Understanding why Austrian Economics is Flawed

Austrian economics has been through quite a rollercoaster ride over the last 10 years as the housing bubble appeared to vindicate many of their views and then the economic recovery proved many of their dire predictions completely wrong.  I think Austrian Economics is deficient and Austrian Business Cycle Theory is inherently flawed and built on misunderstandings about the way the modern monetary system actually works.  Allow me to provide three core reasons why I believe this:

1)  Austrian economics is a political ideology that masquerades as an economic school of thought.  Like most of the economic schools in existence today, Austrian Economics is predicated on a political ideology.  Austrians tend to be vehemently anti-government and pro-market.  So they build a world view that conforms to the world they want and not the world we actually have.

We’ve seen this time and time again in the last 5 years during the recovery as the government picked up spending when the private sector cratered.  There is always an excuse within Austrian Economics that implicitly assumes government cannot spend dollars any better than a household.  This might be true in a general sense, but it is not always true.  For that implies that households and businesses always make rational decisions.  As if choosing to have our government spend money on wars and welfare is all that much different than households spending money on the next release of the tech gadget they probably don’t need or the McMansion they can’t afford.

Austrians aren’t the only offenders of this (see here).  We see it in Keynesian approaches, Market Monetarist approaches, Monetarist approaches and just about all of economics these days.  Economics is built primarily on a bunch of political agendas designed to look like a science.  Austrians (particularly the Rothbardians) are so vehemently against government involvement in the economy that they are among the very worst offenders of trying to pass an ideology off as a school of thought.  It results in a very unbalanced presentation of our reality.

2)  Austrian Business Cycle Theory Misunderstands Endogenous Money.  Like many other economic schools of thought, Austrian economics is predicated on a loanable funds model with a world view designed to demonize just about everything the central bank does.  As I’ve explained before, the primary purpose of the central bank is not a conspiratorial attempt to enrich bankers, but to help oversee and regulate the smooth functioning of the payments system.

The act of targeting interest rates and implementing monetary policy are very much secondary to this primary purpose and the powers of such policy, as presently constructed, are vastly overstated by most economists.  Yes, the central bank controls a component of the interest rate that helps determine the spread at which banks can lend, but the central bank does not determine the rate at which banks borrow to customers.  It merely influences the spread.  Overemphasizing the Fed’s “control” over interest rates misunderstands how banks actually create money and influence economic output.

The primary flaw in the Austrian view of the central bank has been most obvious since Quantitative Easing started in 2008.  Austrian economists came out at the time saying that the increase in reserves in the banking system was the equivalent of “money printing” and that this would “devalue the dollar”, crash T-bonds and cause hyperinflation.  It was standard operating procedure to see charts of the monetary base like this one followed by dire predictions of high inflation or hyperinflation.  Of course, none of this actually panned out.  The high inflation never came, the hyperinflation definitely never came, the T-bond collapse was a terrible call and the USD has remained extremely stable.

So why was Austrian economics wrong on this point?  Because their model is predicated on the same faulty loanable funds based model that most other economists use.  So they assumed that more reserves would mean more “multiplication” of money and thus hyperinflation.   Of course, as I’ve explained numerous times here before, banks are never reserve constrained and do not make loans when they have more reserves.  Further, QE is a simple asset swap that changes the composition of private sector assets.  Referring to this as “money printing” is highly misleading (see here for more details).  Austrians got this wrong because, in an attempt to attack government, they have devised a government centric view of money creation that misunderstand the way money is created primarily by private competitive banks endogenously.

3)  Austrians misunderstand inflation.  Austrian economists actually change the definition of inflation to serve their own ideological needs.  In Austrian Economics inflation is not the standard economics concept of a rise in the price level.  Inflation in Austrian economics is just a rise in the amount of money.  This leads to all sorts of emotional commentary, the most common of which, is the idea that the USD has declined 95% since the creation of the Fed in 1913 (which is true).   But this misunderstands several concepts and misleads us in understanding how the monetary system works.

First of all, the private sector creates lots of “money like” instruments that are not technically included in the money supply but comprise the vast majority of private sector net worth.  I use a “scale of moneyness” to help better understand this concept so that we don’t place an undue specialness on the idea of “money” when trying to understand inflation.  Instead, I try to explain that spending is a function of income relative to desired saving.  And that saving is comprised not only of “money”, but money-like instruments like stocks, bonds, options, etc.  To completely understand how the economy is impacted by inflation we shouldn’t merely focus on narrow definitions of “money”, but should understand the aggregate economic balance sheet.  For instance, if you sell a stock at no gain and obtain cash you’re not necessarily more likely to spend than you were before because your net worth is the same.  Your income relative to desired saving is precisely the same as it was before.  This is basically what QE is.  It is a swap of one type of asset for another and doesn’t actually alter the net worth of the private sector.  Changing the moneyness of private assets does not necessarily mean there will be higher inflation!

But there is a more egregious and nefarious error in this “decline” of the dollar myth.  It completely misunderstands how living standards can rise even while the money supply rises.  In our credit based monetary system the money supply rises primarily when banks make loans which create deposits.  In a highly productive economic environment these loans are distributed by private competitive banks and provide the borrower with the capability to invest in a manner that actually enhances the living standards of society.  So, you borrow $100,000 from the bank, you invent and distribute the washing machine and suddenly we’re all better off because we no longer have to go to the river to wash clothes.  The technological advancement enhances our lives by giving us more time to consume and produce OTHER goods and services.  In other words, the money supply has technically increased, but we’re not worse off because of it.  We’re better off because of it!  What’s happened since 1913 in the USA is just one gigantic version of the washing machine example where our living standards have exploded through the roof in tandem with a rising level of credit and an innovation boom that human beings have never come close to experiencing in the past.

