15 votes

HELP! Someone who knows Austrian Economics, please help me!

I'm in a college macroeconomic theory class.....my professor tried to show me and the class today that the natural effects of market processes are exactly the same as the Fed's actions, and that the Fed raising the money supply increases savings and fixes recessions.

I hold the traditional Austrian viewpoint that an increase in the money supply by the Fed. artificially lowers interest rates, thereby causing firms to "mal"-invest, only to realize that no one has saved any money to purchase the products that result from their investment.

My professor says that during a recession, the increase in the money supply by the Fed lowers interest rates (obviously), therefore stimulating investment....I agree with him on that much.....but he goes on to say that this investment causes firms to increase total output, meaning that income rises (since output=income), and since income rises, individuals (workers, in this case) have more money to both save and consume. Therefore, according to my professor, expansionary monetary policy can fix recessions.....but this runs contrary to my Austrian views.

Is there anyone out there who can help me disprove my professor?

Comment viewing options

Select your preferred way to display the comments and click "Save settings" to activate your changes.

So many pitfalls here

Sounds like there is a huge assumption that money printing actually makes it to the employee in the form of a pay raise so they have more money to spend. Also, many Keynesian economists believe inflation is a function of CPI, not the printing of money, so you will never get them to admit that inflation occurs because of money printing.

Please also keep in mind that

Please also keep in mind that different types of investments are made based on interest rates. Lower interest rates imply excess capital in the system, so a market tends to invest long term projects. Higher interest rates imply the need for more capital in the economy and that people are spending now instead of in the future so shorter term investments are made.

If people are saving, interest rates go down because the banks have excess money when people are putting off their purchasing power into the future. So it also makes sense that businesses would use the lower interest rates to invest in long term investments that pay off when people decide to spend their money in the future. Higher interest rates force businesses to invest in short term projects because its too expensive to try to invest long term.

So artificially low interest rates encourage businesses to invest in long term projects. You professor is assuming incorrectly that investments automatically equal profits. Even if that's true overall and eventually in a market that sets its own interest rates, lower interest rates encouraging longer term investments, may not show profits for that project for some time. It may increase short term employment that "stimulates" the economy, but it doesn't mean overall profits will go up so quickly.

And as others have stated here, when the money supply is low, (which happens when money is cheap and no one is saving) banks will eventually tighten the reigns and stop lending. This puts those long term projects in jeopardy of never getting finished and the investment is wasted. Or mal invested.

Just show him this

Assumption

Sure, it's the broken window theory.

His grand assumption is the primary flaw: it will spur investment.

Read/watch Peter Klein's paper/lecture called "The Myth of Full Employment of Resources"

To sum up broken window theory: a broken window spurs the marketplace because it requires glass, a repairman = exchange of goods & services.

Ok...fair enough, but where's the inherent need for the window to be repaired? Leaving it broken works, too.

Money gets sent to the banks to "spur investment", but many banks still tighten their loans. They sit on the money. They don't "employ their resources" fully. What your prof. says isn't even a "theory" because it's based on assumption.

If I started a company...

And tried to raise money from VC's with my business plan that called offering no services that were valued by the market?, clearly, I would not raise much money if at all.

When something is not bought by the market it is because the market does not find it valuable at that price.

When the Fed forces tax payers at the point of a gun to buy Mortgage Backed Securities (MBS) it is because the creator of the securities has created a product that no one wants and has no voluntary customers.

They have effectively started a business that offers nothing valuable to its potential customer base. As a side note this is with good reason. If the issuer of the mortgage does not intend to be around for the repayment of their loan, the lending standards will become lax and default rates would likely skyrocket (2008 GFC)

The argument equally applies to treasury purchases. The market is looking at the business of being the US government and noticing fiscal irresponsibility. IT has lowered the value of US treasuries as a result. The Fed then forces tax payers to buy this product at a price higher than anyone thinks it is worth. Again sucking resources into a "non-optimal" niche; government.

So every time the Fed prints money and buys X, it is by definition purchasing something at a price above what people value it at. This sends resources to niches that are not the best use of those resources by definition.

The more the Fed acts, the more it wastes resources. And by extension harms the economies ability to grown.

The trip up your professor will have with all of this is as a Keynesian he sees little distinction in types of spending. All spending is equal to a Keynesian. To an Austrian the quality of the spending is all important.

If he tries this angle, I like to hit them with this....

"Why don't we just turn off all the traffic lights and hire all the unemployed to direct traffic. We both solve unemployment and create massive spending to help the economy?"

