the banking actually done under that system was prudent enough, and e.g. bank rate was used countercyclically as Bagehot counseled, it was a livable though imperfect system.

I prefer modern banking. I think we have had monetary authorities who are institutionally too loose, and too given to populist and crank-economic notions from time to time, and that is an evil of the present system. It is also just an evil of the present state of opinion, education, etc. The system is potentially better than its performance over the last 50 years or so, particularly the degree to which it might achieve price stability (if less Keynesian in doctrine and direction etc).

I also think present regulation of financial enterprise is quite poor, and that this partially reflects a moral hazard stemming from too much of it being put in the government’s lap, and not enough being done by voluntary means, by industry bodies and leading bankers.

An example – I was able to look e.g. the financial statements of New Century Financial, the mortgage lender, 5 years ago, and to tell you on simple Graham-Dodd principles and historical experience that this mode of financing was unsound, “bubble” finance, and that the company would not last the cycle. It was insanely aggressive finance and would earn money while the bubble continued but fail catastrophically as soon as it paused. Now, if I could tell that, so could its lenders, in principle. It might have been cut off ages ago.

I see no easy perfect solutions there. But we need not accept the tendency of modern financiers to think anything acceptable and prudent if it is colorably legal and profitable for a single quarter.

I do not believe there are any magical substitutes for better men as officers of important institutions, both public and private. Men are free to screw things up, and responsible for the messes they make. If we have lousy shortsighted bankers we will get lousy finance and misallocated capital.

It would be good to arrange incentive and selection institutions so they do not remain forever, or so failure has consequences. Frankly they do already, it just takes rather too long and the mistakes have to reach an impressive scale before the stables get cleaned.

Jason Cawley September 13, 2007 at 3:16 pm

Though I already addressed some of his points in my previous, I will now speak to Ktibuk’s points in reply to my first series.

You are incorrect that banks promised anything about “safe keeping” under banking systems in which they lent out more than is deposited with them. You are free to get a safe deposit box at a bank and to stuff it with Federal Reserve Notes, or with gold bullion if you prefer, and the bank won’t touch them.

If all you want is safekeeping, you contract with the bank for safekeeping only, not a deposit, and that is what you get. You won’t get interest, you won’t get checking ability against your deposited assets, you won’t get clearing vs. other parties by order entry – but you won’t get those things because you haven’t lent to the bank.

If instead you lend to a bank, you are accepting its debt in return for your money. Now, under old commodity standards, one reason you might be inclined to do so is the bank might offer to exchange its debt back for gold coin on demand, and you might *credit* the bank with an actual ability to perform this. Which it might actually have, and all it well, or might not have, and you have made an error in the estimate of the ability of a borrower to repay you, on contracted terms. He might still be able to repay you in some workout, but without being able to pay as contracted – and that is what typically actually happened in bank failures past. Nevertheless, plenty of banks went through the toughest times and did not fail.

Under fiat money, you aren’t contracting that. If you lend to a bank today, it promises only that you can get federal reserve notes on demand. It promises nothing about the purchasing power those might or might not retain. In practice, interest and the fall in the purchasing power of FRBs have essentially kept pace, though with some temporal variation.

But the reason people use bank debt as money is its liquidity conveniences, not its ability to store value through extended periods of time. Portfolio investment or real productive assets are clearly superior at the latter task, and is what people with anything much to transmit through time actually use.

As for the statement that it “increases the credit stock artifically”, it certainly increases credit outstanding. But what is artificial about it? Or, otherwise put, what is natural about any other form of pure credit? Yes there are credit transactions that are not pure credit, but e.g. buying consumer goods on an installment plan, or paying for anything with a credit card, or funding a business by issuing promissary notes, are actions of precisely the same character. The only difference is that the credit of banks generally stands so high they have less fear of their debts flowing back to them rapidly for repayment. But ask e.g. Countrywide Financial whether debts ever do flow back in that manner.

Mises makes numerous comments about what is possible for all banks as a group if following a uniform and cooperative policy. Yes, gratuitous credit can go a lot farther if those with the most real economic credit uniformly and cooperatively abuse that trust as egregiously as possible, and especially so if that continues for ages without that trust being removed. But this need not happen and in practice does not happen. It is approximated by rather loose central banks as a group, all practicing Keynesian policies, say. But it is not forced by the nature of banking as such.

Again, all credit is created out of thin air, that is what credit is. Yes, rapid credit creation, if more rapid than the increase in real wealth, harms static holders of money balances, particularly if unexpected (since otherwise it is typically compensated by earned interest). If credit creation occurs but is slower than the increase in real wealth it gratuitously benefits holders of static money balances, since over and above any interest they may receive, the exchange value of what they hold also rises.