Austrians, in their fervor to demonize the fiat money system, make several errors here.  First, they assume the government controls the money supply (which they don’t).  It’s actually controlled primarily by private banks in a market system that Austrians should love.  Second, they move the goal posts on the definition of inflation to imply that inflation is always and everywhere a bad thing (which, it can be, but generally isn’t).

That really just scratches the surface on some of the flaws in Austrian Economics.  I think Austrians provide some good insights on the way the economy and money works, but these are glaring flaws in the school of thought that render it highly inadequate in helping us understand the world of money in a balanced and objective way.

See also: 

Understand the Modern Monetary System

Monetary Realism Recommended Reading

Cullen Roche

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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Comments

  1. So first they predicted hyperinflation, then when they explain why hyperinflation is not here yet, you divert to the fact that they are using the wrong money multiplier. Let me tell you a little secret, prices of goods, oil, CPI, etc.. have over a 90% correlation to bank lending..

    “HE MAIN POINT OF THIS ARTICLE WAS TO HIGHLIGHT THAT AUSTRIAN ECONOMISTS USE AND USED A DEFUNCT MONEY MULTPLIER MODEL”

    First spell multiplier correct, then please define “defunct” as I think we went over that. Then, explain to me who cares how they believe money gets lent or not, it doesn’t change the FACT THAT LENDING CAUSES PRICES TO RISE. You think lending happens one way, they another. Big deal. They don’t only look to reserves to cause a rise in prices.. Stop misquoting people.

    • 1. Plenty of Austrians predicted that the inflation would come and that it would come by 2010, 11, 12, 13. There are plenty of quotes from Murphy, Woods, Schiff, Faber, Rogers, etc. You’re just playing revisionist history. Now you’re all scrambling trying to hide the fact that you all made the absolute worst prediction in the last 5 years.

      2. Misunderstanding the way things work is not an excuse for faulty predictions. Not only did the Austrians get the prediction wrong, but they misunderstood why they were getting it wrong. At least they got the gold predictions right even if it was for the wrong reasons.

      3. Don’t worry about my spelling. This isn’t a grammar contest. And if it was I’d happily give you a gold star for your outstanding performance. Your economic performance, on the other hand, leaves much to be desired.

      • Could the flaw be ….PREDICTING ?
        Who is 100% correct ?
        Why fault the entirety of one for surely “by chance and timing”
        they got something right (a broken clock is the only perfectly accurate clock twice a day- no other clock can beat the speed of light to record the exact time), does that mean we should only use broken clocks ?

      • 1). Plenty of Austrians (and others) did predict inflation, most of those predictions presumed recovery. Most of us Austrians or not grasped that the Fed will face significant problems backing out of QE. The entire economy is jittery even about hints of scaling it back. Economists as a whole are notoriously bad at prediction.

        2). You claim facts trump ideology and then rant because Austrians got the facts right on gold for the wrong ideological reasons.

        • This was inevitable. The gold call. I also pointed out over the years that gold has a high correlation to negative real interest rates. This has been written about in econ papers for decades. It’s nothing new and you didn’t have to be an Austrian economist or understand any of their misleading nonsense to see why gold would rally in a negative real int rate environment. You just had to understand Gibson’s Paradox and a 35 year old paper.

          The bottom line is that ABCT is based on the loanable fund theory. You all believe people have to save before they can spend and that banks lend out their reserves. This is one of the most central and important components of the entire economic school. It’s wrong. Demonstrably wrong. And it renders the ABCT flawed. If you don’t get that then you don’t get it. Which is fine. I am not here to twist your arm about what you want to understand. But don’t be shocked when your false idols continue to make absurd hyperbolic predictions about things based on the world they don’t come close to understanding.

          • I am not sure why you are fixated on gold. Few of the counters here are. i really do not care whether Austrians got gold right, or wrong or right for the wrong reasons.
            While many including an increasing number of mainstream economists are starting to question the current central bank regime, i am not aware of an actual economist of any repute that thinks that gold is some magical substance and the only basis for money. At best it is a means of imposing discipline on central banks run amuk.

            You keep ranting about ABCT and loanable funds theory.
            Your critique seems to amount to “they are wrong because I say so” and they are core to Austrian economics because I say so, and therefore Austrian economics is wrong.
            You can read alot of Hayek or Mises without encountering either. And as best as I can tell your attacks on them would contradict economists atleast as far back as Say, and probably most modern non-keynesians. Possible some Keynesians.

            I think both assertions are false. Regardless, I say so is not an argument.

            • Look, I am not just “saying so”. This is how banks actually operate. And loanable funds is central to Austrian thought. If you want to claim I am wrong about banks then fine. No skin off my back if you keep using a flawed model of the way the world works. I am not here to twist your arm into believing that I am right.

              • Saying “that is just how banks operate” is just a permutation of I say so. I am not claiming that you are right or wrong about banks. You have not said anything about them for me to agree or disagree with.

