The Austrian School of Economics

Posted by PITHOCRATES - March 3rd, 2014

Economics 101

(Originally published February 27th, 2012)

Because of the Unpredictable Human Element in all Economic Exchanges the Austrian School is more Laissez-Faire

Name some of the great inventions economists gave us.  The computer?  The Internet?  The cell phone?  The car?  The jumbo jet?  Television?  Air conditioning?  The automatic dishwasher?  No.  Amazingly, economists did not invent any of these brilliant inventions.  And economists didn’t predict any of these inventions.  Not a one.  Despite how brilliant they are.  Well, brilliant by their standard.  In their particular field.  For economists really aren’t that smart.  Their ‘expertise’ is in the realm of the social sciences.  The faux sciences where people try to quantify the unquantifiable.  Using mathematical equations to explain and predict human behavior.  Which is what economists do.  Especially Keynesian economists.  Who think they are smarter than people.  And markets.

But there is a school of economic thought that doesn’t believe we can quantify human activity.  The Austrian school.  Where Austrian economics began.  In Vienna.  Where the great Austrian economists gathered.  Carl Menger.  Ludwig von Mises.  And Friedrich Hayek.  To name a few.  Who understood that economics is the sum total of millions of people making individual human decisions.  Human being key.  And why we can’t reduce economics down to a set of mathematical equations.  Because you can’t quantify human behavior.  Contrary to what the Keynesians believe.  Which is why these two schools are at odds with each other.  With people even donning the personas of Keynes and Hayek to engage in economic debate.

Keynesian economics is more mainstream than the Austrian school.  Because it calls for the government to interfere with market forces.  To manipulate them.  To make markets produce different results from those they would have if left alone.  Something governments love to do.  Especially if it calls for taxing and spending.  Which Keynesian economics highly encourage.  To fix market ‘failures’.  And recessions.  By contrast, because of the unpredictable human element in all economic exchanges, the Austrian school is more laissez-faire.  They believe more in the separation of the government from things economic.  Economic exchanges are best left to the invisible hand.  What Adam Smith called the sum total of the millions of human decisions made by millions of people.  Who are maximizing their own economic well being.  And when we do we maximize the economic well being of the economy as a whole.  For the Austrian economist does not believe he or she is smarter than people.  Or markets.  Which is why an economist never gave us any brilliant invention.  Nor did their equations predict any inventor inventing a great invention.  And why economists have day jobs.  For if they were as brilliant and prophetic as they claim to be they could see into the future and know which stocks to buy to get rich so they could give up their day jobs.  When they’re able to do that we should start listening to them.  But not before.

Low Interest Rates cause Malinvestment and Speculation which puts Banks in Danger of Financial Collapse

Keynesian economics really took off with central banking.  And fractional reserve banking.  Monetary tools to control the money supply.  That in the Keynesian world was supposed to end business cycles and recessions as we knew them.  The Austrian school argues that using these monetary tools only distorts the business cycle.  And makes recessions worse.  Here’s how it works.  The central bank lowers interest rates by increasing the money supply (via open market transactions, lowering reserve requirements in fractional reserve banking or by printing money).  Lower interest rates encourage people to borrow money to buy houses, cars, kitchen appliances, home theater systems, etc.  This new economic activity encourages businesses to hire new workers to meet the new demand.  Ergo, recession over.  Simple math, right?  Only there’s a bit of a problem.  Some of our worst recessions have come during the era of Keynesian economics.  Including the worst recession of all time.  The Great Depression.  Which proves the Austrian point that the use of Keynesian policies to end recessions only makes recessions worse.  (Economists debate the causes of the Great Depression to this day.  Understanding the causes is not the point here.  The point is that it happened.  When recessions were supposed to be a thing of the past when using Keynesian policies.)

The problem is that these are not real economic expansions.  They’re artificial ones.  Created by cheap credit.  Which the central bank creates by forcing interest rates below actual market interest rates.  Which causes a whole host of problems.  In particular corrupting the banking system.  Banks offer interest rates to encourage people to save their money for future use (like retirement) instead of spending it in the here and now.  This is where savings (or investment capital) come from.  Banks pay depositors interest on their deposits.  And then loan out this money to others who need investment capital to start businesses.  To expand businesses.  To buy businesses.  Whatever.  They borrow money to invest so they can expand economic activity.  And make more profits.

