Regulatory Obfuscation and Accounting Gimmickry Have Been the Preferred Approaches of Central Banking with Respect to Capital Inadequacy in Banking

Today [June 1990], many large banks are operating with capital ratios below 5 percent. But even these ratios overstate capital adequacy in the banking system because banks do not adjust the value of their loan portfolios to reflect market values. The resort to accounting gimmickry to mask weakness in the banking system is not new, although it is accelerated when that weakness becomes widespread. One economist noted that “indeed, the use of book value accounting in banking was promoted by regulators in the 1930s to deliberately mask the banks’ poor financial condition . . . . It appears that opposition to market value accounting comes less from banks themselves than from the regulators.” The practical difficulties of marking loans to market value are starting to be overcome with the rise of a secondary market for bank loans. But this market is simultaneously providing evidence of how far bank loan values are overstated. For example, most banks have written down loans to Latin American countries by 25 percent, carrying them in effect at 75 cents on the dollar. Yet the secondary market for such debt shows its market value to be approximately 25 cents (as of late 1989) and declining rapidly, from 65 cents only 1 year earlier. Many money center banks would wipe out their equity cushion by recognizing the market value of these loans alone. The market for bank stocks has reflected this fact better than bank accountants and regulators (who should know better), as investors discount bank stock prices in relation to book values. Capital adequacy also has been overstated to the extent that banks have moved a significant amount of their liabilities off the balance sheet in the form of credit commitments, interest rate swaps, and standby letters of credit. The most important point is that regulatory obfuscation and accounting gimmickry, not genuine reform, have been the preferred approaches of central banking with respect to capital inadequacy in banking. 

—Richard M. Salsman, “Breaking the Banks: Central Banking Problems and Free Banking Solutions,” Economic Education Bulletin 30, no. 6 (June 1990): 65-66.

A Government-Guaranteed Deposit System Artificially Lowers the Cost of Debt Financing for Banks and Increases the Proportion of Debt in the Balance Sheet of the Banking System

Central banking’s provision of deposit insurance with artificial ceilings on interest rates paid on those deposits also diminishes capital adequacy in the banking system. Finance theory demonstrates that firms (banks included) will choose a proportion of debt and equity in their capital structure that minimizes the blended cost of capital. But a government-guaranteed deposit system that is backed by a central banking institution with a monopoly on fiat base money creation, lender-of-last-resort powers, and the right to limit deposit rates, artificially lowers the cost of debt financing for banks and increases the proportion of debt (and lowers the proportion of capital) in the balance sheet of the banking system. Banking is the only industry in which the government agrees to guarantee the short-term liabilities of every participant. It is an arrangement that naturally encourages the use of debt (deposits) instead of capital to finance asset growth. There is a substitution of “public capital” (government-insured deposits) for “private capital” (equity that would have been employed in the absence of government-guaranteed deposits). The imposition of corporate taxation and the tax-deductibility of interest expense (but not dividends) also reflects government intervention and further promotes leveraging and capital inadequacy in the banking industry. Although the banking industry shares with other industries this tax-driven motivation to employ more debt than capital, corporate taxation and tax-deductible interest nonetheless remain nonmarket factors bearing on the decision to leverage. They would not be operative in a free market.

—Richard M. Salsman, “Breaking the Banks: Central Banking Problems and Free Banking Solutions,” Economic Education Bulletin 30, no. 6 (June 1990): 30.

The Lender-of-Last-Resort Function Inherent in Central Banking Encourages Capital Inadequacy in the Banking System

The lender-of-last-resort function inherent in central banking also encourages capital inadequacy in the banking system. The central bank agrees to lend reserves to illiquid banks even if they also are insolvent. The lender of last resort is not concerned with the cause of the illiquidity, even if it arises due to depositors anticipating a bank’s insolvency. The illiquidity, not the insolvency, is seen as the problem requiring a solution. When illiquidity arising from the threat of bank insolvency is remedied by such nonmarket “lending” as the central bank provides, and when such lending is promised unconditionally as a matter of policy, capital adequacy is further undermined, or at least not rectified. 

The expectation that central bank lending is unconditional and unlimited derives from the fact that it is not actually lending at all. Last resort lending by a central bank does not have its source in some existing supply of capital or reserves. In the marketplace, “lending” consists of the transfer of existing purchasing power from one party to another, in which one foregoes its use over time in return for interest. But a central bank committed to rectifying banking system liquidity does not lend or transfer existing reserves. It “creates” reserves, not out of real resources or capital but solely by virtue of its monopoly power over fiat base money creation. This monopoly power sanctions risky banking and promotes banking system leverage through enhanced inflating capacity. Advocates of central banking believe that such a reserve base is beneficial because it is nearly costless. But the creation of fiat reserves costs the banking system its long-term strength.