                To the extent i understand Loanable funds theory – which is not something i have come accross alot in my reading Austrian or otherwise, it is the application of Says law to credit. Are you really arguing that Say’s law is wrong ? If so you are taking out alot more than Austrians. Further though I am not expert on the financial market as a whole, it is not my understanding that banks are the primary source of capitol today, so in the event that your Banks do not operate that way argument actually works, it still insufficient.

  2. Oh man. Looks like the Austrian trolls are starting to rain down. Good luck CR. Those guys are worse than M M Ters.

    • Austrian troll? It’s called logic with common sense economics. I don’t call myself an “austrian”. Every group has flaws, though the Austrians have more going for them than other schools. One of the most important things is to keep government out of the economy. When you start with premises like that you can come up with much better solutions, no matter what you think the government should or should not do.

      It’s very simple, the free market works, therefore let the market alone… You don’t need a fed, and you don’t need QE.

    • I always thought Cullen was at his best when confronting M M Ters but they are fellow PKers. Taking on the Austrians is much more fun!

  3. I don’t think you understand how credit is created.. You seem to think that when financial assets are exchanged for goods or cash, because net worth changes it doesn’t affect us. That isn’t true because when more money is chasing fewer goods, it causes prices to rise. Simple supply and demand.

    I would like you to lay out step by step your “idea” of how inflation takes place. I don’t think you understand it.

    Of course, I don’t see any shiny examples of your wonderful predictions, all I see is Austrian bashing.

    • You can’t be serious. You post a bunch of links to explanations about the money multiplier and then claim I don’t understand how banks create credit? Are you even reading this website?

      And I took the opposing side of the hyperinflation bets years ago. Here’s just one quote from 2010 with multiple (all correct) claims:

      UK is the next Greece (WRONG!). Oh no! Niall Ferguson says the US empire is over and we’re going bankrupt (WRONG!). Nouriel Roubini says the big bad bond vigilantes are coming for the USA next (WRONG!). Robert Shiller is correct (as usual) – we’re literally going to scare eachother into a second Great Depression. Meanwhile, the very crowded short t-bond trade is where the supposed “smart money” is lined up. Unfortunately, we have the playbook for this environment and it doesn’t involve hyperinflation, skyrocketing bond yields or sovereign bankruptcy (at least not in the case of the USA). Treasury bonds will continue to be the ultimate safe haven play despite the fact that every hedge fund manager in America thinks the USA is bankrupt (WRONG!):

      http://pragcap.com/three-things-i-think-i-think-12

  4. Austrian troll? It’s called logic with common sense economics. I don’t call myself an “austrian”. Every group has flaws, though the Austrians have more going for them than other schools. One of the most important things is to keep government out of the economy. When you start with premises like that you can come up with much better solutions, no matter what you think the government should or should not do.

    It’s very simple, the free market works, therefore let the market alone… You don’t need a fed, and you don’t need QE.

    • “You don’t need a fed”. And who will manage and regulate the payments system? Jamie Dimon, Stan O’Neal, Lloyd Blankfein? Are you kidding me? This is hopeless.

      • The “payments system” is a group of smaller payment systems that can all be managed individually. That’s like saying we need a governmental housing authority to manage all the housing communities. No, you don’t.

        And yes, lay out how you believe inflation is caused. If it’s so easy to point out why the Austrians are wrong about it, then it should be easier to explain the correct explanation.

        • DP, I think we all agree that creating too much money will cause inflation. But do you really understand how money is created? Hint: it isn’t through QE.

          • That depends on what kind of money you are talking about, fiat or real money that was created from market forces?

            And there are many ways money is created. QE is one of them. The government buys assets from a bank. With what money? Digital currency. That digital currency is then on the balance sheet of the bank in which it can lend out approx. 10X of that amount. That money gets lent, goods are purchased and the amount of goods owned increases. Whether or not enough printed fiat money hits the hands of consumers or not, there is an increase in “money”.

            • Yes, the bank receives “money” when it sells assets to the fed, but it lost those assets that it sold! It was a simple asset swap. The size of the bank balance sheet remains basically unchanged, as does its capital, which is the real constaint on lending. Not reserves. Banks don’t lend reserves (except to one another). There is no 10X multiplier effect.

              • What assets do you think were swapped? I do see your point but what you don’t see is that they are getting paid on their reserves, and it’s coming out of our taxes! They also are able to borrow more from the Fed window as they took the “bad assets” off the balance sheet. It’s not a one-to-one swap completely, and it’s not a 10X multiplier effect either.

                However, you are still missing something. Debits and credits. Where did the “money” come from that allowed the fed the ability to buy those assets?

                • The Fed created the money out of thin air to buy those assets. What’s your point? It doesn’t change the fact that those assets have been removed from the bank’s balance sheet. Bottom line is that bank balance sheets remain unchanged, nobody received any free money, and nobody’s spending power increased.

                • DPinGA, take at look at this, it shows where the money comes from:

                  http://brown-blog-5.blogspot.com/2013/08/banking-example-41-quantitative-easing.html

                  The money the Fed buys assets with does not come out of taxes. The Fed credits the banks for it (case 1) and the bank may have in turn credited a non-bank for it (case 2). The two cases are similar. In a sense it’s all credit. All of our money can be created or destroyed. There’s a process in place for both and both happen on a daily basis.

                  Every dollar is as asset to some entity and a liability to another.

