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New money does not have to enter the loanable funds market
It is one of the standard claims of Austrian business cycle theory that the "new money" enters the economy through the loanable funds market. Yes it usually does, but it is important to recognize that this happens because of decisions by banks, not because government somehow forces the money to go there.
Consider an expansionary open market operation. Banks now hold fewer T-Bills and more cash. Presumably the cash is more liquid (though if you are puzzled by this assumption in the context of a bank, join the club, Brad DeLong is a member too), so the banks will do something liquidity-like with it. That could mean making a loan, but it also could mean spending the money to refit the ATM machines, or for that matter increasing dividends to bank shareholders.
But no, bank managers make an independent judgment that there are loans worth making. Of course sometimes they are wrong. But they know they got this new money through open market operations. And they decided to go ahead and make the loans anyway. They didn't have to. They could have re-routed the new money to some other injection path altogether. But they didn't.
That is another reason why the Austrian theory of the trade cycle is as much a market failure theory as a government failure theory.
Posted by Tyler Cowen on January 3, 2008 at 04:15 AM in Economics | Permalink
Comments
Friedman was right: he preferred a helicopter because it didn't matter how money entered into circulation.
In addition, as long as the Fed prefers to issue money through banks, the Fed knows what banks are going to do. It's not a market failure, at least according to the standard definition. Perhaps you prefer money to be issued to pay government expenses. I couldn't understand the point of your post.
Posted by: Edgardo at Jan 3, 2008 5:42:13 AM
"Austrian theory of the trade cycle"?
Always thought it is a "business cicle" theory.
Anyway, it says the problem is in the rate dictate from the
government, and access restrictions (banks only). So you can can
call this mfrket "open" only as a joke. Rate fix and access privilege
shurely shift bankers preferences, as marginalists you have to
know this.
Posted by: Vvagr at Jan 3, 2008 6:23:22 AM
So if the money goes into the upgrading of ATMs, the boom/bust cycle will occur in the ATM sector. The cycle is not eliminated.
Posted by: Robert Wallach at Jan 3, 2008 8:54:44 AM
Then, if government provides unemployment subsidies and the beneficiaries decide not to work because they are paid anyway, the government decision has nothing to do with this result because "government doesn't somehow forces people to remain unemployed" and "they decide not to work but they didn't have to"? Is this also market failure?
Posted by: Albert at Jan 3, 2008 9:06:00 AM
Tyler,
This relates to the general thread rather than this particular one concerning ABCT. Isn't the issue really about the "cluster of errors", not just error? And if the "cluster" is a consequence of a government intervention, then how can the errors in that cluster be termed "market failure" as opposed to "government"?
Pete
Posted by: Peter Boettke at Jan 3, 2008 9:39:25 AM
My biggest complaint that the prevailing interest rate cannot be in any way "the" defining number for
the market's preference for delaying consumption. Stock returns indicate the return on delaying consumption
just the same and can be much higher. People who delay consumption will buy stocks, not just interest-
bearing investments.
Also, the "malinvestments" Austrians like to mock (for getting liquidated and turned useless in the bust)
are typically very speculative investments that demand a very high ROR agains t-bills to justify doing.
Something on the order of 50% over t-bills. So, it's not like anyone ever says:
"Well, we thought a 50% ROR would be acceptable for this project. But come on -- that was when I could
get 4% from nice, risk-free government bonds. Now that I can get 5% ... I'm ****in' pullin' the plug
on you guys. Your offer of 50% returns is joke when I can get those yields without your risk."
Posted by: Person at Jan 3, 2008 9:41:14 AM
"...That could mean making a loan, but it also could mean spending the money to refit the ATM machines..."
Assuming that the bank (or any firm) is credit-worthy, investment decisions will not be appreciably affected by having and using cash on hand vs borrowing. If an additional cash lump is significantly better allocated for ATM refitting, then it is highly likely that the previous cash lump should also have been so allocated.
Regards, Don
Posted by: Don Lloyd at Jan 3, 2008 10:10:50 AM
That is another reason why the Austrian theory of the trade cycle is as much a market failure theory as a government failure theory.
This claim does not hold, unless you let people decide freely which money do they want to make transaction with.
"Money" is supposed to have certain attributes, among others as-fixed-supply-as-possible. Government money does not meet this criteria well. Thus, on a free market, people would NOT choose government paper as "money".
It is the same as saying that it is "market-failure" when there are shortages because of price-ceilings. People would choose to change prices, if they could. People would choose different money media not susceptible to manipulation, if they could.
Other Austrian position is: Money is NOT NEUTRAL. Even if you reject austrian business cycle theory (which I personally believe is not completely correct, however it seems to me that in reality it is quite close), monetary expansion still causes dis-synchronization of market information. You cannot claim it is free-market failure when the government hijacks the synchronization mechanism (price) or even in this case the synchronization medium itself.