But the same is true of absolutely every other commodity whose real value changes over time, as the market evolves. If you hold commodity X, you benefit if its real exchange value rises and are harmed if it falls. Money is just another commodity in that respect. We do not call every economic action of anyone anywhere, that changes the exchange value of any other asset of anyone else, theft of that asset. If my invention of a new machine makes your stock in an old company that used a now obsolete process, go down, this does not mean I have committed fraud or stolen your stock.

You have zero a priori right to the present purchasing power of whatever commodities you freely choose to hold. You and only you are fully responsible for any risk and any potential gain that may fall to you through changes in the real value of the commodities you hold, to everyone else.

This is equally true of changes to other economically vital variables, and other factor influences. If another man starts working in your field and lowers the average wage for those with your skill, this does not mean he has robbed you – because you do not own the present exchange value of your skill projected unchanged (or changed only upward like a ratchet) forever. You only deserve the real value of the real usefulness of your services to others.

And the same is true of the commodities you hold. Their real usefulness to others can and does change. You have no a priori right to stipulate that their real value to everyone else shall remain unchanged henceforth forever. You are not being robbed if their real value does change. The government does not merit being enlisted to go chasing after everyone whose actions you think may impair the value of some asset of yours, forbidding their free actions just to save the present exchange value of some commodity you own.

If you don’t like the expected future changes in the exchange value of money, don’t hold great whopping balances in money. You can put all your assets in bank stock and write checks against the brokerage account that holds them for specific transactions, if you like. Then you aren’t being exploited by any imaginary bugbear financiers, you can have the supposed benefits yourself. If you dislike not the side of the transaction you think you are forced into (but in fact are not, as the above amply demonstrates), then you can substitute whatever other line of business you consider promising. Or you can hold commodities and get a futures broker to give you credit against your warehouse receipts.

The average person does not do these things for transactions balances because any loss from inflation exceeding interest for the small amounts he leaves for those, is utterly swamped by the value of the great convenience of using money forms that everyone else uses. They voluntarily prefer the set, gradually devaluing but highly liquid money, for modest balances, to having everything in less liquid forms.

They are therefore *not* wronged by the existence of such transactions. They judge themselves to be benefitted by them.

“I would love to give you one billion dollars of credit. Even on a 1% annual rate.”

Decrying the fact that others possess a real economic credit that you do not, such that their debts are accepted as money and yours are not, is not more defensible than any communist’s screams against earnings from owning property, or any medieval borrowers screams against paying interest.

Credit is as real an economic fact as interest or profit, and pretending that it is illegitimate is as indefensible as assailing either of those. If a man or a company earns something because he has better credit than you do, then you can seek to improve your credit to his level, or you can join or share in his enterprise, or you can leave his gains to him as his own source of fortune.

If you won’t take both sides of a transaction at some price or reward, you are in no position to denounce terms offered as another as unjust. Someone who plans only ever to sell commodity A can scream that it is unjust that its price isn’t twice what the rest of the world decides it should be. But until he “makes a market” by offering to buy it too, his ideas about the fair price can be dismissed as “just jawing”.

There is some degree of economic reward to engaging in credit operations, that suffices to attract capital and talent to those operations, sufficient to supply such services on a scale beneficial to the rest of society. If you claim the rewards to supplying credit services are too high to be morally justified, then by honesty as well as interest, you are obligated to go provide them, risking your own capital. If you are unwilling to do so at present market terms of risk and reward, then you are demanding that the rewards others reap for running risks you will not run, be reduced. Which is unjust.

Either bankers have the easiest job in the world that effortlessly gives them a license to steal, or you are slandering them. If the former, then you are fool to carry bank deposits instead of bank stock. But you cannot twist it any way to being forcefully wronged by them, since you are free to pick which side of the transaction you wish to be on. If it were illegal for you to own bank stock, if the state reserved it to a hereditary nobility as a privilege, then you might conceivably have a legitimate grievance if you were right about the economics involved. Since they don’t, you don’t have a legitimate grievance even if you are right about the economics involved. Your calling them thieves is therefore slander pure and simple, of exactly the same form as the property denunciations of Proudhon or Marx.