                  If you took all the financial balance sheets (excluding real goods, like houses, etc) of all the entities in the economy (Fed, Tsy, banks, non-banks) and consolidated them onto a single balance sheet with just a total dollar amount for assets and a single dollar amount for liabilities, those two numbers would be equal at all times… that one value might go up or down, but the assets would always balance the liabilities. Total equity (assets in excess of liabilities) remains zero at all times.

                  Technically I just lied, because of the way the accounting is done for coins, but coins are still an “obligation” of the Tsy… so if we included that on the liabilities side, it would remain zero equity.

                  • Your sort of right. If I owned a stock, and it was bought on borrowed money, say 30 dollar stock and I borrowed 30 dollars but then the value of the stock went up my assets and liabilities are off. How does this affect us in the USA? Simple, foreign assets flow in causing the value of the assets to increase relative to the US liabilities. It’s kind of like a debt ponzi scheme.

                    But the amount of goods and real assets in circulation matters. Because if I took that increased value and bought a real asset, the asset goes up in value. The seller of that asset has also increased his value. He is now able to buy more stock.. And it goes on and on and on.. The system is fueled by debt and valuation and bubbles. And when there is a reset, the liabilities decrease and the asset holders don’t suffer..

                    What a system!

                  • I’m not so sure you can describe an economy using that balance sheet arrangement.
                    A bank, yes, but the economy, no.
                    In such a model, the U.S. and North Korea are equal, because each has assets that are balanced by liabiilites.
                    I don’t get that.
                    For one thing, the U.S. has assets for which there are no liabilities. If I go out in the backyard and grow tomatoes, my vegetable garden is an asset. When my house is paid, it’s an asset. Where is the liability in either case?
                    It seems vaguely like the ‘debt is money’ idea taken to an extreme.
                    We unfortunately have an economy based on the idea that if I borrow money, I can go buy vegetables, instead of an economy based on, ‘hey, let me grow some vegetables and then trade them for something of value and we’ll use money to keep track.’
                    So we’re sitting around figuring out how to create money and maybe call it a loan or a NFA just so we can get people to produce. Seems backward.
                    Especially when the money we are creating is just being used to trade pieces of paper.

                  • Tom Brown, “Every dollar is as asset to some entity and a liability to another. ”
                    Does that state Soddy, (paraphrase) ‘Every NOTHING is a SOMETHING to exchange into ANYTHING’ ?

                    • ALSO:”I think people sometimes have a wrong conception of what money is, which is why
                      I pointed out that it all nets to zero at all times (the BSs that is).,Tom Brown
                      When banks lends $100 billion @4% compound interest for 18 years while abiding by a 6% capital requirement.Please tell me how the net result to the bank is zero when the loan is paid in full what actually happens is the banks have $6 billion in their accounts but they created a future income of $200 billion. They subtract the “fictitious” money (the loan amount) because they created that out of thin air, but they get to keep and spend ‘real money’ in the amount of $100 billion. There is something really un-equal about they way banks can make money. If the loans were on houses, the builders and sellers of the $100 billion of houses probably had to put up $50 billion a lot of sweat and work to produce a gain of $50 billion. The banks do not even put up the $6, they only have to show they have it.
                      True or false: IF 1,000 banks were to loan $1 billion at 4% over a period of 180 years, they would only need to know what date they would posses all the assets of the entire world and still have a balance. This zero sum game means: Private for profit banks 100%, 99% of the world 0 !

                    • justaluckyfool,

                      Don’t read too much into my statement. It has more to do with what money is in our system: I think people think of money (incorrectly) as a pile of gold, which it’s not: like there’s an inflexible set amount of it in the world.

                      Regarding your example, all I can suggest to you is don’t forget that a bank’s equity belongs to people… shareholders, bondholders, etc. That equity will be distributed back into the system. It’s false to assume the banks equity will just continue to accumulate w/o every leaving the bank again. Why would anybody be interested in owning a bank if that were the case? The fact is that banks buy stuff with their capital by crediting bank deposits: electricity, office supplies, loans (i.e. make new loans or buy existing ones), employee time, etc. It’s what simple parables like this one on youtube never mention:

                      https://www.youtube.com/watch?v=3HdmA3vPbSU

                      They do not describe the full flow of funds in that “tale.” They should be honest and describe that part too. They wouldn’t have to change much about the video and it would make it more accurate. Now is this system fair? Isn’t it just the shareholders that end up w/ all the wealth? I won’t get into that! That’s where your opinion comes in… I just want people to be aware of the shortcomings of the kind of analysis presented in that video. People should get all the facts to base their opinion on. This is super simple, but it might help too:

                      http://brown-blog-5.blogspot.com/2013/08/banking-example-10-principal-interest.html

                      If you believe banks will end up owning the world, maybe you should invest in bank stock. :D

                    • @TomBrown RE: “They do not describe the full flow of funds in that “tale.” They should be honest and describe that part too. ”
                      First, thank you for referring those sites to visit. As to ‘full flow of funds” and the effects of compound interest, would you glance at …”Governments can create new credit electronically on their own computer keyboards as easily as commercial banks can. And unlike banks, their spending is expected to serve a broad social purpose, to be determined democratically. When commercial banks gain policy control over governments and central banks, they tend to support their own remunerative policy of creating asset-inflationary credit – leaving the clean-up costs to be solved by a post-bubble austerity. This makes the debt overhead even harder to pay – indeed, impossible. … It is too early to forecast whether banks or governments will emerge victorious from today’s crisis. As economies polarize between debtors and creditors, planning is shifting out of public hands into those of bankers. The easiest way for them to keep this power is to block a true central bank or strong public sector from interfering with their monopoly of credit creation. The counter is for central banks and governments to act as they were intended to, by providing a public option for credit creation. ****Read more..by Prof. Michael Hudson ; http://www.globalresearch.ca/index.php?context=va&aid=28938 FOUR:The most powerful force in the universe is being used against mankind,rather than for the benefit of mankind. “…. The Mathematics of Compound Interest .
                      Questions 1. Does this mean you agree that a bank can create a loan for $100 and get $200 back in 18 years if @4% interest while using NO real money of its own albeit it must have $6 in real money in its bank ?
                      If so then we only need to resolve the question of ..How the private for profit banks “redistribute” their net interest income.