At this point most Keynesian's are trapped and should have to confess that quality of spending is important, but sadly they just call you names and run from the argument.

www.SuccessCouncil.com
Protect your assets and profit from the greatest wealth transfer in history.

Spend time www.mises.org All

Spend time www.mises.org

All you ever wished to learn about austrian economics you can find there.

Also, try Chris Martinson's Crashcourse. This video is fantastic, and everyone should watch it:

http://www.youtube.com/watch?v=XnXZzx9pAmQ&list=PL7E8A774DA8...

Cyril's picture

Not For Your Professor, Only For Your Personal Advantage:

Not For Your Professor, Only For Your Personal Advantage:

http://www.dailypaul.com/271610/cows-economics-throughout-th...

Traditional Economics is the only sane way to go, as you'll see.

You're welcome. :)

"Cyril" pronounced "see real". I code stuff.

http://Laissez-Faire.Me/Liberty

"To study and not think is a waste. To think and not study is dangerous." -- Confucius

They do. That is one reason

They do. That is one reason so much money is in the stock market, more importantly why it is so volatile. In a free market the primary reason to own stock is dividends. You own part of the firm and you get part of the profits. Now they may reinvest and tell shareholders this and they hold the stock with the expectation of greater future divi.

In our fascist model people have an expectation stocks will always appreciate, except when they don't. This should be as much of a red flag as people thinking buying a house is a business model, ie their house will always appreciate. A house is worth a house. A share of a factory is worth a share of a factory. Everything cannot simultaneously appreciate unless something else is going on. The something else is the thedt via inflation. When you see a bubble in something you are seeing the redistributive effects of inflation. When you see a bubble in ALL assets that is when the jig iis up and you have hyperinflation.

The reason people are in the stock market is precisely because they understand or have an intuition about what is going on. So they DON'T attempt to start their own capital expansion, which contributes to unemployment, but that is wise of them.

Instead they put money in GE or big oil or someone who they have an expectaion the CEO has political connections and can ensure that firm receives market protection. This is also why they get paid so much. They have connections to the corrupt government. The return on investment for a CEO who is on first name terms with the president or gop or dem leadership or federal reserve insiders is simply unachievable otherwise.

Two points. The first is I

Two points. The first is I don't see why there is anything necessarily bad, even in a purely free market, for people to make bets about which companies are going to do well and which aren't, and then to trade stocks accordingly, even if they do not expect to collect any dividends as a result.

The second, which is more germane to the larger discussion, is that I don't see how this explains the mechanism that Austrians often describe, which is: Fed lowers rates --> capitalists have false impressions about the state of the economy --> capitalists malinvest.

Edit: I just reread this and I think it might seem a little curt. for a more nuanced discussion, see my reply to Huskier underneath my initial reply to you.

Don't worry at all about

Don't worry at all about being curt. They are good questions. I tried to answer with some context and examples but I musn't have done a good job.

They do see it coming. Everyone doesn't understand the mechanism but 'the market' does eventually figure it out. It is exactly because after two bubbles in quick succession the market has figured out expanding without benefit of government corruption is a suckers game that they don't.

Hence japans lost decade and our current situation. Monetary stimulus is a trick and no one who has any capital left after being fooled twice either is sitting it out, or else buying into the crony capitalism game.

The easy marks have already been fleeced. Your average Joe who has any money left is in a similar boat. He's gotta be in the stock market because sure as hell saving is no good.

And it is important to note the entire media is feeding people propaganda that the stock market is the place to be.

All of this should tell you the stock market is a bubble. People are in it because they don't see a safe way to protect their capital and they are told this is what to do. Add in 401k law, etc, and you have a whole lot of capital in the stock market that should not be there and is going to evaporate directly.

Bubbles pop.

I have no problem with people gambling on wall street. It is however a big problem when all of tax and monetary policy is telling people play the market or we'll take your money anyway through taxation or inflation.

Literally you can see all of the mechanisms that money is being shoved onto Wall Street. You don't need any econometrics to understand that policy is making people put their money someplace they otherwise would not. Wall Street is a bubble, and that bubble is the foundation of the rest of the economy. We are in the stimulated 'recovery', it only gets worse from here.

We're not going to 'recover' from this stimulated recovery.

All bubbles are caused by policy, and this one will be very ugly when it blows.

I'm curious why you a priori

I'm curious why you a priori believe the Austrian model to be correct before you can even articulate for yourself why it is correct.

Because he probably believes

Because he probably believes in voluntary actions. While I encourage others to become knowledgable on free markets, the core of austrian economics is the theory of voluntary contracts between individuals.