—Richard M. Salsman, “Breaking the Banks: Central Banking Problems and Free Banking Solutions,” Economic Education Bulletin 30, no. 6 (June 1990): 29-30.

The Two Rules Regulating Socialism’s Capital Structure Can Be Viewed Profitably Alongside their Free-Market Counterparts

The controversy surrounding socialism does not so much concern the above; rather, it concerns production and how socialism can have accurate factor pricing without competition. Lange here introduces several rules that are intended to replace and improve upon capitalist production. The first rule is to have all producers equalize the ratios of marginal productivity to their prices, for all the factors of production (e.g.,  MP_a ÷ P_a = MP_b ÷ P_b = MP_n ÷ P_n ).

The second rule, to be used in tandem with the above, is to price production equal to marginal cost, a principle first recommended by Fred Taylor and readily adopted by Lange. This marginal cost principle, the welfare ideal of neoclassical economics, is addressed not only to the singular firms but to the industries as well.

The above two rules regulating socialism’s capital structure can be viewed profitably alongside their free-market counterparts. Profit maximization under capitalism is replaced by producing at minimum average cost. Free entry/exit and the optimum size of plant in the market order are likewise duplicated by the same rule. The second rule, of setting price to marginal cost, conforms to the “pure and perfect competition” ideal under capitalism. Setting marginal benefits to marginal costs is seen as maximizing welfare (the Pareto optimality) for society. In all, the rules fully cover the economics of production, “determin[ing] the combination of factors of production and the scale of output” while also maximizing welfare. 

—Robert Bradley Jr., “Market Socialism: A Subjectivist Evaluation,” Journal of Libertarian Studies 5, no. 1 (Winter 1981): 24-25.

Rampant Inflation Destroys the Capital Markets that Sustain Economic Production; Capitalists and Businessmen Learn to Hedge for Financial Survival

The Keynesian commitment to expansionary policies is a commitment to inflation that does not promote full employment. It does not achieve the “miracle . . . of turning a stone into bread,” but generates the business cycle with periods of high unemployment. Continued application of the Keynesian recipe must finally lead to the complete breakdown of the monetary system and to mass unemployment. 

Rampant inflation destroys the capital markets that sustain economic production. The lenders, who sustain staggering losses from currency depreciation, are unable to grant new loans to finance business. Even if some loan funds should survive the destruction, lenders shy away from monetary contracts for  any length of time. Business capital, especially long-term loan capital, becomes very scarce, which causes economic stagnation and decline. To salvage their shrinking wealth, capitalists learn to hedge for financial survival; they invest in durable goods that are expected to remain unaffected by the inflation and depreciation. They buy real estate, objects of art, gold, silver, jewelry, rare books, coins, stamps, and antique grandfather clocks. Surely, this redirection of capital promotes the industries that provide the desired hedge objects. But it also causes other industries to contract. It creates employment opportunities in the former and releases labor in the latter. As the hedge industries are very capital-intensive, working with relatively little labor, and the contracting industries are rather labor-intensive, with a great number of workers, the readjustment entails rising unemployment. Of course, the readjustment process is hampered by labor union rules, generous unemployment compensation, and ample food stamps. 

Similarly, double-digit inflation causes businessmen to hedge for financial survival. They tend to invest their working capital in those real goods they know best, in inventory and capital equipment. Funds that were serving production for the market become fixed investments in durable goods that may escape the monetary depreciation. Economic output, especially for consumers, tend to decline, which raises goods prices and swells the unemployment rolls.

—Hans F. Sennholz, “The Causes of Inflation,” in Age of Inflation (Belmont, MA: Western Islands, 1979), 37.

How Was It Possible that a Rich Nation, France, Let Her Finances Deteriorate to the Point of Literal Bankruptcy?

How was it possible that a rich and self-respecting nation let her finances deteriorate to the point of literal bankruptcy? Why let the hard money reserves go down the drain? Why permit herself to sink to the level of an international beggar? Why risk the breakdown of her most highly valued political institutions for which bloody revolutions and wars had been fought? An inflation-ridden France had lost her international position as a major power. 