Your last line claimed that others “have to hold cash”. They are under no such compulsion. No banker puts a gun to anyone’s head and says “if you don’t hold cash for me to tax through inflation, I’ll kill you”. Holding cash is purely voluntary, and people do it because it confers what they themselves judge to be benefits. Just as no worker “has to” work for money wages from an imaginary exploiter capitalist, and no borrower “has to” borrow from an imaginary exploiter ususer. Voluntary transactions are voluntary, and claiming those providing you a real benefit are antisocial criminals, is itself an antisocial and unjust attidue.

Jason Cawley September 13, 2007 at 4:19 pm

A further point on Ktibuk’s unjustified opinion that only central bank authorities have credit, and his hypothetical wish to issue $1 billion himself, for my benefit, at 1%. I can illustrate the actual constraint and real economic ability involved by taking this literally.

He can present a convincing business plan to the capital markets and issue 100 million shares of stock at $10 each, and take the proceeds and lend them to me at 1% interest. Unfortunately, when I repay him only $10 million in the first year as agreed, his stockholder will get rather upset at the wasteful misuse of their $1 billion, and the value of the shares will not remain where he issued them.

Instead it will fall, if he is lucky stopping between $1 and $2 on the strength of my actually paying the interest. But more likely, further still, based on a justified opinion that he has had my interests in mind and not his new stockholders’ interests, throughout the entire transaction. He will emphatically not be able to issue anything more after such a performance. The slightest hint that it was the original intention would prevent the entire affair from ever getting off the ground.

Why does this happen? Because credit issuance justifies itself by the use of the capital so deployed being really justified economically. If it isn’t, real value is destroyed. If it is but fraud is actually practiced on the creditors involved, then real assets are moved (from purchasers of the stock to me in the above example, from bank despositers to lendees, potentially, in interested bank mislending). But the mere raising of the capital one promises is not fraud, and it is open to anybody to try it.

Banks are marked by their superior ability to market their debts, because those are so trusted they act as money. But that trust is a real economic fact, with real economic antecedents, and it is a creature of the bank’s continuing to act in ways that merit that original trust. Including allocating loans sensibly, not senselessly, and increasing its outstanding debts sensibly and sustainably, not as some ponzi scheme.

Jason Cawley September 13, 2007 at 6:33 pm

Now to reply to Fundamentalist, my most learned critic.

“Mises was smarter than you give him credit for being.”

You have no clue where I rate Mises intellectually. He not only makes recommendations about gold, he also analyzes how fiat money functions. Since we actually live with the latter, his remarks on it are decidedly more important. He regards any issuance of fiduciary media as dangerous, and a fiat money system that issues no new fiduciary media (leaving it fixed) is necessarily committed not to price stability but to deflation – and not a gradual deflation I might add. It is in fact tighter than a gold standard. Since he admits that price stability is better than a continually changing exchange value of money, he is stuck with simultaneous mutually incompatible recommendations. That they are incompatible should be a clue that his analysis of the supposedly horrible effects of any issue of new fiduciary media are overblown, and actually arise only from overissue, sufficient to cause inflation.

As for rates of money growth, obviously it depends on the measure used and on the time period. The lower figure I gave is correct for M2 – 6.87% from 1959 to now, 5.65% from 1982 to now, 6.16% from 2000 to now, etc.

“He claims at one point that investments with the shortest lifetimes always have the highest returns, and that longer date investments are only made after all shorter ones are exhausted.”

“Read it again.Mises does not write that.”

I’ve read in n times, and it says exactly what I claim it says. It is flat wrong, it is downright silly, but it is right there in black and white and von Mises wrote it. It is a scandal, but it is what he said. Worse, Hayek who definitely knew better repeated the error in correspondance with Keynes, when pressed to explain the precise mechanism whereby misallocation was supposed to result in real value loss. Misallocation does result in real value loss. But the Keynesians may be forgiven for not having believed the Austrians on the point, because the latter argued their case with an utterly worthless argument. The right cause and the good argument do not always coincide, and here they emphatically did not.

“He shows that when interest rates are lowered artificially, that the shorter term investments earn the highest rate of return.”

Except this is utter nonsense, nothing of the kind happens. In fact, when rates fall below levels that are sustainable, and while they are below their equilibrium level, it is precisely the assets with the longest income streams most heavily weighted to distant future cash flows, that rise the most in present value terms. A 30 year zero coupon cash flow will rise 120 times as much as a single quarter bill. The same is true of any business with cash flows so structured, if the new low rates are believed. It is in reality precisely the (eventually) unjustified scramble into long dated assets during the boom, that constitutes the capital misallocation. The whole society trades more present income for future income, than actual time preferences would support. It overinvests, and some of the overinvestment will end up worth less than what was sacrificed to make create it.