                    • justaluckyfool,

                      $202.58 actually.

                      Yes and what you’re forgetting is that even here when you sign a loan agreement, both you and the bank are taking a risk. There’s the obvious risk of default on your part that the bank takes on, but there’s a further risk associated with changing interest rates and the inflation rate.

                      As a simple example of assume Bank A makes a loan to Person X for $100 to buy a house at 4% for 18 years, compounded annually and all due (interest and principal) in one balloon payment of $202.58 at the end of the period. The house seller (Person y) is a crazy paranoid who wants the $100 in cash so she can buy weapons and food for her cave in the wilderness, so the bank borrows $100 in cash reserves from the Fed to hand to her.

                      Now say inflation runs at 6% over 17 of the 18 years in this period, and that the bank didn’t forecast that correctly! Also assume the Federal funds rate on that borrowed $100 in cash is raised to 5% for these same 17 years. Guess what x’s house is worth now? And how much is that balloon payment worth now 18 years later in real terms? Now who came out ahead?

                      (What’s worse is that person y happens to own the bank, so she’s doubly out of luck!)

                      I’m not arguing that this is a perfect system we have or that the financial sector has perhaps grown too large (I think you could make good arguments to that effect), but I’m saying we need to look at the full picture.

                    • Wow, RMM would say ,”That is some real misdirection.”
                      That the bank receives $202 in real money in exchange for $100 ‘bank “fictitious” (Frederick Soddy) simply because it has $6 on it capital sheet is what needs to be address.
                      If you wish to talk about risk/reward on bank loans,haven’t you discovered yet that normal loan risk by banks to people is less than 2%. Bank risks when they are in trillions of dollars are much higher BUT not to the banks because the larger the amount the less rick because the Fed will HAVE TO make it good or else what ? “systemic failure”?.

      • Are you kidding me…. you think Jamie Dimon et.al. do NOT control the “payments system”?

        I’m not sure how things would work without the Fed, but as I understand it, the Fed was created to, in essence, eliminate the boom bust cycle – as you said in your paper, “to eliminate the sever financial crises…” (because the “poor” people – meaning the wealthy this time – were finally included in the pain during the Panic of 1907). IMHO, the FED has done an “absolutely stunning” job (I sure have been stunned!), since there haven’t been any busts – or financial crises – since the fed was created :-)

        The fact is all economic theories are unreliable because “ceteris paribus” is impossible in economics. The (economic) world is not some science lab where you can hold everything else constant and change one variable.

        If you could, perhaps the Austrians were right about inflation; that is, pumping money into the banking system should have pumped money into the economy (it didn’t cause the bankers sat on it – they were panicked too – shame on them for staying static like ceteris paribus “demanded”). And this, in theory, should have ignited inflation (so much for economic theories!), but that’s a lot of ifs because you can’t hold everything else stationary.

        At the most basic level, economics – real world, not textbook – has been a trial and error process over hundreds of thousands of years involving billions and billions of people throughout time. So I look at the world to see which countries have been economically the most successful. Without a doubt, those successes come from countries where governments have least interfered in the markets.

        This USE to be America and a handful of city-states like Singapore at one end and communist countries like China and the USSR at the other (and including 3rd world countries where a small elite control the economy… like America!). America changed, of course, when the Keynesians took charge in the Great Depression. These are LONG cycles and it finally looks like it is time to pay the piper.

        You said “Austrian economics is a political ideology that masquerades as an economic school of thought.” Damn right, sort of. Austrian economics is an economic theory that unmasks the charades going on in BOTH government and Keynesians economics.

        In case you MISS the point, charades is a GUESSING GAME. As an Austrian, I don’t care whether QE causes inflation (per se), and I’m not going to even argue the point. Rather, I just understand that a few elite in Washington making the decisions is a worse economic outcome that letting America’s 300 million decide with their pocket books and feet (or the world’s 6 billion).

        You said in your paper that “One of the key understandings here is that government can be used as a tool to help the private sector achieve prosperity… the government is primarily a facilitator in terms of private sector prosperity and that the private sector is the primary driver of economic growth and prosperity.”

        YOUR problem is you’re suppose to be “Pragmatic”. As far as our government is concerned, there is nothing further than the truth than what you said in the quote above, in the sense that the government no longer sits idly by “facilitating the private sector”.

        I am not anti-government per se. Rather, I am pro-”free market”. MY problem is that the further away the government has moved from your description, the more “anti-government” I’ve become. And as Keynesianism has grown, especially recently under Bush followed by Obama, I’m just about an anarchist now!

