What a time-travelling Austrian might think of today’s economy

16 Nov

The Austrian School’s theory of credit and capital has a reputation for being complicated, and some posit that the reason Keynes’ ‘General Theory of Employment, Interest and Money’ holds such weight with policymakers is that it draws on the psychology of lending. Keynes saw the amount of capital channelled into investment as being inherently uncertain, a product of employer confidence in demand for goods, which depended on wider factors like the level of employment, income distribution and wage levels.

Austrians have been caricatured as prophets of the ‘efficient markets’ hypothesis, which essentially holds that artificial credit injections mess with the natural pattern of investment. They believe investment should stem naturally out of normal saving behaviour, as this creates sustainable demand for the goods and services produced through borrowing; loans or debt instruments initiated by banks which are backed on margin and not fully offset by the bank’s stock of available capital represent ‘artificial’ credit whose long-term effect is to cause price increases.

Austrian School economists are sceptical about policymakers’ belief that they can engineer optimal market conditions, believing that artificial intervention causes market inefficiencies. Broadly speaking, the argument runs that inefficient loan allocation to companies which are not sufficiently equipped to use them, or for whose products there is not enough demand, may in the short-term stimulate ‘growth’ – employment and consumption.

But the consequence of this ‘growth’ – the increase in wages and concordantly prices – will be priced into existing and future loans. The unregulated growth of credit will eventually cause a systemic shock, as confidence fails and many of the riskier debt instruments shed as investors try to exit their positions en masse. The value of higher-risk instruments plummets further, as some of the underlying assets – e.g. homes in the case of sub-prime mortgages – undergo foreclosure and are sold at a discount at auctions. Sound familiar?…

Disciples of Haberler, who was more concerned with the structural allocation of credit across the ‘vertical’ chain of production – from commodity mining and production to equipment manufacture to the factories where this equipment is used – would focus more on the credit tied up in cap ex by companies investing in new technology or expansion.

The central bank is supposed to moderate growth, preventing unsustainable expansion and stimulating consumption and/ or investment. Setting a minimum interest rate is just one of many ways in which it does this. Asset purchase schemes, and quantitative easing, are two others. Note in support that the ‘inflation premium’ detailed by economist Irving Fisher is priced by default into interest rates by commercial issuers; the government traditionally just provided a benchmark.

These asset purchase and what we’re going to nickname ‘capital injection’ schemes (when the government creates bonds it then buys back from banks, creating liquidity but also increasing the public deficit) have the net result of more reserves ending up deposited with the central bank. As more capital is circulating, some of it inevitably ends up in current accounts with the banks and they are required to hold a certain ratio of this capital as reserves with the central bank for security.

If and when the central bank decides to raise interest rates, in fairness it must apply the policy rate to its own reserves, effectively paying interest on its own debt at the taxpayer’s expense. If it does not, this will act as an ‘opportunity cost’ – effectively a tax – to banks who could have invested the money elsewhere at a profit. This trend has been analysed in more depth by those such as Claudio Borio, Head of the Monetary and Economic Department of the BIS. For a brief introduction to the argument, see the speech given by him and the Bank of Thailand’s Mr Piti Disyatat on ‘Helicopter Money’.

One of those historical Austrian economists, transported to the present day, might find that their essential doctrine that when tampered with interest rates can have a distorting effect on growth, still has relevance. Unquestionably, QE has boosted spending, and new, sometimes innovative investment. But the cost has fallen on those financial institutions that must take the new risks, as they are forced to chase ever higher yields; pension funds which are struggling to climb out of their own deficits, as former ‘safe-haven’ assets provide insufficient income to meet their liabilities.

The rise of alternative finance seemed for some time to provide another option to the legislation-hampered banks, whose rigorous screening tests and core capital obligations prevented them from extending loans to all comers. But the marketplace lenders’ models which were heavily reliant on ‘diversifying’ the risks they did not properly analyse, by aggressively seeking new loan applicants to replace the loans that had gone bad, are now looking likely themselves to face the price of over-expansion.

The USA’s Lending Club is a prime example, and has suffered losses of $36.5m in the third quarter of this year – though up from $81.4m in the second quarter – as it confronts the need to tighten up its due diligence operations and tackle non-performing loans.

Reversing the secular and government-sponsored decline in interest rates may not be a painless process, but the alternative is to enshrine a borrowing climate which is not profitable for the majority of lenders, or investor in the resulting securities. Can the market rely forever on the government to prop it up, even as the government’s own debt must increase to fund its stimulus measures? Does this rhetorical question even need a response?…

 

Ludwig von Mises

The ‘Austrian’ Theory of the Trade Cycle

Borrowed the capital theory developed by Carl Menger and elaborated by Eugen von Bohm-Bawerk. Mises attempted to prove that when, in an unsustainable credit expansion, interest rates are forced down, capital is allocated inefficiently. Because loans are granted in an indiscriminatory fashion, the production process ties down capital for too long a period in relation to ‘the temporal pattern of consumer demand’. In the end, the discrepancy means the market for both consumer and capital goods (loans) readjusts to counteract the misallocation.

 

Friedrich A. Hayek

Can We Still Avoid Inflation?

Plotted series of right-angled triangles to show the two factors of time and money, as capital flows through the production process. It is agreed to have been overly simplistic in imagining capital as ‘tied down’ in development loans when in reality it still circulates fairly freely. But Hayek pioneered the use of time as a vital factor in analysing the boom-and-bust sequence.

 

 

 

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