The schedule used to decide on investments is return and not period, but when rates are forecast to be lower, the returns for investment that pay over long periods of time look higher, than they look when forecast rates are lower.

Mises and repeating him Hayek both claimed that investment in capital goods proceeds from short term to long term, as a way of trying to mix together their idea of a wage-fund style limit to total investment, with their correct appreciation that too much goes to long dated assets in the boom. They therefore conflated the quantity of total investment with its composition.

To get them to move in direct relation, they argued, quite falsely, that returns on investment are highest in the shortest lived assets, so that the whole society only invests in 10 year long items after it has exhausted the more profitable 9 year long ones, and so forth. They wanted to equate the extension in average capital life that an increased total value of capital stock involves, with the process of picking down through possible investments from highest returns to lowest, which is the real schedule of investment priorities.

But this is a flat error. It is utterly false that the shortest investments give the highest returns, either simply, or when rates move lower than their free market equilibrium level. Some short investments have high returns and will be done earlier in the process of societal capital accumulation (gather food), others very late (make iced lattes). Some long dated investments will be made early (create elementary shelter, build basic tools), others very late (launch satellites).

In addition, they argued from a too mechanical assumption about investment being undertaken and the value of invested capital rising. In fact the value of installed capital fluctuates with every change in the market. If capital gains from revaluation of assets are considered income, then one can say savings passively occur whenever long dated claims rise in present value through rate decreases. Just lowering rates will raise the present value of identical future cash flows by huge amounts, generating “savings” of out thin air by generating “capital income” out of thin air.

But the problem then is not that investment is made without savings to match (because if those gains are included, they will and to spare), but that later, when unsustainable rates reverse themselves and rise, income plummets through capital losses to long dated assets. Notice that this form of the cycle would occur even if there were no fiduciary anything involved, even if savings and investment matched each other exactly throughout, etc. All that is necessary is that interest rates move, because by definition a rate that moves is not permanently at a sustainable level.

If instead one excludes the capital account fluctuations occasioned directly by rate changes affecting present values of unchanged future cash flows, from income, then the theoretical (explanatory) cost is that no direct relation need remain between savings and changes in the value of the capital stock. Because the first derivative of the value of capital is not dominated by new savings inputs, but by changes to the value of existing assets as conditions shift, rendering them better or worst adapted to the new state of the market (including both rates and demand etc).

And in that case, if a new issuance of gratuitous credit shifts existing capital assets to uses that wind up working out and thus creating capital gains, that issuance will justify itself, without need for prior savings. If not, then it won’t justify itself. But this is the relation automatically present whenever capital is deployed. If the use is sensible, it remains “capital”. If the use is senseless, the *value* (not the plant etc) evaporates.

So we are left with the true cause of the cycle, partially diagnosed by the Austrians but explained with a mixture of true and falsehood – that misallocation of capital through poor investment decisions, spurred by miscalculations that any false price signal can create, but that are particularly potent when it is a matter of interest rate forecast error, because that effects all long dated assets and does so in large ways.

Has the Fed made errors? Sure. So have private bankers, traders, and merchants. Without regulated restraint of the money supply, they would undoubtedly make even larger ones. They did in the past, long before the Fed existed. They would again even if it did not. The largest error the Fed ever made was not its period of greatest looseness but that of its greatest tightness, when it let the money supply drop 30% in the face of collapsing world trade etc.

It has made errors in both directions since then, but definitely more often on the side of looseness. Very often it has been too complacent about credit growth because items it was regulating or tracking closely were well behaved, while new money substitutes found by creative finance were burgeoning and barging without restraint. As for who made the *first* error, the canonical answer is Eve, as I recall. But economic life does not have an original sin. Instead it has lots of fallible actors each responsible for their own actions, every one of whom can and does frequently screw the pooch, royally. In part because the economy simply has a difficult allocation problem to solve, and in part because men can be short sighted, vain, pig ignorant, etc.

And I am not forgeting what Hayek traced incompatible future plans, to. But the notion widely peddled by libertarians that only government officials make mistakes is laughable on its face, as is the idea that only they have sufficient power to mess things up on a large scale, or the idea that they should be held to a perfectionist standard – that is all nonsense and always has been. Hayek got it right when he instead argued that freedom is superior to planning for the information it mobilizes, but further that we accept the costs of error and the insecurities in brings for the sake of freedom and the higher values freedom brings in its train, and not because of any imaginary perfection in market outcomes.