Unfortunately for France, the Poincare-stabilization of 1928 was barely more than a year old when the global depression came along. It caused less suffering in France than in any other country; the number of unemployed never reached beyond a very moderate 400,000. But prices, working hours, take-home wages, profits, and capital values fell. It was simple to blame it all on the return to gold. With the automatic gold standard abandoned in 1936 — the manipulated variety of monetary standard was subjected to devaluations and restrictions, to be replaced in 1939 by a “closed” paper money system — the belief in saving and economy, in the free market, and in the welfare-creating incentives of the price mechanism fell into disrepute. 

A popular front of communists and socialists, followed by Petain’s fascist State, was a natural breeding ground for bureaucratism — and for legalized robbery, as Premier Reynaud branded, in 1939, the inflationary practices. But socialists and fascists were mere pikers in inflation compared with the full-fledged Welfare State that emerged from France’s liberation in 1944. 

A decisive influence was the Keynesian philosophy that became dominant in France, under Anglo-American influence, after World War II. Its basic tenet was that due to its inherent propensity for saving (hoarding?), a free enterprise economy is hell-bent for depression — mass unemployment — in perpetuity. The Keynesian answer was: perpetual inflation, with the government planning and directing investments, if not prices, wages, and many other functions as well. Distributing “purchasing power” was to provide stable employment, and let such “antiquated” concepts as monetary stability (and all economic freedoms, for that matter) hang. This crude revival of the crackpot doctrines current in the 17th Century suited the communist and socialist doctrinaires; it was a godsend for the power-minded politician (like Mendes-France, a leading self-styled “liberal”) and the job-conscious bureaucrat. Both groups, and their intellectual fellow-travellers, found a most convenient rationalization, or alibi, in favor of ever-more inflation: compassion for the fellow citizen’s sufferings due to the inflation — that was eagerly promoted by the same humanitarian bureaucrats and politicians. 

—Melchior Palyi, A Lesson in French Inflation (New York: Economists’ National Committee on Monetary Policy, 1959), 15-16. 

The Federal Reserve Has Been Following in the Shadow of the Bank of Japan by Mimicking Its Policies Since the 2000s

Since the 2000s, Federal Reserve officials have been following in the shadow of the Bank of Japan, mimicking its policies to no avail. For reasons we examine in the paper, Federal Reserve officials have largely ignored the Japanese experience. Yet the results of Federal Reserve policy have been disappointing. The bursting of the dot-com bubble was followed by a period of then-extraordinarily low interest rates. Those rates inflated a housing bubble, which also burst, resulting in the Great Recession. The Federal Reserve then engaged in rounds of large-scale asset purchases, or quantitative easing policy (QEP). That was part of a zero interest rate policy (ZIRP). 

Like the Japanese experience, the US recovery has been weak by almost any measure. To name just one, the US economy has gone a decade without one year of at least 3 percent real GDP growth. That is a historical record of economic weakness. There are proposals for institutional redesign of the central bank (e.g., Cochrane and Taylor 2016; Fed Oversight Reform and Modernization Act of 2015, H.R. 3189). These discussions and legislative proposals would benefit from considering the Federal Reserve in the shadow of the Bank of Japan. Though not well known, many fundamental issues of Federal Reserve policy and institutional redesign, as well as the political economy of constraints on central bank policy, have been experienced by the Bank of Japan well before they became issues in the United States. In fact, the policy discussion in Japan about central bank policy in the context of other policies has been far more transparent than discussion in the United States. . . .  

Hence, the bubble economies in both Japan and the United States have common ground. Both bubbles were the outcome of easy monetary policy in the context of a flawed financial system that directed imprudent lending to specific economic sectors supported by government guarantees and incentives. In both cases, financial regulators and supervisors failed to appreciate the feedback between increasing asset prices and lending. And, in both cases, central bank officials failed to appreciate the interaction between the structural flaws of the financial system and monetary policy. 

As long as government financial policy and the structure of the financial system go unchanged, central bank policy errors are amplified. The asset bubbles, their bursting, and the subsequent economic and financial distress illustrate the problems central banks face. When their respective governments use the financial system to pursue industrial and social policies, central banks cannot pursue price stability without inflating asset bubbles. The behavior of spot prices no longer provides reliable information about economic stability (Leijonhufvud 2007). 

—Thomas F. Cargill and Gerald P. O’Driscoll Jr., “The Federal Reserve in the Shadow of the Bank of Japan,” Journal of Private Enterprise 33, no. 1 (Spring 2018): 47-48, 53.