Posted by: andy at Jan 3, 2008 10:28:54 AM
I think Tyler just makes these threads to stir the fever-swamp Austrian base (like andy). They often miss the point of the posts in delightfully humorous ways.
"Your criticism of how Austrians describe the consequences of monetary injections is unfounded because the money supply should stay as fixed as possible" hahaha splendid.
Posted by: Student at Jan 3, 2008 11:03:23 AM
The inability of kittens to fetch the paper is less to do with any inherent weakness of kittens but more generally due to their lack of dog-edness!
Posted by: Joseph Becker at Jan 3, 2008 11:11:35 AM
That could mean making a loan, but it also could mean spending the money to refit the ATM machines, or for that matter increasing dividends to bank shareholders.But no, bank managers make an independent judgment that there are loans worth making.
The yield curve was inverted and banks were already finding other uses for their money.
Posted by: 8 at Jan 3, 2008 12:15:01 PM
Let me get this straight. You are saying that because the banks choose to exercise their government-granted legal privilege to create multiple property titles (bank accounts) to the same property (bank reserves) upon receipt of government-monopolized legal-tenderized paper, that the resulting economic disruptions are a free market failure? Weak.
Posted by: Matt at Jan 3, 2008 12:58:38 PM
Tyler:
Whoever gets the new paper money also surrenders an equal amount of bonds, so their net worth is unchanged. The Fed, meanwhile, gets the bonds, but also sees its liabilities (i.e., paper dollars) rise by an equal amount. The backing for the dollar rises in step with the number of dollars issued, so there is no change in the value of the dollar. The new money has no effect on prices, so there is no reason to care who got it first.
Posted by: Mike Sproul at Jan 3, 2008 1:15:37 PM
Let me get this straight. You are saying that because the banks choose to exercise their government-granted legal privilege to create multiple property titles (bank accounts) to the same property (bank reserves) upon receipt of government-monopolized legal-tenderized paper, with the full knowledge that under conditions of "stress" that they will always have access to the "lender of last resort" with unlimited ability to print, that the resulting economic disruptions are a free market failure? Weak.
Posted by: Matt at Jan 3, 2008 1:33:20 PM
It appears true that market behaviour is part of the Austrian theory of the business cycle. However, I imagine they would argue that government is still the root cause of the problem. The basic issue is that government can be held responsible for failing to prosecute the 'fraud' of fractional reserve banking. It is only through this method that banks are allowed to expand the money supply at their discretions. Although the rest is happening within a market mechanism the root of the problem is the government's endorsement of a bankrupt system.
It might be argued that the market itself should reduce flow of funds to banks with low reserve banks. However, historical government bailouts would also reduce the effectiveness of market forces here also. Either way, there is a good case that business cycles due to fluctuations of the money supply are more due to government effects than natural market ones.
Posted by: Simon at Jan 3, 2008 1:54:28 PM
Tyler says: "Presumably the cash is more liquid (though if you are puzzled by this assumption in the context of a bank, join the club, Brad DeLong is a member too)".
I think the answer to that puzzle is that given that your LONG-TERM investment objective is to hold T-bills, and you hold T-bills NOW and you are in temporary need of cash NOW, but you have more cash coming in SOON, then it's much (by a factor of 10 or so) cheaper to repo your T-bills (i.e. borrow money using them as collateral) than it is to sell the T-bills outright and buy them back later.
Posted by: Foolish Jordan at Jan 3, 2008 2:37:25 PM
Simon:
Fractional reserve banking is not fraud. If I deposit $100 in my bank, and the bank lends $90 at interest, (part of which goes to me), and if I agree to it, then it is simple voluntary exchange. Furthermore, the resulting expansion of the money supply is matched by an equal increase in bank assets, so there is no effect on the value of the dollar.
More at:
www.csun.edu/~hceco008/realbills.htm
Posted by: Mike Sproul at Jan 3, 2008 3:59:59 PM
Mike, that is questionable. If you put your money into the bank and while the bank lends the money, you are not allowed to use it - that is not fraud and it does not expand money supply. However: if you allow fraction-reserve banking - the money is lent, you are still allowed to take it from bank - then you base your decision on the assumption that you still own the money and you can use it. This expands the monetary base and arguably leads to business cycles.
Whether it is fraud or not is another question, I would argue that if the banks were not bailed out by the government, if they stated openly how would they react in case of bank run, if they failed for bankruptcy if they were not solvent and if the government did not impose any "banking holidays" - you could expect much higher reserves, much more responsible lending standards and actually less volatility of the money supply. It would be roughly equivalent to an open fund.
Posted by: andy at Jan 3, 2008 4:22:26 PM
"If I deposit $100 in my bank, and the bank lends $90 at interest, (part of which goes to me), and if I agree to it, then it is simple voluntary exchange."