And I am sorry, but even if new investment comes from savings, plenty of projects can and do become incompatible. There is no substitute for good finance, and good finance is not a morality tale in which never going into debt is the saintly high road to perfection. As for the difficulties occasioned by competing for scarce resources, inflation is the signal of that getting out of hand. And business and sectors always compete for scarce resources; we depend on it to allocated capital rationally. None of that is the problem. The problem is the wrong investments being made, because the long dated ones look like they can’t miss when rates are falling, and this lets poor investments through.”

“If investors and businessmen made mistakes on their own, the mistakes and successes would be randomly distributed across time and industries.”

Sorry, that is pure ipse dixit. You say it so it must be so. It is false empirically. Not only under Fed governership but in general. It is also belied by any close analysis of the interconnectedness of the economic system. Trend following is popular because it can work for short enough periods and drastically reduces the cleverness required to deploy capital. Fads exist. Market psychology exists. Overvaluation of stocks allows overfunding of dubious ventures. Easy money is freely spent, and seeking to sop up free spending positions other supplies right where the demand is likely to prove the most ephemeral.

The economic system contains restoring forces, yes, and can correct its errors eventually. It offers sizable rewards to those who correct widespread errors, if they are brave enough, right enough about the timing, and have the wherewithal to remain solvent longer than the market remains wrong. But it has none of the inherent stability of a pure Gaussian independent randomness. It is shot through with feedbacks and autocorrelation. In shorthand we simple say, “the credit system is inherently unstable”. So we get booms and busts – we got them before modern banking and they are not going to disappear. We may manage them better, we might moderate their amplitude, etc. But they are not the readily correctable byproduct of a simply stupid policy or institutions. That is as crank an idea as the contrary inflationist fallacy, that we could all be rich if we could just counterfeit enough.

Beware of men who argue that economic realities have been demonstrated in the books of their school, especially when worded in the subjunctive. That is called ipse dixit reasoning, or it is advocacy. Economic realities are demonstrated, or better evidence is found for them, in the real world. In the real world, mild inflation has generally proved better for economies than mild deflation (ask the Japanese), though there have been successful periods of either. Both have proven better than unmild versions of either. Unmild versions of deflation are easily the greatest catastrophes on economic record.

Inflation hurts savers if savers save in money or fixed denomination debt. Even this can be overstated because rates soon compensate, though not without some loss, especially to those lending long before the inflation was expected. Deflation hurts debtors absolutely. There is no doubt whatever that debtors being numerically larger than lenders, plus democratic governments, are the prime reason that inflation is more popular and common in practice, than deflation. The diagnosed cause also puts paid any schemes for simply reversing this by publishing a tract exclaiming the supposed virtues of deliberately supporting the financial fortunes of the less numerous and wealthier group. When pigs fly. Mises was enough of a realist to acknowledge that the cause of present monetary policies are political and not simply wonk-policy issues.

Price stability is a better target, is better justified economically as Mises himself showed, and is much more feasible, politically and institutionally.

Anthony September 13, 2007 at 6:34 pm

Jason, thanks for your further comments. I agree with your points on voluntarily-driven market regulation.

scott t September 13, 2007 at 7:20 pm

” Gold was the monetary standard in most countries until 1914, or even until the 1930s. Furthermore, gold was the standard when the U.S. government in 1933 confiscated the gold of all American citizens and abandoned gold redeemability of the dollar, supposedly only for the duration of the depression emergency.”
http://mises.org/daily/1503
this doesnt sound like voluntary-driven market regulation.

“The economic system contains restoring forces, yes, and can correct its errors eventually”
well..yeah, of course – life goes on. but why did the us government confiscate gold in teh first place?

“So we get booms and busts – we got them before modern banking and they are not going to disappear.”

weren’t the previous booms and busts simply using earlier versions of modern banking techniques?

except if say, spain had to invest in mining equipment exploration and instead of slaughtering natives and shuttling gold back to europe – would the same level of inflation (boom/bust) have taken place?

Jason Cawley September 13, 2007 at 9:25 pm

I promise to address Scott’s questions in a moment, but first I have one piece of unfinished business with Fundamentalist. I have to substantiate my claim that Mises made the mistake of conflating the allocation of capital down through the scale of potential returns, with the allocation of capital across uses with different terms.

My source if the Theory of Money and Credit, liberty classics edition, page 399-400. If your pagination is different, the chapter is the one of Money, Credit, and Interest and the subsection is the 4th, the influence of the interest policy of the credit issuing banks on production.

Immediately preceeding the critical passage, Mises puts forth a version of the wages fund theory, citing Bohm Bawerk on an important subsidiary point (that if workers are not provided for through the whole period of production, and “the consequence would be an urgent offer of the unemployment (sic) economic factors”).