Ask your professor

what happens when unlimited amounts of currency are pumped into the markets? Ask him/her to consider the devaluation of the currency, causing prices to rise with consumers spending more for the same goods and services while their salaries remain the same or decrease (which is happening now).

Keynesian economics produces cycles of boom and bust with each boom and bust cycle occurring closer together. Eventually, the central bank can't pump more money into the markets to create the boom (because the money isn't worth anything anymore), and the economy is bust. There's no evidence, over time, that keeping interest rates at 0% for years and devaluing the currency ever lead to prosperity. In fact, the opposite is true. Keeping interest rates too low over a long period of time and devaluing the currency by pumping new money into the system (which devalues the money already in circulation) leads to economic chaos.

Youre correct, your professors error is malinvestment

Government policies that change the money supply or asset levels of banks arent equivalent to savings because they dont price in risk or opportunity cost. Hence government liquidity is more risky than savings (e.g. the failures of Freddie and Sallie Mae). This is bad because we have a fractional reserve banking system which is especially sensitive to risk since it can pyramid liabilities.

"My professor says that during a recession, the increase in the money supply by the Fed lowers interest rates"

Except for TARP and QE the Fed doesnt usually directly increase the money supply. Usually banks regulate the money supply and the Fed encourages banks to increase the money supply by lowering interbank interest rates.

"investment causes firms to increase total output... individuals (workers, in this case) have more money to both save and consume. Therefore.....expansionary monetary policy can fix recessions"

The government can stop recessions using interest rates. Interest rates encourage lending and Americans treat credit like savings. Credit can disappear or appear overnight, changing the money supply and influencing the actions of people.

Agreed....

The professor is making a lot of inaccurate assumptions but this is the one that leads to his inaccurate conclusion of the "Multiplier effect"

Basically, right now, the

Basically, right now, the federal reserve really isn't using monetary policy. They are trying to keep interest rates low to spur activity, true, but they are basically trying to give banks confidence that they will be the lender of last resort. The banks are still trying to work out their own books...

Plan for eliminating the national debt in 10-20 years:

Overview: http://rolexian.wordpress.com/2010/09/12/my-plan-for-reducin...

Specific cuts; defense spending: http://rolexian.wordpress.com/2011/01/03/more-detailed-look-a

Ducktales - Season 3 Episode 7

"Dough Ray Me" shows what happens with easy money from a duplication machine used by Huey, Dewey and Louie.

http://tune.pk/video/32616/Ducktales-Season-3-Episode-7-Doug...

thank you for making my life meaningful

Ducktales beat Paul Krugman to the punch; complete with alien ray guns and the flaws of Keynesianism. Those Disney creators are GENIUS!!!!

The rate changes the supply...

The typical action of the Fed is to change the interest rate on the money it lends to member banks which tends to change the money supply. A crucial difference contrasted to the idea of changes in the money supply leading to changing interest rates.

Granted that bailouts and quantitative easing are direct injections of money into member bank ledgers, these types of actions are historically atypical.

.
~wobbles but doesn't fall down~

This is the mistake your Professor is making

When the market sets the interest rates it is based on the amount of savings. As savings go up, interest rates go down, and as savings are exhausted, interest rates go up, simple supply and demand stuff. Now here is the key thing to understand:

the savings isn't just money, it represents capital that the people have produced, but have not yet consumed. Easy enough to understand, people have produced, but want to "save" the consumption for later so others borrow their production for use now. What businesses need is NOT savings, but the CAPITAL that the savings represents.

So when the fed artificially lowers the interest rates it tricks businesses into thinking that there is capital available for use, when they borrow the money and go to purchase the capital products it represents they are unaware that someone else has also been loaned the money and is interested in purchasing the same capital products... And while initially there is a boom with all the new activity, we all know what happens when more money is chasing the same amount of goods... prices go up. This makes the cost of the long term projects that businesses have embarked on more expensive than originally planned causing many to become poor investment decisions. When it is realized that poor investments were made we have the busts.

Basically your Professor doesn't understand the Business Cycle Theory. To bad too, a basic understanding of this concept could revolutionize the world.

The thing I never understood

The thing I never understood about this explanation is why, under this theory, businesspeople are incapable of acting in their self interest. That is, why don't thye just notice that the fed has artificially lowered rates, and therefore decide not to increase investment?