        • If government can be used as a tool to help the private sector achieve prosperity, then government can also be a tool to decide who within the private sector succeeds and who fails. A government that has the power to pick winners and losers will be corrupted by those who want picked. People do not become better when they enter public service.

          • dhlii says:
            09/12/2013 at 12:35 PM
            “If government can be used as a tool to help the private sector achieve prosperity, then government can also be a tool to…..”
            WOW, great statement, and that’s no ‘if’ for government can and should be used to help the “people to prosperity, equality and pursuit of happiness. The unbelievable part is that it is possible with a simple action: Make the Federal Reserve Bank work ‘for the people’, stop working ‘for the private for profit banks’, at which they are doing an excellent job.

      • The US ran relatively badly for over a century in the hands of politicians. Since 1913 it has been run at the very best no worse by a central bank.
        That is not a glowing endorsement of central banks.

        Presuming that what exists is what must exist is fallacy.
        In 1970 it would have been easy to say “How could one possibly call someone without AT&T?”. Today few of us own traditional phones.

      • Actually, Cullen, I believe about half of all payments in the United States are currently processed by the Clearing House Payments Company, which is privately owned.

        http://en.wikipedia.org/wiki/Clearing_House_Interbank_Payments_System

        “The Clearing House Interbank Payments System (CHIPS) is the main privately held clearing house for large-value transactions in the United States, settling well over US$1 trillion a day in around 250,000 interbank payments.”

        Historically, in the US private clearinghouses such as the Suffolk Bank in MA processed payments. The successful MA system would have undoubtedly been copied by other states had the Civil War not broken out and the National Bank Acts (designed to generate wartime revenue) had not been passed.

        http://www.adamsmith.org/sites/default/files/images/uploads/publications/suffolkbank.pdf

        In Canada, until 1935, all payments were privately processed. So yes, a private clearing system has existed historically and continues to function in the US.

          • Right, good point. Still, in the absence of Fedwire, what would prevent private banks from coming up with a comparable system? Surely it’s technically feasible.

            Btw, please don’t think of me as a hard-headed Austrian who isn’t willing to learn anything. I’m very interested in learning more about a Post-Keynesian flow of funds framework for examining the economy. I know you have links, but I learn best from books. What do you think of Lavoie and Godley’s “Monetary Economics”? Any other book recommendations?

            • Hi John,

              I think the key is that the Fed still dominates interbank payment no matter how private companies clear if they’re substantial. If they are large enough to move markets and influence the economy then I think they will eventually fall under the jurisdiction of Fed regulations.

              I think Monetary Economics is the best one. It’s very dense. Have you read my paper on the monetary system? That is usually a pretty good starting point. If you read everything on this page you’ll pretty much know where I am coming from on all of this:

              http://pragcap.com/mr-recommended-reading

              Let me know if you have questions. Have a good one!

              • You are correct – in any market that the federal government or its minions enter, it will dominate, monopolize and otherwise regulate in order to control for governments benefit. Nothing new here.

                But the relevant question and your claim was that these things can not be handle as well if not better privately.

                The fact that government or its agents have taken them over, and prevent real alternatives does not make it self evident that it must be that way.

          • So anything private to replace a government system that does not exist in the form you deem necessary at this moment is impossible or can not be done without government ?

  5. The banks received free money by holding reserves and getting a higher rate on them than they had to pay to borrow from the fed! That’s free money if I ever saw it. And yes, the fed’s spending power increased. What happens when those assets mature? You think that money is just going to sit there? You think it’s really just sitting there, under the fed’s mattress? Banks deserved to fail,, they failed!

    And QE wasn’t only to buy assets from bank balance sheets. It also buys financial assets, in which banks are the largest holders of. Market rally anyone? It also allows the fed to lend to foreign nations, as it did, and those nations actually bought some American financial assets with them!

    Yup, still no free “money” for those that hold financial assets… HA

    • The banks sold bonds yielding 3% in exchange for reserves earning 0.25%. That’s not free money you nitwit.

      Did you read Cullen’s primer on QE? He’s been correctly explaining all of this for years.

      • That’s not what I said nitwit.. I never said they sold bonds, I said they borrowed money from the fed at a rate lower than they would get paid to hold it in reserve..Reading 101 Nitwit..

          • I didn’t say that is what QE is. I said that’s part of it..

            The banks ARE able to borrow from the central bank window and get paid more on reserves than they paid to borrow them. That dichotomy was caused by the LOW RATES of QE..

            And for the record I was just returning the name nitwit to Mr. LVG after being called it myself..

            • You’ve been perfectly cordial so no worries.

              Fed discount window borrowing has been very low during the QE era so I don’t see how that is really relevant. QE is ENTIRELY separate from banks lending or banks borrowing from the Fed. It’s just an open market purchase of bonds. I think you’re confusing multiple things here.

              • It’s not just the regular discount window but the emergency window that was open to banks.. In which a lot of money was borrowed. It is relevant, as the banks are making money off our taxes.

                • I’m not sure where the taxes come into play there… The Fed doesn’t take tax money to run it’s operations. Actually the Fed remits most of the money it makes to Tsy (helping to relieve us of part of our tax burden). Also, traditionally reserve levels were adjusted through repos, not discount window loans. Now they’re there through QE.

                • The banks aren’t using that facility so again, there’s no “free money” being handed out via QE that wasn’t there before. If you want to say ZIRP is a free lunch then fine, but that’s not QE.