But investment capital from savings is different from investment capital from an expansion of the money supply.  Because businesses will act as if the trend has shifted from consumption (spending now) to investment (spending later).  So they borrow to expand operations.  All because of the false signal of the artificially low interest rates.  They borrow money.  Over-invest.  And make bad investments.  Even speculate.  What Austrians call malinvestments.  But there was no shift from consumption to investment.  Savings haven’t increased.  In fact, with all those new loans on the books the banks see a shift in the other direction.  Because they have loaned out more money while the savings rate of their depositors did not change.  Which produced on their books a reduction in the net savings rate.  Leaving them more dangerously leveraged than before the credit expansion.  Also, those lower interest rates also decrease the interest rate on savings accounts.  Discouraging people from saving their money.  Which further reduces the savings rate of depositors.  Finally, those lower interest rates reduce the income stream on their loans.  Leaving them even more dangerously leveraged.  Putting them at risk of financial collapse should many of their loans go bad.

Keynesian Economics is more about Power whereas the Austrian School is more about Economics

These artificially low interest rates fuel malinvestment and speculation.  Cheap credit has everyone, flush with borrowed funds, bidding up prices (real estate, construction, machinery, raw material, etc.).  This alters the natural order of things.  The automatic pricing mechanism of the free market.  And reallocates resources to these higher prices.  Away from where the market would have otherwise directed them.  Creating great shortages and high prices in some areas.  And great surpluses of stuff no one wants to buy at any price in other areas.  Sort of like those Soviet stores full of stuff no one wanted to buy while people stood in lines for hours to buy toilet paper and soap.  (But not quite that bad.)  Then comes the day when all those investments don’t produce any returns.  Which leaves these businesses, investors and speculators with a lot of debt with no income stream to pay for it.  They drove up prices.  Created great asset bubbles.  Overbuilt their capacity.  Bought assets at such high prices that they’ll never realize a gain from them.  They know what’s coming next.  And in some darkened office someone pours a glass of scotch and murmurs, “My God, what have we done?”

The central bank may try to delay this day of reckoning.  By keeping interest rates low.  But that only allows asset bubbles to get bigger.  Making the inevitable correction more painful.  But eventually the central bank has to step in and raise interest rates.  Because all of that ‘bidding up of prices’ finally makes its way down to the consumer level.  And sparks off some nasty inflation.  So rates go up.  Credit becomes more expensive.  Often leaving businesses and speculators to try and refinance bad debt at higher rates.  Debt that has no income stream to pay for it.  Either forcing business to cut costs elsewhere.  Or file bankruptcy.  Which ripples through the banking system.  Causing a lot of those highly leveraged banks to fail with them.  Thus making the resulting recession far more painful and more long-lasting than necessary.  Thanks to Keynesian economics.  At least, according to the Austrian school.  And much of the last century of history.

The Austrian school believes the market should determine interest rates.  Not central bankers.  They’re not big fans of fractional reserve banking, either.  Which only empowers central bankers to cause all of their mischief.  Which is why Keynesians don’t like Austrians.  Because Keynesians, and politicians, like that power.  For they believe that they are smarter than the people making economic exchanges.  Smarter than the market.  And they just love having control over all of that money.  Which comes in pretty handy when playing politics.  Which is ultimately the goal of Keynesian economics.  Whereas the Austrian school is more about economics.

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Spain is Taking Center Stage in the Eurozone Crisis

Posted by PITHOCRATES - May 5th, 2012

Week in Review

To be a generous welfare state requires one of two things.  Either a population making babies like bunnies.  To keep the base of the pyramid of the welfare state expanding greater than the top.  Or a booming economy that showers money onto the treasury.  If you have neither than you better have good credit (see Spanish borrowing costs to jump at auction, bank buying eyed by Paul Day posted 5/3/2012 on Reuters).