The Central Issue in Macroeconomic Theory Is the Extent to which the Economy May Be Regarded as a Self-Regulating System

The central issue in macroeconomic theory is the extent to which the economy, or at least its market sectors, may properly be regarded as a self-regulating system. While the general belief in the superiority of self-regulating, polycentric, market-based economic systems had undoubtedly been intensified since the collapse of the former Soviet Communist system, now two decades ago, in the field of money and banking authoritative economists still adopt a radically different stance, and go on developing proposals for what are essentially new variants of central planning in monetary matters. 

While it is today seldom contested that we can rely on self-regulating, decentralized, market-based systems as far as the production and allocation of commodities in general — such as automobiles, computers etc. — is concerned, in the field of money and banking the monocentric presupposition still almost universally prevails: in order to function properly the monetary and banking system has to be constantly monitored by a central agency, viz. by the central bank. A number of economists have nevertheless recognized the inconsistency implicit in this special treatment of the monetary and banking sectors as contrasted with economic issues in general, and have developed models of decentralized monetary and banking systems which are supposed to function as polycentric, self-regulating orders. While the general direction of this branch of research can be welcomed with some enthusiasm, the ways in which the “details” of some of the better known proposals for “free banking” have been elaborated until present, remain subject to a certain amount of well-founded criticism. The recent republication by the Ludwig von Mises Institute of Larry Sechrest’s Free Banking offers an opportunity to draw special attention to two particular claims revealed by the argumentation off the free bankers which struck this author as rather questionable. 

—Ludwig van den Hauwe, “Free Banking, the Real-Balance Effect, and Walras’ Law,” Procesos de Mercado: Revista Europea de Economía Política 7, no. 1 (Spring 2010): 242-243.

Keynes Transformed Fractional Reserve Bankers from Economic Villains Who Cause Depressions into Economic Heroes Who Enrich Society

Many critics of John Maynard Keynes attribute the success of his ideas to political appeal. No doubt, politicians are attracted to Keynesian economics because it can be used to justify profligate government spending. While important, political appeal alone cannot totally explain his triumph. Since Keynes’s theory is purportedly an economic theory, it could have never prevailed without the economists. So why does Keynes’s theory attract so many economists, and the most influential economists in particular? The answer is that influential economists in the banking system are attracted to Keynesian economics because it can serve as an economic justification for fractional reserve banking. The Keynesian interpretation of fractional reserve banking is an important reason Keynes’s theory conquered the economics profession.

Economists were becoming increasingly critical of fractional reserve banking in the years before Keynes published his theory. Even Alfred Marshall, the founder of the Cambridge school of economics, argued fractional reserve banking amplifies the business cycle. In 1912, Ludwig von Mises showed that fractional reserve banking is the fundamental cause of the business cycle. The Great Depression led many eminent American economists, including Irving Fisher, Frank Knight, Henry Simons, and Jacob Viner, to advocate abolishing fractional reserve banking. In fact, it was the American backlash against fractional reserves in the early 1930s that led directly to the formation of the Chicago school of economics. During the Great Depression, Senator Bronson Cutting and other politicians in the United States introduced legislation to abolish fractional reserve banking. 

Keynes’s theory was a godsend for the defenders of fractional reserves. Pre-Keynesian economics showed fractional reserve banking causes the business cycle and thereby makes society poorer than it otherwise would be. Before The General Theory of Employment, Interest and Money (1936), the defenders of fractional reserve banking had no answer to the pre-Keynesian analysis. But Keynes gave defenders of fractional reserves a weapon with which to combat the pre-Keynesian analysis. While the pre-Keynesian theory shows fractional reserve banking destroys wealth, the seemingly scientific New Economics purports to show that it is good for the economy. Rather than impoverishing society, fractional reserve banking actually creates prosperity in Keynes’s system. In short, Keynes transformed fractional reserve bankers from economic villains who cause depressions into economic heroes who enrich society. It is no wonder so many influential economists in the banking system have enthusiastically adopted Keynes’s theory.

—Edward W. Fuller, “Keynes and Fractional Reserve Banking: The NPV vs. MEC,” Procesos de Mercado: Revista Europea de Economía Política 15, no. 1 (Spring 2018): 40-41.

Hayek’s “Profit, Interest and Investment” (1939) Is a Theoretical Explanation of the High and Persistent Unemployment of the 1930s

It is usually assumed that, while John Maynard Keynes developed a theory of chronic unemployment, Friedrich August Hayek did not. Indeed, a theory like this one was never explicitly explained by Hayek. 