It's a little hard

Think about telling a house flipper or real estate mogul its a bad investment in the middle of the housing boom... they have seen success and are drunk on the booming profits. And the thing is, is some houses are needed, which ones are bad??

no one knows what the interest rate should be, or more importantly where in the economy the inflation will show up first. It's effect seems to be to encourage speculation over prudent investment. This is from economics in one lesson by henry hazlett on inflation:

"But the situation is even worse than this, because, as we have seen,
inflation does not and cannot affect everyone evenly. Some suffer more than others. The poor may be more heavily taxed by inflation, in percentage terms, than the rich. For inflation is a kind of tax that is out of control of the tax authorities. It strikes wantonly in all directions. The rate of tax imposed by inflation is not a fixed one: it cannot be determined in advance. We know what it is today; we do not know what it will be tomorrow; and tomorrow we shall not know what it will be on the day after.
Like every other tax, inflation acts to determine the individual and
business policies we are all forced to follow. It discourages all prudence and thrift. It encourages squandering, gambling, reckless waste of all kinds. It often makes it more profitable to speculate than to produce. It tears apart the whole fabric of stable economic relationships. Its inexcusable injustices drive men toward desperate remedies. It plants the seeds of fascism and communism. It leads men to demand totalitarian controls. It ends invariably in bitter disillusion and collapse."

This kind of argument implies

This kind of argument implies that entrepreneurs are incapable of acting in their own self-interest. Austrians tend to believe in a mechanism like this:

Fed expands the money supply --> interest rates drop in the short term --> capitalists react to the drop in rates through malinvestment

What I'm questioning is why the investments are presupposed to be malinvestments. I agree that lower reates will encourage more investment, but wy would those investments be malinvestments? Why are entrepreneurs supposed to be so shortsighted that they do not see the folly of what they are doing, that the inevitable increase in rates and subsequent economic contraction will wipe them out?

As Bryan Caplan, one of my favorite libertarian economists, describes it: "The problem is supposed to be that businessmen just look at current interest rates, figure out the PDV of possible investments, and due to artificially low interest rates (which can't persist forever) they wind up making malinvestments. But why couldn't they just use the credit market's long-term interest rates for forecasting profitability instead of stupidly looking at current short-term rates? Particularly in interventionist economies, it would seem that natural selection would weed out businesspeople with such a gigantic blind spot. Moreover, even if most businesspeople don't understand that low interest rates are only temporary, the long-term interest rate will still be a good forecast so long as the professional interest rate speculators don't make the same mistake."

couple things

first - think about this - no one teaches businessmen about the business cycle, the college professor here is a great example of that... so what your asking is why don't businessmen ignore their schooling and "conventional wisdom"... So if you can overcome that...

"but wy would those investments be malinvestments? Why are entrepreneurs supposed to be so shortsighted that they do not see the folly of what they are doing, that the inevitable increase in rates and subsequent economic contraction will wipe them out?"

Not all those investments are malinvestments, but because there is more investment than is sustainable some of the investments are 'mal', plus the resources are directed from good investments toward malinvestments making some of the good ones appear to be mal.

As Hazlitt points out "inflation does not and cannot affect everyone evenly. Some suffer more than others."... Take the housing bubble, we can agree that too many resources were directed to housing. where should those resources have gone?? how many industries experienced losses due to lack of resources that the housing bubble was consuming? how were the people in the other industries supposed to know, simply by interest rates short or long term, how to factor this bubble in?

This is what hazlitt means when he says "It discourages all prudence
and thrift. It encourages squandering, gambling, reckless waste
of all kinds. It often makes it more profitable to speculate than to produce." - The economic conditions make it so you are better off going to the place all the resources are being directed (housing) than actually producing something that the market would have indicated we need.

Hazlitt continues - "It tears apart the whole fabric of stable economic relationships." - the market signal IS interest rates. when you distort it sends ripples through the economy that effects more than just interest rates, as hazlitt explains it "drives men toward desperate remedies. It plants the seeds of fascism and communism. It leads men to demand totalitarian controls. It ends invariably in bitter disillusion and collapse." - when they understand economics the way it was taught to them anyway...

People don't think about rates

They only think about their immediate consequences. For example: When shopping for a house, nobody thinks about the rate, they only think about the total amount the bank is willing to lend.

When running a business, all you care about is the month, the quarter, the year. The construction sector expands as fast as possible during a construction boom. It doesn't try to constrain itself for when monetary policy changes reduce the demand. It demands government step in with shovel ready projects. That's how entrepreneurs act in their own interests in the real world.

The entrepreneurs do not see what they do as mal investment. Anyone who sells houses will never believe there are too many houses. If there is no demand, they'll claim the market is broken.

Above post was a reply to you

Above post was a reply to you but I accidentally posted to everyone. I hope that helps a little answering your question.

Cyril's picture

My first comment was rather softball

My first comment was rather softball, in fact, and rather of the kind giving pearls to the swine.