Spain has jumped to the forefront of the euro zone debt crisis due to concern over its public deficit and shrinking economy and pressure is growing for a plan to recapitalize its banks, which are burdened with bad debts from a property market crash…

Spanish banks, virtually cut out of wholesale debt markets after losing billions since a decade-long property bubble burst in 2008, snapped up cash the European Central Bank pumped into the euro zone banking system in December and February, in operations totaling more than a trillion euros.

Recent data from the Bank of Spain suggests that they used a portion of the ECB’s ultra-cheap three-year money to buy up high-yielding sovereign debt.

According to the central bank, Spanish lenders held just over 13 percent of domestic debt in November 2011, but that total soared to almost 30 percent by March. Non-residents held almost 56 percent of all Spanish debt in November, but by March, that proportion had fallen to 38.8 percent.

Spain has neither a population boom nor an economic boom.  Nor is her credit looking all that good.  Which does not bode well for the Eurozone. 

Too many countries look to the housing market as the panacea for all that ills an economy.  Keep money cheap to borrow.  To encourage people to borrow.  So they can borrow.  And buy overvalued houses.  This is the kind of government Keynesian tinkering that never ends well.  And there are so many examples in history you’d think we’d have learned this lesson by now.  Japan, Ireland, Spain and the United States.  And now even China is growing a little housing bubble of their own.  Bubbles are not good.  They are artificial economic growth.  And they always pop.  Just ask our good friends in Japan, Ireland, Spain and the United States.

And when those bubbles pop recessions set in.  To correct all of those overvalued prices.  There’s deflation.  Old debt that becomes impossible to repay.  So banks fail.  Just because government Keynesians had to tinker.  Playing with interest rates.  To keep them below what the market would have them.  It was good on the upside.  Great new government spending and benefits.  Which have to go away on the downside.  Because there isn’t the robust economic activity to pay for it.  Even the interest on the debt becomes difficult to pay.  And because all of this is in play no one wants to buy their sovereign debt anymore.  Which raises the interest they must pay on new debt to retire old debt.  And the vicious cycle just continues.

Trying to fix the debt problem is looking at a system and not the disease.  The disease is the welfare state.  And until they cut that spending the debt problem will never go away.

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The Austrian School of Economics

Posted by PITHOCRATES - February 27th, 2012

Economics 101

Because of the Unpredictable Human Element in all Economic Exchanges the Austrian School is more Laissez-Faire

Name some of the great inventions economists gave us.  The computer?  The Internet?  The cell phone?  The car?  The jumbo jet?  Television?  Air conditioning?  The automatic dishwasher?  No.  Amazingly, economists did not invent any of these brilliant inventions.  And economists didn’t predict any of these inventions.  Not a one.  Despite how brilliant they are.  Well, brilliant by their standard.  In their particular field.  For economists really aren’t that smart.  Their ‘expertise’ is in the realm of the social sciences.  The faux sciences where people try to quantify the unquantifiable.  Using mathematical equations to explain and predict human behavior.  Which is what economists do.  Especially Keynesian economists.  Who think they are smarter than people.  And markets.

But there is a school of economic thought that doesn’t believe we can quantify human activity.  The Austrian school.  Where Austrian economics began.  In Vienna.  Where the great Austrian economists gathered.  Carl Menger.  Ludwig von Mises.  And Friedrich Hayek.  To name a few.  Who understood that economics is the sum total of millions of people making individual human decisions.  Human being key.  And why we can’t reduce economics down to a set of mathematical equations.  Because you can’t quantify human behavior.  Contrary to what the Keynesians believe.  Which is why these two schools are at odds with each other.  With people even donning the personas of Keynes and Hayek to engage in economic debate.

