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Saturday, December 13, 2014

What Can We Learn From Austrian Economics?

Although they are now thin on the ground within academia, 'Austrian' economists are ubiquitous in the financial markets and across the internet. (They are called Austrian because many of the founders of the school of thought were originally from that country.) Since Austrian economics is a fairly pure 'free markets' doctrine, it is politically attractive to many in finance, which partially explains its appeal. But the question is whether it offers any insights that give an 'edge' to analysts? I recently read "Paper Money Collapse: The Folly of Elastic Money" by Detlev Schlichter, and I am somewhat unconvinced about the amount of insights that are on offer.

With a title like "Paper Money Collapse", it is pretty clear that this was not going to be a scholarly tome. Detlev Schlicter had a 19 year career as a portfolio manager and trader at various large institutions (J.P. Morgan, Merrill Lynch and Western Asset Management) and hence is not an academic. Meanwhile, his target audience appears to be readers who know little about economics. But even so, there is little theoretical content within the book. Schlichter drops the details of Austrian Business Cycle almost completely, and focusses on just one small slice of it, which is the Cantillon Effect. It is not a positive commentary on Austrian Business Cycle Theory that someone writing a book about it omits almost all of its details.

There are presumably better modern sources for understanding Austrian economics. But pretty much all I have seen on the internet, or in market newsletters, are similar to what is in the book by Schlichter. I will therefore discuss this book as an example of that popular Austrian literature. But I believe that there are Austrian academic writers who may offer a more substantial and nuanced version of the theory.

All Paper Currencies Are Doomed!

He hammers home one point repeatedly: all previous attempts at having a "paper" currency have previously resulted in that currency being worthless (other than for collectors). And although it somewhat undermines his distaste for paper, even nominally metallic currencies were often debased. He then extrapolates that historical experience to argue that all the existing unbacked paper currencies now in existence are all eventually doomed.

I am in agreement with that view, but there is a lot of information buried in the word "eventually". Eventually, all life on Earth will be sterilised by a cosmic catastrophe, and all of Mankind's works will be no more.

Although this can be seen as somewhat depressing, such a forecast tells us little how to live our lives now. The same holds for his prognostications regarding paper currencies. Eventually, every political system crumbles, and its economy will go with it. But modern representative governments are robust; if they crumble, it will be the result of changes in the real economy, or the (geo-)political environment. Looking at the central bank's balance sheet tells us nothing about such political processes.

Cantillon Effects

Schlichter's book gives a long introduction to fractional reserve banking, and it leads to inflation. He argues (correctly, in my view) that many economists place too much emphasis on economic models with only a single composite good. In such a model, there is a well-defined price level. This model price level behaviour is then extrapolated to the consumer price index in real world economies.

His explanation is that as money is created (by the banks, or the government), the first recipients of money will bid up the prices of particular goods and services. It is only as this process is repeated does it become clear that the general price level is rising. Since most people were unaware of the possibility of the price level rising, they would do nothing to protect themselves from the loss of purchasing power. As a result, the first entities with access to money benefit at the expense of everyone else. This is known as the Cantillon Effect.

Since a rising broad money stock almost invariably accompanies a rising price level, this verbal description of the process appears correspond to reality. But it does not appear to pass the "so what?" test any analyst should ask of any theoretical framework.
  • Can we relate the behaviour of sub-indices of price indices to sectoral borrowing patterns? For example, did the price of oil fall because some oil consumers paid back their borrowings?
  • Since most sensible entities within United States (and similar countries) have correctly expected inflation to stick around 2%, in what sense does the Cantillon Effect matter? That is, even though individual borrowers are allegedly raising the prices of particular goods on a continuing basis, I will have already arranged my affairs to take into account a steady 2% loss of purchasing power of money.
  • Can we make quantitative inflation forecasts with this theory? (There was no attempt within the book.)
He does his best to get readers mad at how these entities with "first access" to new money take advantage of the situation. But as a political observer, I cannot see how this strategy works. In the 1800s, access to credit was not democratised, and so one could run for office on theories that impugned bankers and borrowers. But who are those people that have "first access" to new money now?
  • Anyone with a mortgage or credit card;
  • businesses with debt or even account payables;
  • investors in bonds, whose principal payments are often made by issuing new debt;
  • investors in equities, as their dividend payments are also often financed by new debt.
Good luck running a political campaign against that voting bloc.