As Keynesian theory really is nothing but intellectual fraud, pseudo science transmitted from generation to the other of a parroting academia that has surrendered on any critical thinking - it is also deceptively easy to expose it as such - fraudulent - even with the most humble arithmetic basis, as this non-sense is based on Groucho Marx maths anyway:

The Keynesian Fiscal Multiplier is so fudging FRAUDULENT that it's brilliant

http://www.dailypaul.com/284503/the-keynesian-fiscal-multipl...

Better yet, you can even be much cruder and more expeditious, in destroying your professor's "argument" by asking him:

if anything of what he claims would happen to hold anyhow, how come what his "science" 's advocated policies allegedly predict... is in fact completely invalidated by the simplest FACTUAL observation?

In other words, just ask your professor WHERE, HOW, and WHEN - EXACTLY - the recurring money supply expansion shown in the following STUNNINGLY BEAUTIFUL CHARTS, from 2008 until today, has demonstrated IN ANY EVIDENTLY POSITIVE WAY his...

"meaning that income rises (since output=income), and since income rises, individuals (workers, in this case) have more money to both save and consume"

STUNNINGLY BEAUTIFUL CHARTS FOR THE CONTEMPLATIVE KEYNESIAN

http://dotxml.brinkster.net/2012/Misc/G4_Charts.pdf

?

Yes... WHERE, HOW, and WHEN - EXACTLY - professor, is it apparent in the corresponding official BLS datasets for that period?

Where did all this money ACTUALLY go, instead of what you claimed, dear professor?

People are STILL WAITING to see ANY OF IT, ANYWHERE REMOTELY CLOSE to their WOULD-BE ENHANCED purchasing power and/or savings, you know!

Unexpected delays, much?

"O U C H ."

"Cyril" pronounced "see real". I code stuff.

http://Laissez-Faire.Me/Liberty

"To study and not think is a waste. To think and not study is dangerous." -- Confucius

Cyril's picture

(@ the OP) Btw, I forgot to give you a useful tip:

(@ the OP) Btw, I forgot to give you a useful tip:

consider bringing with you your most powerful b.u.llsh.i.t cutter for when he bothers to come back to you with his answer to the above.

You know,

"Just in case."

"Cyril" pronounced "see real". I code stuff.

http://Laissez-Faire.Me/Liberty

"To study and not think is a waste. To think and not study is dangerous." -- Confucius

Ask him why increasing the

Ask him why increasing the money supply didn't work in Zimbabwe or the Weimar Republic.

Ask him about the role of the petrodollar system in pricing the dollar. Does he think the US economy benefits more from the creation of more dollars or from the fact that the world is forced to purchase dollars in order to keep the lights on?

Your professor probably talks a lot in terms of aggregates. You can point out that the real world market is comprised of discrete transactions. Prices don't gradually rise in unison for all things and all market participants.

He's absolutely right that creating money stimulates investment, however he ignores the unintended consequences. The central bank can't control exactly where the money ends up.

New funds are released into the market by way of loans. This is true for any type of bank. Remember, fractional reserve banking is at play here so credit can expand and contract without involving the central bank.

Is an investment bank borrowing for more leverage to buy stocks? Is the government borrowing to fund a war? Is the national residential mortgage insurer borrowing so it can expand the amount of mortgages it's holding? Is a commercial bank borrowing so it can loan more to commercial enterprises?

Does your professor tell the story as if all the new credit is going to productive business that hire workers to create products we can buy? Or so that government can build roads and operate schools?

If only it were that simple. Market participants generally want to make a profit. So the money flows into investment assets: Stocks, real estate, and commodity futures.

It's true that investment in these things does indirectly drive productivity. Companies sell shares and use the proceeds to hire workers and serve the market. Investment in real estate fuels the construction industry. Investment in commodities leads to investment in resource extraction.

But it's also true that not all of these activities create wealth. Just because the NASDAQ closes high doesn't mean we're getting more productivity out of the companies listed on it. Was technology innovation greater in 2000 than in 1995 or 2005? Is accumulation of gold bullion making us more productive? Of course not.

The Austrian school clearly establishes the fact that inflation results in bubbles which burst when the inflation stops.

It also establishes the fact that inflation benefits some at the expense of others: It benefits borrowers and punishes savers. More specifically, it benefits some borrowers at the expense of other borrowers.

It is a system where whoever can become the most leveraged without becoming insolvent can dominate the market and control the fate of us all. And that is whoever the central bank favors.

egapele's picture

Reagan tried that

Bad move.

The Bush theory of economics never bodes the Country well. People get shot.