  6. “I am sorry, but you need to wake up to reality. Our govt is substantial and it’s not going away. We can quibble over the size of it, but the fact is, when it comes to cutting the size of govt almost NO ONE actually wants to cut the size of govt because we’re all indirect beneficiaries of various programs whether it’s the police force, the military, the social security payments, etc. Do you benefit from our govt at all? Do you use public roads? Do you ever call 911? Do you appreciate our military? Do you receive social security? Do you own government bonds that pay you interest? Do you want to cut all those things? Get real. Stop living in a fantasy.”

    That is known as the tragedy of the commons. Everybody wants something for free, but nobody wants to pay for it. Nothing to see here (you live in the fantasy here that socialism works over the long run; and you lived in another fantasy 2-3 years ago called MMT, so it seems that you are prone to it).

    “Pragmatic Capitalism is about understanding the great system we’ve designed. The system that has created ungodly wealth and a living standard that makes EVERY SINGLE AMERICAN IN THE TOP 1% OF GLOBAL WEALTH.”

    Many moving parts here:
    1) Your “American” system is now applied everywhere in the Western World. But why did the English that revolutionized capitalism, industrial production etc. drop from their dominant position they had prior to the American greatness, although they apply the same system basically? See – there are geopolitical factors and many others.
    2) How about that U.S. greatness was achieved, because you had a huge continent to settle in, while killing the indogeneuos people, plenty of natural resources, and then when time was right, you meddled in the 2 WWs (against your constitution) and came as a winner of the last one, so that you enjoy the permanent C/A deficits after that as a result of your reserve currency status? How about you enjoying your current status from your global military empire controlling the world to your liking while killing millions of people post World War II?
    3) Were all the achievements because of the current great system or in spite of it and due to factors in point 2) above? You have no proof of your statement.
    4) Additionally to 3), your current system is very different from the one in the 1800s, when higher real GDP growth was achieved than in the last 20-30 years. Back then you had a gold standard, flat CPI over 100 years, governemnt part of GDP at 2% (now 40%), no Fed etc. You are standing on the backs of the 1800s development much more than on the back of the last 30-40 years of interventionism / bank protectionism / govt creep / corporatism etc. Your system is also very different from the 1930s, 1950s and 1970s. It has been a creep.

    Some food for thought about the “great current system” and “American exceptionalism”, which sound like hollow platitudes to me, used laways in times when you have difficulties concentrating on some issues or finding arguments. And do not tell us that the current system is the best because it is evolution, because such evolution has also brought us Stalin, Hitler, Mao etc.

    • We did not have a gold standard in the 1800′s, we had a variety of schemes with Central Banks, treasury control of money, bi-metalic standards.

      These all proved flawed – though not appreciably more so than our current federal reserve system.

      The Austrian Business Cycle that is being criticized here has its origins in analysis of the fiscal and monetary failures of the 19th century. It is often argued that all economic downturns have monetary roots. That MIGHT not be an absolute truth – but certainly the overwhelming majority are.

      • dhlii,

        Are you familiar with George Selgin’s research on the 19th century US banking system? Essentially, most of the troubles came from:

        1) restrictions on branch banking (resulting in overexposure to local econ conditions and overdependence on NY, Chi, and St. Louis correspondent banks for access to major money markets);

        2) bond collateral requirements for new banknote issuance (e.g. to issue $100 of notes, a bank first had to buy $110 worth of state govt bonds). This arbitrarily tied note issuance to the state bond market (and overconcentrated bank assets in this category, which often turned to junk–the source of failures for most of the “wildcat” banks).

        3) the Civil War National Bank Acts, which eliminated private note issuance by state-licensed banks via a 10% tax on such issues.

        You may find the link below of some interest. I don’t agree with most of the Austrian monetary theorists (e.g. Rothbard, Salerno), but Selgin and Larry White have produced what I feel is outstanding work.

        “The Case for Free Banking: Then and Now”
        http://object.cato.org/sites/cato.org/files/pubs/pdf/pa060.pdf

        This talk is also excellent on the 19th century problems (in comparison with Canada, which largely avoided such currency panics):
        http://www.youtube.com/watch?v=kkpgJ1g-I-8

  7. This is fun… you bring up M M T or Austrians you’re SURE to get lots of spirited comments. The MM sites get the same… go to Sumner’s site and look for “Cantillion Effects” you’ll find about a half dozen posts (all close in time) each with about 200 comments! One of his posts is called “There Really, Really, Really, Really aren’t any Cantillion Effects” … way to throw gas on the fire!

    … LOTS of push back there from the Austrians.

  8. Mr Roche,

    Austrians have a major issue with fractional reserve banking.

    If the central bank of any country clearly declared its intentions to move towards a fully maturity matched banking model. i.e. checking accounts would not be lent out, 3 month loans would have to be matched with a 3 month deposit, 10 year loan would have to be matched with a ten year deposit, etc.

    This need not be sudden. The central bank could declare the current figure for maturity mismatch in the system (no. of $ * days of maturity mismatch) and target to reduce this with time. They could commit to do enough QE to not allow the economy to collapse.

    So, if the banking industry moves to such a model, then would the austrians’ logic be more valid, being a world that their model is supposed to reflect.

