August 20, 2011

The World Economic Disorder Explained

In a single link. I try to avoid the "read it all" exhortation but this is the one. The sine qua non for understanding the causes and remedies for the international banking crises and related economic maladies we're living through. Hint: Fiat currency.

So what did the presumably most important representatives of the Austrian School Ludwig von Mises (18811973) and Friedrich August von Hayek (18991992) have to say about fiat money?

They found that the injection of fiat money through bank credit expansion[6] lowers the market interest rate to below the natural rate level as the Swedish economist J.G. Knut Wicksell (18511926) called it that is, the interest rate that would prevail had the credit and money supply not been artificially increased.

The artificially suppressed interest rate makes firms increasingly shift scarce resources into more time-consuming production processes for capital goods at the expense of production processes for consumer goods, causing intertemporal distortions of the economy's production structure, leading to malinvestment.

Fiat-money injection increases consumption out of current income at the expense of savings, and, in addition, leads to higher investment, so that the economy enters an inflationary boom, living beyond its means.

If the injection of fiat money created through bank-circulation credit out of thin air were a one-off affair, it presumably wouldn't take long for the artificial boom to unwind. A recession would restore the economy to equilibrium as people returned to their truly desired consumption-savings-investment relation (as determined by time preference).

In a fiat-money regime, however, increases in credit and money are not a one-off affair. As soon as signs of recession appear on the horizon, public opinion calls for countermeasures, and central banks try their best to "fight the crisis" by increasing the fiat-money supply through bank-circulation-credit expansion, thereby bringing interest rates to even lower levels.

In other words, monetary policy usually to the great applause of mainstream economists fights the correction of the problem by recourse to the very action that has caused the debacle in the first place.

Such a strategy cannot be pursued indefinitely, though. When credit expansion comes to a shrieking halt that is, when banks refrain from lending the inevitable adjustment unfolds. Borrowers default, and firms liquidate unsound investments and cut jobs.

But there is a cure.

In contrast to these concepts which are, and unsurprisingly so, interventionist by nature economists from the Austrian School have been putting forward recommendations and strategies for reforming the monetary system along free-market principles.

Their recommendations are driven by the insight that the great financial and economic crises are not inherent in capitalism, but result from government interventionism in monetary affairs, most importantly by monopolizing money production. Hayek put it succinctly in 1976:

The past instability of the market economy is the consequence of the exclusion of the most important regulator of the market mechanism, money, from itself being regulated by the market process.[11]

Austrian economists are of the opinion based on elaborate economic-ethical considerations that curing the current financial and economic crisis would require a return to sound money. By "sound money," they mean money that is compatible with the principles guiding the free-market economy.

Sound money is free-market money, money that is the result of the free supply of and the free demand for money. It is money that is produced in unhampered markets where there are no longer any legal privileges for, for instance, central banks.

While those of us in the Liberty Movement think cutting government spending to sustainable levels is a sisyphean task, dislodging the self-dealing central bankers will be even more difficult, perhaps requiring something on the order of the French Revolution. Maybe that "treason" remark by Governor Perry wasn't as misguided as first believed.

2012 Economics and Markets Tea Party Posted by JohnGalt at August 20, 2011 11:23 AM

I have long found ABCT elegant and do not doubt its validity. I put monetary policy at the top of my causes for the housing bust and Panic of '08. I even complained when Gretchen Morgenstern did not in her otherwise excellent "Reckless Endangerment."

I'm on board and have on occasion called myself an Austrian "Ich bin ein Österreicher!" I even have the Aryan features to pull it off. But I get off the train right before Vienna.

My appreciation for Mises is long established, but I cannot accept a gold anchor. Why gold? If we perfect alchemy or find a big mine under Cleveland, we have an expansionary boom? If not we risk deflation?

Hayek seems closer with competing currencies, though it is difficult to wrap one's head around it.

I return to the Constitutional, enumerated power "To coin Money, regulate the Value thereof." An economics professor suggested we made a big error there, but it is there. I don't think going back to Breton Woods is the answer.

The phrase "Sound Money" -- if not "coined" -- popularized by President William McKinley. He did not give a fig about monetary policy, but had to run twice against William Jennings Bryan who wanted to talk about nothing else. "I'm for sound money" allowed the candidate to quickly talk about the tariff, which was his concern, without providing any specifics. I accuse today's rabble of the same offense. Do you mean metalism? I'll ask Well, not necessarily, [and the vowels get longer and the tone falters] but sound money.

I purport that a 2% inflation target fiat currency is sound money. And that QEn were required to keep the target when the FOMC could not inject liquidity using normal methods.

Yes, I worry that it will be overused and I dislike giving the government the option to monetize the debt. But I don't see a gold peg as the answer.

I always think I got off the Austrian Express at Chicago: Milton Friedman's computer Fed, really a set of rules to set rates and supply without human intervention or opinion is the best way to go. In the meantime, Chairmen Bernanke (the greatest villain since Hitler to some) is essentially doing that and doing it pretty well.

The other thing I have noticed, is that when ThreeSources discusses monetary policy, readership asymptotically approaches zero.

Posted by: jk at August 21, 2011 12:07 PM

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Posted by: johngalt at August 21, 2011 6:28 PM

(That oughtta buy us a few more volleys back and forth. I'll just let it soak a while...)

Posted by: johngalt at August 21, 2011 6:30 PM | What do you think? [3]