Understanding why Austrian Economics is Flawed

Austrian Economics is a small school of mostly online Libertarian commentators that has gained popularity due to its large internet presence. The school has relatively little academic support and mainstream economics rejects many of the views espoused by its adherents. Much of Austrian Economics can be boiled down to the oversimplified idea that free markets are good and governments are bad. I don’t disagree with this view necessarily and find a good deal to agree with in the idea that the government should do less and downsize, but there can be a tendency to overstate this view in Austrian Econ. More importantly, I find several operational errors in the Austrian Econ description of the financial system. I’ve previously covered most of the myths espoused by Austrian adherents. While useful in some ways, the Austrian school has a tendency to play more politics than economics. This is a brief overview of some operational issues I find with the Austrian view.

1)  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. One of the core tenets of ABCT is that interest rate intervention by the Central Bank leads to a misallocation of capital and that Central Banks control the money supply via reserve creation.  These are both misleading ideas.  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.

The core misunderstanding here was their steadfast belief in the concept of the money multiplier – the idea that the Central Bank can control the money supply by controlling the quantity of reserves. The textbooks teach us that the Central Bank provides reserves and banks then multiply those reserves. But the crisis proved this wrong. In fact, adding reserves does not increase lending. That is because banks don’t lend out their reserves. Bank make loans and find reserves after the fact. Banks are not reserve constrained. They are capital constrained. This core misunderstanding if Austrian Economics is what led to so many bad predictions and misunderstandings of what QE and the Central Bank’s interventions might do to the economy.

Source: The Basics of Banking

2)  Austrian Econ Misunderstands Interest Rate Dynamics. Austrians constantly talk about “interest rate manipulation” in their critiques of Central Banking. But this misunderstands an operational fact – a Central Bank supplies reserves which puts DOWNWARD pressure on overnight rates. Banks don’t want to hold reserves in aggregate so the natural rate on reserves MUST be 0% because banks want to lend their reserves, but they can’t lend them out in aggregate because the reserve system is a closed system. Therefore, the Central Bank must always manipulate rates UP, not down. So it is illogical to argue that low interest rates are manipulation that leads to misallocation of capital.  This doesn’t even touch on the fact that the Fed controls one interest rate out of thousands….This rate, as  we’ve learned in recent years, is no omnipotent policy tool.

So why was Austrian economics wrong on this point?  Because their model is predicated on the same faulty loanable funds and money multiplier 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 misunderstands 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. In any modern economy with financial assets we will virtually always see an increase in the amount of money and money-like instruments across time because of population increases and demand for money. As endogenous money teaches us, most of the money in the financial system is created by banks and those loans create deposits, which are functional money. Loans, and thus deposits, will virtually always increase over time because the elastic demand for money will generally rise over time. So it makes no sense to say that the money supply is equal to “inflation” when the money supply is always rising in the long-term.

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).

Conclusion

I agree with the general ethos of Austrian Economics. Free markets are good. We should be skeptical of the government’s interventions. But we also shouldn’t go overboard with this skepticism based on operational errors. There’s balance to be found here and we can utilize some of the lessons from Austrian Economics without supporting them with flawed understandings.

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See also: 

The Austrian School is Crank Science

Debunking Austrian Econ 101

Understanding the Modern Monetary System