    • @prakash
      Quote Justaluckyfool (Google or Bing),”What if the Federal Reserve Bank were to mandate: all loans must be 100% capitalized? All loans must be backed 100% by the ‘good faith and credit ‘ of the Monetary Sovereignty.” Since this would perhaps cause “systemic failure” since there is not enought real money in existance to cover, included in the mandate would be that banks would be allowed to borrow the amount needed to be solvent at 2% compound interest for 36 years.
      OMG, if $72 trillion was needed that would produce ‘a revenue income of $4 trillion per year.
      OMG,eliminate federal income taxes, eliminate FICA, reduce student loans to 0.25% !
      Prepare the people for prosperity.”

  9. Prakash,

    Please note that not all Austrians oppose fractional reserve banking. The GMU/Free Banking Austrians have pointed out that full reserve banking has never outcompeted fractional reserve banking in the marketplace.

    http://www.freebanking.org/2011/05/31/the-state-and-100-percent-reserve-banking/

    http://www.freebanking.org/2012/07/02/testimony-on-fractional-reserve-banking/

    Free market banks can, and have historically, come up with ways to cope with the danger of bank runs.

    1. Option clauses
    http://monetaryfreedom-billwoolsey.blogspot.kr/2013/03/free-banking-and-bank-runs.html

    2. Private lender of last resort (clearinghouse associations)
    http://www.minneapolisfed.org/publications_papers/pub_display.cfm?id=758

    Had free banking been allowed to develop (i.e. if the US had followed the Canadian free banking system after the Panic of 1907, a possibility which was investigated), other ways to protect banks from runs would surely have evolved. JP Koning here speculates on private liquidity options:

    http://jpkoning.blogspot.kr/2012/05/free-banking-alternative-to-centralized.html

    I don’t believe Austrians should oppose fractional reserve banking. It is a contractual agreement btw individuals, which the govt should not have the right to forbid. Opposition to central banking, on the other hand, is something all Austrians should in principle be against.

  10. CR,

    Serious question I am hoping to get some insight on:

    What is your working knowledge of Austrian economic theory based upon?

    Do you just read some Austrian “headlines”, or are you serving up someone like Peter Schiff as an example without naming him, or have you read some or all of the major Austrian theoretical works during your intensive study period in 2008?

    The claims you advance in this article would be easier to understand if I had a better idea of what you’ve read of “Austrian economics”.

  11. This blog is the perfect example of why economics and economic theory is essentially the by product of society reaching a point in which people have too much time on their hands. Do you think native Americans sat around trying to explain the intracies of how their system if trade worked? Do you know why? Cause nobody gave a shit, they were to busy working to survive. By work I mean producing something of real value to contribute to their society so that they too could benefit from what others in society contributed. Pretty simple. Without wasting time with the history of money lets just keep it simple. Money in its intended state was nothing more than a way to measure a mans work and ingenuity. If it takes twice as much effort to produce a pound of squash than a pound of potatoes or if people found squash more desirable than the squash would cost twice as much. Now today the financial system is a touch more complicated but one thing does remain the same, today’s financial system is still made up of the same simple component…humans. I’m pretty sure humans are animals and like all animals they need incentive. At the root of everything that incentive is survival. If I take a wolf pup and raise it from birth hand feeding it everyday do you think that wolf is ever going to have incentive to chase an elk all over a mountain. Hell no, that would be work and work by its very nature kinda sucks and if you are given the elk meat there is absolutely no point in running all over the place getting tired, risking injury trying to produce elk meat for yourself and your pack. Even a f**kin dog has that reasoning capacity. The two main differences in economic theory as I see it come down to one simple question. Is money/ wealth something that is created by the people of the society through the incentive to create better goods and services for that particular society and in turn a better life for ones self ? Or is money just something the government creates and uses to control society in an attempt to mantain power. Currently it seems like the popular belief is the latter. The bottom line is this. If we had a healthy economy there would be no need for our government to intervene in any way in the process of how our government is financed and the fact that it is doing so is insane. I don’t think it really matters whether it increased bank reserves, money supply or any of that crap . The bottom line is that it is artificial demand for the primary product our government uses to finance itself so when that demand is removed there is no way in hell that the result will be good. Perhaps if that artificial demand was being used to actually produce incentive among its citizens the result may not be all that bad but it’s not. It’s being used to prop up a society with a growing percentage of fat lazy wolves who think they have the right to lay in the sun while the rest of the pack hunts their food for them. How this party ends is anyone’s guess but I think a little insight may come from looking at places like Detroit and Chicago. In closing let me leave you with what I consider to be the single best quote with regard to economics. No order of society can last in which one man says to another, “you work and toil, and earn bread, and I will eat it”. Abraham Lincoln.

    • “This blog is the perfect example of why economics and economic theory is essentially the by product of society reaching a point in which people have too much time on their hands.”

      The beautiful irony is that you just wrote one of the longest, rambling posts in this comment section.

  12. Oh and CR if we are far from broke please explain to me why we are 20 trill in debt and now adding 1 trill roughly per year. You may want to tell the people of Detroit not to worry cause their city is not really broke. There is not a doubt in my mind that you are an incredibly bright person so please explain to me how a government that at current levels needs to borrow almost half of its yearly budget with the largest generation in history about to retire is not in serious trouble. Lets not even talk about the fact that the percentage young people in the labor market is as low as its ever been. By your logic if a corporation had the ability to just create revenue out of thin air and use that revenue to buy it’s bonds so that their interest payments stayed low and their value high enough to prevent selling you would say there is no problem there and those bonds should remain triple a. Why didn’t Greece just do this if it was that simple?