Keynesian economics is more mainstream than the Austrian school.  Because it calls for the government to interfere with market forces.  To manipulate them.  To make markets produce different results from those they would have if left alone.  Something governments love to do.  Especially if it calls for taxing and spending.  Which Keynesian economics highly encourage.  To fix market ‘failures’.  And recessions.  By contrast, because of the unpredictable human element in all economic exchanges, the Austrian school is more laissez-faire.  They believe more in the separation of the government from things economic.  Economic exchanges are best left to the invisible hand.  What Adam Smith called the sum total of the millions of human decisions made by millions of people.  Who are maximizing their own economic well being.  And when we do we maximize the economic well being of the economy as a whole.  For the Austrian economist does not believe he or she is smarter than people.  Or markets.  Which is why an economist never gave us any brilliant invention.  Nor did their equations predict any inventor inventing a great invention.  And why economists have day jobs.  For if they were as brilliant and prophetic as they claim to be they could see into the future and know which stocks to buy to get rich so they could give up their day jobs.  When they’re able to do that we should start listening to them.  But not before.

Low Interest Rates cause Malinvestment and Speculation which puts Banks in Danger of Financial Collapse

Keynesian economics really took off with central banking.  And fractional reserve banking.  Monetary tools to control the money supply.  That in the Keynesian world was supposed to end business cycles and recessions as we knew them.  The Austrian school argues that using these monetary tools only distorts the business cycle.  And makes recessions worse.  Here’s how it works.  The central bank lowers interest rates by increasing the money supply (via open market transactions, lowering reserve requirements in fractional reserve banking or by printing money).  Lower interest rates encourage people to borrow money to buy houses, cars, kitchen appliances, home theater systems, etc.  This new economic activity encourages businesses to hire new workers to meet the new demand.  Ergo, recession over.  Simple math, right?  Only there’s a bit of a problem.  Some of our worst recessions have come during the era of Keynesian economics.  Including the worst recession of all time.  The Great Depression.  Which proves the Austrian point that the use of Keynesian policies to end recessions only makes recessions worse.  (Economists debate the causes of the Great Depression to this day.  Understanding the causes is not the point here.  The point is that it happened.  When recessions were supposed to be a thing of the past when using Keynesian policies.)

The problem is that these are not real economic expansions.  They’re artificial ones.  Created by cheap credit.  Which the central bank creates by forcing interest rates below actual market interest rates.  Which causes a whole host of problems.  In particular corrupting the banking system.  Banks offer interest rates to encourage people to save their money for future use (like retirement) instead of spending it in the here and now.  This is where savings (or investment capital) come from.  Banks pay depositors interest on their deposits.  And then loan out this money to others who need investment capital to start businesses.  To expand businesses.  To buy businesses.  Whatever.  They borrow money to invest so they can expand economic activity.  And make more profits.

But investment capital from savings is different from investment capital from an expansion of the money supply.  Because businesses will act as if the trend has shifted from consumption (spending now) to investment (spending later).  So they borrow to expand operations.  All because of the false signal of the artificially low interest rates.  They borrow money.  Over-invest.  And make bad investments.  Even speculate.  What Austrians call malinvestments.  But there was no shift from consumption to investment.  Savings haven’t increased.  In fact, with all those new loans on the books the banks see a shift in the other direction.  Because they have loaned out more money while the savings rate of their depositors did not change.  Which produced on their books a reduction in the net savings rate.  Leaving them more dangerously leveraged than before the credit expansion.  Also, those lower interest rates also decrease the interest rate on savings accounts.  Discouraging people from saving their money.  Which further reduces the savings rate of depositors.  Finally, those lower interest rates reduce the income stream on their loans.  Leaving them even more dangerously leveraged.  Putting them at risk of financial collapse should many of their loans go bad.

Keynesian Economics is more about Power whereas the Austrian School is more about Economics

These artificially low interest rates fuel malinvestment and speculation.  Cheap credit has everyone, flush with borrowed funds, bidding up prices (real estate, construction, machinery, raw material, etc.).  This alters the natural order of things.  The automatic pricing mechanism of the free market.  And reallocates resources to these higher prices.  Away from where the market would have otherwise directed them.  Creating great shortages and high prices in some areas.  And great surpluses of stuff no one wants to buy at any price in other areas.  Sort of like those Soviet stores full of stuff no one wanted to buy while people stood in lines for hours to buy toilet paper and soap.  (But not quite that bad.)  Then comes the day when all those investments don’t produce any returns.  Which leaves these businesses, investors and speculators with a lot of debt with no income stream to pay for it.  They drove up prices.  Created great asset bubbles.  Overbuilt their capacity.  Bought assets at such high prices that they’ll never realize a gain from them.  They know what’s coming next.  And in some darkened office someone pours a glass of scotch and murmurs, “My God, what have we done?”