He then proceeds to explain that and why the entrepeneurs can only extend total investment by entering on more roundabout processes of production. (Hence my earlier reference to capital intensity, as an aside). And writes, first -

“It is true that longer roundabout processes of production may yield an absolutely greater return than shorter processes; but the return from them is relatively smaller, since although continual lengthening of the capitalistic process of production does lead to continually increasing returns, after a certain point is reached the increments themselves are of decreasing amount.”

Here the overall quantity (with physical or by value left horribly unspecified) of capital being employed is clearly regarded as proceeding down a marginal series. The increments are to total capital and there are decreasing marginal returns. But he has already conflated the total quantity, through the wage fund idea, to an average total length of production. He is therefore already dangerously close to claiming that shorter means higher marginal return.

He continues -

“Every new roundabout process of production that is started must be more roundabout that those already started; new roundabout processes that are shorter than those already started are not available, for capital is of course always invested in the shortest available roundabout processes of production, because they yield the greatest returns. It is only when all the short roundabout processes of production have been appropriated that capital is employed in longer ones.”

One scarcely recognizes an economist of the stature of von Mises in these passages. The wage funds theory morass has simply swallowed him, and transformed the sensible expected yield schedule of possible capital investments, into a schedule rigorously arranged from short investments to longer ones, such that all the shorter ones have higher marginal returns than any longer one, and therefore no longer ones are entered on until all shorter ones are exhausted.

Nor is this a simple oversight and readily removable. Without it, the entire wages fund argument collapses. As soon as it is admitted that some of the new investments that might be made possible by a lower than clearing rate of interest, might actually be shorter than the present average length of production, it ceases to be necessary that an increase in the quantity of capital employed, corresponds to a longer schedule of real arrival of the stream of goods.

Capital intensity is distinct from capital duration. And there is no time of arrival ordering of the schedule of investments.

More, the underlying fallacy can be easily spotted. The average period of production is an arithmetical artifact of a whole sum of individual valuations of a whole series of processes. The items being summed are not quantities but momentary valuations at one set of prices, and moreover valuations created by discounting projected future flows at some momentary rate of interest (or curve).

Additional capital value can be invested in ways that will arrive in 30 days or in ways that arrive in 40 years, or anything in between. It has many internal degrees of freedom, and is not determined by the total value of invested capital.

The divisor that is supposed to reduce this diverse set of cash flows to a single number and that with the units of a time, is supposed to be the cost of employing the workers per unit time. This is the wage fund theory in all its … well, you pick a word. But if this is a value, not a physical quantity, why is this expected to be fixed? See the Bohm Bawerk citation above, where a possible change showing one is not at equilibrium is just dropped.

Later he shows that he understands the wages fund theory in a physical sense – he speaks of a possible peril to human existence, as though while everyone was trying to build the tower of Babel, the food runs out and everyone starves to death. He admits that price changes will save the day and keep it from being that drastic. The change he has in mind is the price of consumer goods rising – that the wages of the workers might fall in real terms is not mentioned as a possibility.

Then at the end of page 401, we get a further whopper. After describing the countermovement as demand for consumer goods rises and that for producer goods falls, he say “that is, the rate of interest on loans rises again”. Here we have a clear conflation of relative prices of consumer goods and production goods, with the rate of interest. As though the interest rate were the ratio of the PPI and CPI series.

The Austrians were right to diagnose the cause of loss in the cycle as misallocation of capital, and to see that this misallocation becomes real during the boom and not in the slump, that the slump is repairing past errors and acknowledging and adjusting to their cost, that permanent “goosed” boom is impossible, and that keeping the rate of interest below its equilibrium level causes capital misallocation and if sustained long enough, inflation. But they were quite wrong about the transmission mechanism and the specific constraints involved, which are not of this mechanical nature.

Misallocated capital does its damage by failing to produce the returns expected of it, because it is misaligned with people’s actual schedule of demand. That reduces the real income of the whole community below what it could have been with proper application of the capital. The problem is not that everything will run out and everyone will starve if too much is invested. It is that what is being invested is being aimed quite poorly.

Note that Hayek repeated many of these errors in his correspondance with Keynes in the 30s. I think Hayek knew better later on, and his discussions of the importance of information and plan compatibility is a sounder analysis of the real forces making for loss in the cycle, than the wages fund theory.