Even if all parties are aware of the mechanism (which in reality is far from true), the deposit contract is technically and legally illogical, and so long as society is to be governed under the rule of rational law it must be forbidden. Furthermore, equal protection under the law does not allow one group of individuals to have this privilege at the expense of others. Brokers must be allowed to loan stock they do not own, and grain silo owners to loan wheat contracts, and millions of other cases. Finally the massive and cyclical resulting economic distortions cause harm to otherwise uninterested parties. Money market accounts have no such problems and would serve the purposes of bank accounts in a rational system.
Posted by: Matt at Jan 3, 2008 4:28:08 PM
I'm confused? Everything I've read about ABCT by Garrison states that the problem is discoordination caused by the manipulation of the safe rate of interest. The thing that causes the business cycle, as I understand it, is not directly related to where the new money goes. Of course, banks face strong incentives to lower interest rates when the Fed lowers rates, so we all know a decrease in the Federal Funds Rate generally means more loans are going to be taken out. The "new money" could be spent on hookers for bank executives, while more of the "old money" goes into loans. I don't see why it would matter.
Why does it seem like a GMU economist is beating up a straw-man of Austrian economics?
If Tyler does not believe the rate of interest coordinates intertemporal action, what does he believe DOES coordinate such actions? Perhaps if there is no such coordinating mechanism inherent in loan markets (as Tyler seem to be suggesting), there might be a market for businesses which would provide such information? But, according to Hayek, such a firm would face an insurmountable knowledge problem...
Posted by: G at Jan 3, 2008 4:49:33 PM
Mike, perhaps I'm confused but to me the example you give is not what I mean by fractional reserve banking. I agree there is no fraud in your case. But I also don't even see why there is creation of money even in the example you give.
Let me illustrate my understanding of fractional reserve banking. I receive deposits of $100 worth of gold from various sources. At the time I issue claims to the gold for $100. These scrip become currency and are traded in lieu of gold. Then I notice that at any time, there are only small claims on my pile of gold so I issue loans of more pieces of scrip, another $100 worth of claims. I hope that these will come back with interest before anyone claims back the gold. But in fact I have issued more claims than I have reserves. The money supply is now increased but I am really bankrupt and have perhaps committed fraud. If there is a run on my bank, people will discover that I only have $100 of gold and the money supply will fall back.
We seem to have different ideas of what fractional reserve banking is. What's right? I'm not a professional economist so I may have misunderstood.
Posted by: Simon at Jan 3, 2008 4:58:21 PM
But no, bank managers make an independent judgment that there are loans worth making. Of course sometimes they are wrong. But they know they got this new money through open market operations. And they decided to go ahead and make the loans anyway. They didn't have to. They could have re-routed the new money to some other injection path altogether. But they didn't.
Wouldn't you agree that banks face very strong incentives to lend what they can profitably lend? After all, the total harm from a credit crunch is not kept internal to the banks who give out bad loans. Also, most publicly-traded companies have a ton of trouble justifying poor short-term earnings to shareholders.
Person, I've never seen any attempted explanation of why many modern bubbles seem to be concentrated in a single sector, have you?
Posted by: G at Jan 3, 2008 5:00:40 PM
Andy:
Fractional reserve banking does indeed expand the money supply, but remember that every time a bank creates a new dollar and lends it, the bank gets a dollar's worth of assets from the borrower. Before the loan, the borrower based his spending on the fact that he had the dollar's worth of assets. After the loan, the borrower bases his spending on the fact that he has the bank's dollar, but no longer has the assets he posted with the bank. The loan doesn't change anyone's net worth, and if the value of the dollar were reduced by the loan, the bank would eagerly buy back those dollars to make an arbitrage profit.
Posted by: Mike Sproul at Jan 3, 2008 5:21:25 PM
Matt:
Most people don't understand what Title Insurance companies do either. That doesn't make them fraudulent. There is nothing illogical about fractional reserves. Every dollar issued is backed by a dollar's worth of bank assets, so the bank always holds enough assets to buy back every dollar it has issued, should the need arise. Of course, I'm assuming we're talking about solvent banks, but that's another issue.
Posted by: Mike Sproul at Jan 3, 2008 5:28:14 PM
Simon:
"The money supply is now increased but I am really bankrupt and have perhaps committed fraud. If there is a run on my bank, people will discover that I only have $100 of gold and the money supply will fall back."
You aren't bankrupt, since you never would have lent the additional $100 without getting a $100 IOU from the borrower. So you have issued a total of $200 of money, against which you hold $100 of gold plus $100 worth of IOU's. If everyone suddenly brought your dollars back to you, demanding gold, you could first sell the $100 IOU for 100 of your dollars, then burn them. Then you could pay out the $100 of gold for the remaining $100 that you issued. Everyone gets their stuff back.
Click on my name below to learn about the real bills doctrine, which is the basis of this analysis.
Posted by: Mike Sproul at Jan 3, 2008 5:34:58 PM