The central bank may try to delay this day of reckoning.  By keeping interest rates low.  But that only allows asset bubbles to get bigger.  Making the inevitable correction more painful.  But eventually the central bank has to step in and raise interest rates.  Because all of that ‘bidding up of prices’ finally makes its way down to the consumer level.  And sparks off some nasty inflation.  So rates go up.  Credit becomes more expensive.  Often leaving businesses and speculators to try and refinance bad debt at higher rates.  Debt that has no income stream to pay for it.  Either forcing business to cut costs elsewhere.  Or file bankruptcy.  Which ripples through the banking system.  Causing a lot of those highly leveraged banks to fail with them.  Thus making the resulting recession far more painful and more long-lasting than necessary.  Thanks to Keynesian economics.  At least, according to the Austrian school.  And much of the last century of history.

The Austrian school believes the market should determine interest rates.  Not central bankers.  They’re not big fans of fractional reserve banking, either.  Which only empowers central bankers to cause all of their mischief.  Which is why Keynesians don’t like Austrians.  Because Keynesians, and politicians, like that power.  For they believe that they are smarter than the people making economic exchanges.  Smarter than the market.  And they just love having control over all of that money.  Which comes in pretty handy when playing politics.  Which is ultimately the goal of Keynesian economics.  Whereas the Austrian school is more about economics.

www.PITHOCRATES.com

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Financial Crises: The Fed Giveth and the Fed Taketh Away

Posted by PITHOCRATES - December 3rd, 2010

Great Depression vs. Great Recession

Ben Bernanke is a genius.  I guess.  That’s what they keep saying at least. 

The chairman of the Federal Reserve is a student of the Great Depression, that great lesson of how NOT to implement monetary policy.  And because of his knowledge of this past great Federal Reserve boondoggle, who better to fix the present great Federal Reserve boondoggle?  What we affectionately call the Great Recession.

There are similarities between the two.  Government caused both.  But there are differences.  Bad fiscal policy brought on a recession in the 1920s.  Then bad monetary policy exasperated the problem into the Great Depression. 

Bad monetary policy played a more prominent role in the present crisis.  It was a combination of cheap money and aggressive government policy to put people into houses they couldn’t afford that set off an international debt bomb.  Thanks to Fannie Mae and Freddie Mac buying highly risky mortgages and selling them as ‘safe’ yet high-yield investments.  Those rascally things we call derivatives.

The Great Depression suffered massive bank failures because the lender of last resort (the Fed) didn’t lend.  In fact, they made it more difficult to borrow money when banks needed money most.  Why did they do this?  They thought rich people were using cheap money to invest in the stock market.  So they made money more expensive to borrow to prevent this ‘speculation’.

The Great Recession suffered massive bank failures because people took on great debt in ideal times (low interest rates and increasing home values).  When the ‘ideal’ became real (rising interest rates and falling home values), surprise surprise, these people couldn’t pay their mortgages anymore.  And all those derivatives became worthless. 

The Great Depression:  Lessons Learned.  And not Learned.

Warren G. Harding appointed Andrew Mellon as his Secretary of the Treasury.  A brilliant appointment.  The Harding administration cut taxes.  The economy surged.  Lesson learned?  Lower taxes stimulate the economy.  And brings more money into the treasury.

The Progressives in Washington, though, needed to buy votes.  So they tinkered.  They tried to protect American farmers from their own productivity.  And American manufacturers.  Also from their own productivity.  Their protectionist policies led to tariffs and an international trade war.  Lesson not learned?  When government tinkers bad things happen to the economy.