Capitalism Is A Fragile Flower

Back in the days when the Soviet Union existed, there was a serious debate about the merits of central planning. The Austrian contribution to the "Socialist Calculation Debate" (mainly by Mises and Hayek) was that socialists could not rationally plan their economies because they lacked a system of prices to guide decisions. One could easily argue that the Austrian side of the debate won, because there are few serious advocates of centrally planned price systems now. (Central banks still cling to models developed to describe centrally-planned economies, but that is another subject.)

However, within Schlichter's text we discover that there is a system of true prices that is determined by the a true free market system, and government interference or money creation will lead to price "distortions". These distorted prices must be "corrected" to these ideal prices, and they will do so, regardless of what the government wants.

The first practical problem one faces is: since there is always government interference within the economy, and we certainly cannot do much about international actors (will OPEC and the Chinese Communist Party embrace Austrian economics?), we will always have "distorted" prices. How do we know whether a particular action will raise or lower the distortion? 

The second problem is philosophical. The capitalist system Schlichter describes is a fragile flower; it will cease to function properly if real world prices do not exactly correspond to these idealised "free market prices". One could easily draw the implication that governments should enforce laws so that prices do not deviate from what one might call "just prices". My guess is that this obvious conclusion is not what he intended.

I would argue that capitalism is actually fairly robust (if tempered with a welfare state), and it can deal with relative price shifts without a need for liquidating activity in an attempt to reset the system to some set of ideal relative prices. 

Forecasting Is Difficult

Since I do not offer investment advice (for legal reasons), and tend to outline possible scenarios rather than forecast economic outcomes, I am not in a position to throw stones at someone's forecasting record. However, I need an analytical framework to describe my scenarios, so I am still in a position to judge whether Austrian theory can be useful.

I read the first edition of the book, published in 2011. (The second edition was recently published.) Needless to say, we have not had a "monetary breakdown" since then. But we can look at how well his other predictions pan out against what has happened. (The forward-looking sections of the first edition were short, and so I hope he beefed them up in the second edition.)

Schlichter argues in Chapter 10,
Current policies have postponed the crisis and the necessary process of liquidation of misallocations of capital. They have not, and logically cannot, make them go away.
The possibility of postponement provides an analytical escape hatch. Although the paper money system may not melt down, the authorities will need to make greater and greater interventions. His theory is that there will be "nationalisation of money and credit".

Since governments do intervene in credit, one could argue that this forecast is already true in some sense. In Canada, the Federal Government in the form of the CMHC has taken a ridiculously outsized position guaranteeing subprime residential mortgages. In the United States, there is the student loan system and the mortgage agencies. But it should be noted that this form of intervention pre-dated the publication in the book, and there is little sign that most of these interventions make that much of a difference relative to private sector credit creation. (The CMHC in Canada is a case where the intervention makes a big difference.) He argued that it would be "unlikely" that the private sector could create new bubbles to generate growth. (Since this is exactly what has happened, it is a sign he should read less Austrian authors and more Minsky.) But it seems hard to see any reason to fear the effects of "nationalization of credit" any time soon.

He had the obligatory section on "debt monetization". He states,
It is difficult to imagine a scenario in which public finances will not, on trend, deteriorate further, even in the absence of activist fiscal policy.
If we take the case of the United States, the fiscal deficit has declined during the expansion, as is what normally happens. But he is worried about the "trend" getting worse. The question is then: how long will it take to find out? Business cycles are now stretching out over fairly long intervals; it could take decades for trends to exhibit themselves. Additionally, there is no sign that the increasing trend in the debt-to-GDP ratio matters for things like inflation. And finally, central bank balance sheets have mainly consisted of government debt for decades. Yes, they have been "monetising" the debt, without any hyperinflation in sight.

I would argue that the problem with Austrian theory as presented by Schlichter (and others) is that it is so focussed on documenting the allegedly fraudulent nature of our current monetary system that forecasts end up revolving solely around the collapse of that system. This makes the theory unable to deal with rather more mundane things such as business cycles.

Questionable Monetary History

Schlichter has a small potted history in Chapter 2, The Origin and Basics of Fractional-Reserve Banking. In it, we learn that the first bankers were goldsmiths, and that they issued tickets against deposited gold.