I hope this is interesting, at least to some. At any rate, the above shows, I believe, where Mises can be found baldly stating that shorter investments are always more profitable than longer ones and are always filled first. His “all”s are unambiguous. Homer nods, and a cat can look at a king – I am not claiming any general superiority to a great economist. He is certainly not alone in this – you can find worse in Keynes on every other page. But there it is – on an absolutely vital point, the man just wrote nonsense.

Jason Cawley September 13, 2007 at 9:53 pm

“this doesnt sound like voluntary-driven market regulation”

Straw man. The prior comment referred to my preferences to regulating modern fiat banking. You might as readily pretend that anyone who says you should vote in the next US election is advocating war with Great Britain.

As for why the US went off gold in the first place, I thought that was tolerably well known. We had a gold standard. It was managed very badly after WW I, becoming a gold exchange standard and then falling apart as leading states tore into each other. There are plenty of bloody preliminaries in Mises and more in Kindleberger (my personal favorite is the French government demanding Austria renounce the customs union with Germany as a condition for saving its banking system, and the height of the run on central Europe).

The legal side of it was rigid enough that the Fed reduced the money supply 30% in less than 2 years in response to foreign withdrawals of gold, because the rules of the system said it had to keep a definite mechanical relationship between total bank deposits and gold in its vaults. That nearly destroyed capitalism and with it freedom in the modern world. France stayed on gold, everyone else left it.

It would have been better to have left gold legal even after convertibility to it was removed. Obviously the reason it wasn’t is the government feared the new monetary regime might not take, and the banks might instead lose the ability to market their debts, which would sink the money supply down to the coins in country, or oh about another factor of 3 or 4, say. Might have managed to get the unemployment rate clear up to 50% that way, wouldn’t that be great?

But it was a frankly coercive and emergency measure, dubious even at the time, clearly unjust and unnecessary by ten years later etc. So what? Anybody can own gold now and lots do, it has a nice rate against FRBs. But it isn’t money. Bank debt is. You don’t need to like it for it to be so.

As for earlier booms and busts, see Kindleberger for chapter and verse. There are two constants – one, speculation can focus on anything and get as absurd as you please. And two, financiers will play with what counts as money, always have always will, states will play too but are not essential to any of it.

You can find hyperinflations with pure metallic money (Rome had one), you can find paper towers before there were banks (through chains of bills of exchange), you can find whole bubbles financed with nothing more than post dated checks. Rome didn’t have to do anything more, when it wanted to inflate, that debase the currency by alloying – the silver content of the denarius fell by a factor of 45 over 200 years.

If you find yourself in a country or time with a money that does not preserve value through time, do not hold savings in money. Put your wealth instead in productive enterprise and real property. This isn’t rocket science, every decent merchant has known it throughout history.

Yes we can demand better finance, but we need not pretend we are helpless. It is false as well as degrading. You don’t have to stand around waiting for somebody else’s permission to handle wealth soundly. Practical action as financiers ourselves is more useful. If you think modern banks have an outrageously great deal, fine, there they are, go invest in them, instead of lending to them.

TLWP Sam September 14, 2007 at 12:32 am

Wow your last post was perhaps the best one I have read yet on this site Jason Cawley!

scott t September 14, 2007 at 1:38 am

ipse dixit?

“Anybody can own gold now and lots do, it has a nice rate against FRBs. But it isn’t money.”

so if i give gold to someone and they give me somethig in return – would it be money then?

Fundamentalist September 14, 2007 at 8:03 am

Jason,
One of us doesn’t understand Hayek and Mises at all. I’ll leave it to others to decide which.