Then the Fed stepped in.  They saw economic activity.  And a weakening dollar (low interest rates were feeding the economic expansion).  So they strengthened the dollar.  To keep people from ‘speculating’ in the stock money with borrowed money.  And to meet international exchange rate requirements.  This led to bank failures and the Great Depression.  Lesson not learned?   When government tinkers bad things happen to the economy.

Easy Money Begets Bad Debt which Begets Financial Crisis

It would appear that Ben Bernanke et al learned only some of the lessons of the Great Depression.  In particular, the one about the Fed’s huge mistake in tightening the money supply.  No.  They would never do that again.  Next time, they would open the flood gates (see Fed aid in financial crisis went beyond U.S. banks to industry, foreign firms by Jia Lynn Yang, Neil Irwin and David S. Hilzenrath posted 12/2/2010 on The Washington Post).

The financial crisis stretched even farther across the economy than many had realized, as new disclosures show the Federal Reserve rushed trillions of dollars in emergency aid not just to Wall Street but also to motorcycle makers, telecom firms and foreign-owned banks in 2008 and 2009.

The Fed’s efforts to prop up the financial sector reached across a broad spectrum of the economy, benefiting stalwarts of American industry including General Electric and Caterpillar and household-name companies such as Verizon, Harley-Davidson and Toyota. The central bank’s aid programs also supported U.S. subsidiaries of banks based in East Asia, Europe and Canada while rescuing money-market mutual funds held by millions of Americans.

The Fed learned its lesson.  Their easy money gave us all that bad debt.  And we all learned just how bad ‘bad debt’ can be.  They wouldn’t make that mistake again.

The data also demonstrate how the Fed, in its scramble to keep the financial system afloat, eventually lowered its standards for the kind of collateral it allowed participating banks to post. From Citigroup, for instance, it accepted $156 million in triple-C collateral or lower – grades that indicate that the assets carried the greatest risk of default.

Well, maybe next time.

You Don’t Stop a Run by Starting a Run

With the cat out of the bag, people want to know who got these loans.  And how much each got.  But the Fed is not telling (see Fed ID’s companies that used crisis aid programs by Jeannine Aversa, AP Economics Writer, posted 12/1/2010 on Yahoo! News).

The Fed didn’t take part in that appeal. What the court case could require — but the Fed isn’t providing Wednesday — are the names of commercial banks that got low-cost emergency loans from the Fed’s “discount window” during the crisis.

The Fed has long acted as a lender of last resort, offering commercial banks loans through its discount window when they couldn’t obtain financing elsewhere. The Fed has kept secret the identities of such borrowers. It’s expressed fear that naming such a bank could cause a run on it, defeating the purpose of the program.

I can’t argue with that.  For this was an important lesson of the Great Depression.  When you’re trying to stop bank runs, you don’t advertise which banks are having financial problems.  A bank can survive a run.  If everyone doesn’t try to withdraw their money at the same time.  Which they may if the Fed advertises that a bank is going through difficult times.

When Fiscal Responsibility Fails, Try Extortion

Why does government always tinker and get themselves into trouble?  Because they like to spend money.  And control things.  No matter what the lessons of history have taught us.

Cutting taxes stimulate the economy.  But it doesn’t buy votes.  You need people to be dependent on government for that.  So no matter what mess government makes, they NEVER fix their mess by shrinking government or cutting taxes.  Even at the city level. 

When over budget what does a city do?  Why, they go to a favored tactic.  Threaten our personal safety (see Camden City Council Approves Massive Police And Fire Layoffs Reported by David Madden, KYW Newsradio 1060, posted 12/2/2010 on philadelphia.cbslocal.com).

Camden City Council, as expected, voted Thursday to lay off almost 400 workers, half of them police officers and firefighters, to bridge a $26.5 million deficit.

There’s a word for this.  And it’s not fiscal responsibility.  Some would call it extortion.

It’s never the pay and benefits of the other city workers.  It’s always the cops and firefighters.  Why?  Because cutting the pay and benefits of a bloated bureaucracy doesn’t put the fear of God into anyone.

Here we go Again

We never learn.  And you know what George Santayana said.  “Those who cannot remember the past are condemned to repeat it.”  And here we are.  Living in the past.  Again.

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