Needless to say, no dates were given in this "history". When and where did this happen? Considering that the Romans had the equivalent of fractional reserve banking, and the classical Athenians had a bank-like institution in the trapeza, we have to stretch pretty far back in time to get to a period when these alleged goldsmiths operated.

It seems strange to include unusual assertions about unknown historical eras within a book about the demise of the monetary system in 2011.

Concluding Remarks

It is clear that Austrian economics fits a niche - it is a pro-free markets theory that allows for a business cycle. The free market wing of mainstream economics - Real Business Cycle theory - does not tell us anything useful about the causes of recessions.

Criticisms of Austrian economics tend to rapidly turn into a political debate, which I have tried to avoid here. However, a complete lack of desire to think about how governments operate is not a useful attribute for analysts in the government bond market, which is my target audience. And predicting inflation in developed countries where the central bank promises to deliver 2% inflation (successfully, in most cases) is not particularly insightful.

Focus on subjects other than the desirability of a Gold Standard seems to be needed in order for Austrian economics to be useful for thinking about the economy as it currently functions. This may be done in the Austrian academic literature, but those contributions are not very visible to outsiders.

See Also:

  • This list of articles by 'Lord Keynes' debunking Austrian economics is the most concise source that I have found for understanding the theories behind Austrian economics. Most primers that I have seen that are produced by Austrians themselves are similar to the Schlichter text in that they discuss simplified gold-based economies without reference to the operations of real-world fiat money economies. I read the Sclichter book on the hope that it would provide such a summary, but as my review discusses, it had less theoretical content than the articles by 'Lord Keynes'.
  • The Monetary Systems of the Greeks and Romans (Amazon affiliate link), discusses the relatively sophisticated monetary system of the classical Greeks and Romans. It is a collection of articles, edited by W.V. Harris. Historians used to mainly focus on the precious metal coinage of Greece and Rome, and this presumably influenced Austrian historical scholarship. However, textual analysis demonstrates that there were relatively sophisticated financial systems, although they lacked some modern features such as clearing systems. Professor Harris states that the change in attitude started around the early 1990s.
(c) Brian Romanchuk 2014


  1. Thanks. I've been following a blog by an Austrian economist ( that fits the mold you depict here. Jeff Snider nails the operational details of central banking, and points out problems with the conventional wisdom with admirable clarity. The underlying premises are fantasy of the highest order, as far as I can tell.

    1. Thanks. The "popular Austrians" have a fairly similar world view, but it is hard to relate it to the formal Austrian theory.

  2. Have you looked at Roger Garrison

    As far as I can tell he is the most sophisticated modern proponent of Austrian macroeconomics. Although I think the high tide of Austrian macro was in the immediate aftermath of the financial crisis in 2008, when people were desperately seeking the answers that the mainstream neoclassical approach so signally failed to provide.


    1. I have heard the name, but I cannot remember reading his work. I will take a look, thanks.

    2. In some ways, I liked the Austrian market analysis up until 2000 or so. Gold had been in a bear market for a couple of decades, and so they were quieter about how great gold is as an investment. And since there had been no banking system crises for some time (other than S&L crisis, which was fairly easily understood), so there was less complaints about "fractional reserve banking". In order to attract attention, they had to talk about the business cycle, which then revolved around the nuttiness in the tech sector.

      Now, most commentary seems to just revolve around banking and gold. I have the strongly held view that the Financial Crisis was a problem in the shadow banking sector, not the formal (fractional reserve) banking sector, and it could easily have happened with a gold-backed currency. As a result, I find this recent trend of analysis not particularly interesting.

  3. Indeed, fractional reserve banking and close state/banking relationship has been part of the economic scenery for centuries, so looking to that as the "cause" of crisis seems unhelpful. Keynes. Shackle, Leijonhufvud and Minsky are better guides.

  4. "the first entities with access to money benefit at the expense of everyone else"

    The only people who might be directly negatively affected in some way by inflation (supposedly 'caused' by this increase in the quantity of money) are those with savings earning a lower return than the rate of inflation. Even then, there might be more overall savings in an inflationary economy than in a deflationary economy or economy stuck at zero inflation (due to higher growth, investment employment), so overall people would be better off in terms of savings despite the inflation 'cost'. And those people who don't have savings earning a lower return than the rate of inflation will benefit.

    1. It's not just savers, people with a fixed nominal wage or pension loses purchasing power under inflation. Since wages and pensions are typically adjusted for inflation, the problem is whether inflation is greater than anticipated.


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