Thomas Benjamin September 14, 2007 at 9:59 pm

Jason, You have made many, many interesting points in your recent comments. Thank you. I do, however question the claim that credit is always created out of ‘nothing’. If one takes this very general definition of ‘credit’, i.e. that credit is the exchange (exchange in the Misean sense) of present ‘X’ for future ‘Y’, ‘X’ and ‘Y’ being ‘somethings’ (if one assumes that either ‘X’ or ‘Y’ is ‘nothing’, then its counterpart is a free gift, but I think it is safe to assume that all giving is value-for- value exchange of some sort so that if the gift appears free, you should look for the actual value it is exchanged for) agreed upon by the parties involved and that all debt is actually collateralized debt, collateralized by either personal property, real property, or future production (think of the last personal loan you took out–think of the information you provided on the application–If you had no way in the future to return the present goods given, do you think those who would loan you the present goods actually loan them to you?). If this is a good (and correct) definition of credit then credit is not created out of ‘nothing’ but out of an exchange of a present ‘X’ for a future ‘Y’, whatever the ‘X’ and ‘Y’ might be. A better question, I think, ktibuk should have asked, is if, in a completely free market, banks might not be superfluous. Since all it takes to create credit is the exchange of present value for future value by agreement of the parties involved, the written exchange agreement made negotiable (ah, but this is just the ‘bill of exchange’, yes?) one could (and historically did, as you and Fundamentalist correctly pointed out) use these bills of exchange as fiduciary money (though the better way, in my opinion is, if one agrees with the notion that all debts are collateralized by something, is to issue security interest certificates based on the appraised value of the collateral and use that as ‘money’…). It would be up to the commercial enterprise known as a ‘bank’ to show to the market participants that it was superior to the other market participants in ascertaining risk of nonpayment, marketing either the bills of exchange or the security interest certificates, etc. If it could not, then of course no one would patronize that particular enterprise. The ‘fraud’ that ktibuk is reaching for, I think, is illusion that banks are absolutely necessary to the process of credit creation when in fact they are not. In fact, banks are only necessary when warehousing a medium of exchange (historically, commodity money). That is where, at least I understand the Austrian School to say, all the problems begin….

ktibuk September 15, 2007 at 6:39 am

You can not lend out what you dont have and credit can not be given to anybody without saving it first.

If anybody thinks credit can be created out of thin air, without saving it first, either they live in a dream world or they are frauds.

Economy is economy even without the money, all the rules of production, trade, valuation are the same.

What Jason thinks happens can not happen in a barter economy, and if it can be done in a money economy this means money has magical powers besides being a medium of exchange.

And if there is something as overwhelming your opponent with ignorance and absurdity it is this.

Very very long, incoherent posts riddled with absurdities only possible in imaginary fairylands.

Fundamentalist September 15, 2007 at 9:48 am

ktibuk: “it can be done in a money economy this means money has magical powers besides being a medium of exchange.”

Very good point! If people would consider how a theory would work in barter it would stop a lot of dumb theories in their tracks.

Fundamentalist September 15, 2007 at 11:18 am

Jason: “One scarcely recognizes an economist of the stature of von Mises in these passages. The wage funds theory morass has simply swallowed him, and transformed the sensible expected yield schedule of possible capital investments, into a schedule rigorously arranged from short investments to longer ones, such that all the shorter ones have higher marginal returns than any longer one, and therefore no longer ones are entered on until all shorter ones are exhausted.”

For anyone interested, the “offending” passages to which Jason refers are online at http://mises.org/books/Theory_Money_Credit/Part3_Ch19.aspx.

Mises is writing about the “roundaboutness” of production processes, which refers to production processes that take a greater amount of time from input to output, but at the same time produce a greater output.

In the passage Mises is describing why business people must choose more “roundabout”, or longer processes of production, when the interest rate falls. Mises writes “But every new roundabout process of production that is started must be more roundabout than those already started; new roundabout processes that are shorter than those already started are not available, for capital is of course always invested in the shortest available roundabout processes of production, because they yield the greatest returns.”

Why would shorter production processes yield greater returns than longer ones at the same interest rate? Say two people invest $100 with a promise of an absolute return of $10 at the end of the production process. A’s process takes six months and B’s takes a year. What is the rate of return on each? B earns 10% on his investment for one year, but A earns 20%, because his took half the time to complete. Now if the prevailing interest rate is 15%, which businessman will make a profit, assuming all the money was borrowed. That’s really all Mises is saying.

Jason: “Here we have a clear conflation of relative prices of consumer goods and production goods, with the rate of interest.”

Mises explains it himself in the next paragraph: “At first the banks may try to oppose these two tendencies that counteract their interest policy by continually reducing the rate of interest charged for loans and forcing fresh quantities of fiduciary media into circulation. But the more they thus increase the stock of money in the broader sense, the more quickly does the value of money fall, and the stronger is its countereffect on the rate of interest. However much the banks may endeavor to extend their credit circulation, they cannot stop the rise in the rate of interest. Even if they were prepared to go on increasing the quantity of fiduciary media until further increase was no longer possible…”

Jason doesn’t seem to understand that price inflation and interest rates are related. “Rising prices” is the flip side of “devalued money”. When the value of money falls, banks must raise their interest rates or see their real income fall. Mises never has “conflated” interest rates with the prices of goods, but merely explains that rising prices eventually cause interest rates to rise.

Mises’s writing style can be difficult to navigate sometimes, but it seems to have drowned Jason. Anyone who wants to bother can read the passages for themselves and see that Jason simply doesn’t get it.

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