However, we defend “Profit, Interest and Investment” (1939a) was written as a theoretical explanation of the high and persistent unemployment of the 1930s. We believe that the assumptions chosen by Hayek reveal that intention: “We shall start here from an initial situation where considerable unemployment of material resources and labor exists, and we shall take account of the existing rigidity of money wages and of the limited mobility of labor. More specifically, we shall assume throughout this essay that (. . . ) money wages cannot be reduced (. . . )and finally, that the money rate of interest is kept constant.” These assumptions are similar to the institutional and macroeconomic conditions of the British economy in the late 1930s. Besides, these assumptions are radically different from those chosen in Prices and Production (1931). In that book, Hayek assumed as a starting point in his discussion, a) full employment, b) labor mobility, c) flexible wages and d) flexible rate of interest. Thus, we believe that Hayek tried to adapt his model to the new circumstances. 

We will argue in this paper that this essay could be interpreted as a theory of chronic unemployment and economic stagnation. Also, it will be defended that this phenomenon has its explanation in a dynamically inefficient design of some of the institutions that rule the market.

—David Sanz and Juan Morillo, “The Hayekian Theory of Chronic Unemployment,” Procesos de Mercado: Revista Europea de Economía Política 15, no. 1 (Spring 2018): 14.

Keynes Suppresses the Study of the Production Structure in the Concept of Aggregate Investment and Excludes Time as a Relevant Variable

From Hayek’s point of view, the major deficiency in The General Theory is that it is not based on a theory of capital. According to Hayek, the market is a network of millions of companies that complement and coordinate with each other intertemporally and synchronically, forming an extremely complex production structure. In order to understand how and why this structure is coordinated or discoordinated, we need to apply a theory allowing us to study the way it works. However, Keynes does not study this production structure, but suppresses it in the concept of aggregate investment. This is why Hayek thought that Keynes was not able to understand the causes of and the solutions to economic fluctuations. 

According to Hayek, the absence of a theory of capital meant that in the model developed in The General Theory, time is not considered as a relevant variable. In the Keynesian world, when demand increases, a parallel increase in the supply of goods appears almost instantaneously. Therefore, for Keynes, the structure of production does not need a significant amount of time to produce the necessary additional final goods to meet additional consumer demand. Thus, The General Theory never considered that a shortage of supply may occur. In Hayek’s opinion, this approach is wrong.

—David Sanz and Juan Morillo, “Hayek’s Hidden Critique of The General Theory,” in “Hayek, Keynes and the Crisis: Analyses and Remedies,” ed. Carmelo Ferlito, special issue, Journal of Reviews on Global Economics 4 (2015): 214-215.

The Microeconomic Approach Shows that the Belief in a Direct Relationship between Aggregate Spending and Employment Is WRONG

 The microeconomic approach shows that the belief that there is a direct relationship between aggregate spending and employment is wrong. Hayek explains that unemployment is usually concentrated in certain sectors, industries and production stages (for example, let us assume that unemployment is mainly concentrated in sectors A, B, C, D and E). For the Keynesian employment policies to be able to create new jobs in those specific sectors of the market, it would be necessary for entrepreneurs and consumers to voluntarily decide to spend the additional revenue received from these Keynesian policies in those sectors that are in crisis. However, Hayek explains that “[i]f expenditure is distributed between industries and occupations in a proportion different from that in which labour is distributed, a mere increase in expenditure need not increase employment.” Hayek thinks that it is an illusion to believe that these policies would solve the unemployment problem, as the holders of the additional money will spend their money where they consider it most appropriate and not necessarily in areas where there is unemployment (for example, they might decide to spend their money in sectors O, P, Q, R, S and T). Indeed, Hayek points out that it is very unlikely for individuals to choose to spend their money in the specific sectors that are in crisis, since these sectors are in crisis precisely because entrepreneurs and consumers are not willing to buy the output offered by these sectors at current prices. 

—David Sanz and Juan Morillo, “Hayek’s Hidden Critique of The General Theory,” in “Hayek, Keynes and the Crisis: Analyses and Remedies,” ed. Carmelo Ferlito, special issue, Journal of Reviews on Global Economics 4 (2015): 216-217.

The Change in Relative Prices Caused by Keynesian Demand Policies Will Encourage a Spontaneous Process of DISINVESTMENT

The second reason [for why there is not a direct connection between aggregate demand and employment] is what Hayek termed the “Ricardo effect”: the permanence of a productive structure requires the permanence of a parallel structure of relative prices. Hayek noticed that Keynesian demand policies have the special feature of modifying the pricing structure so as to promote investments with reduced maturity periods (i.e., less intensive capital investments). Hayek explains that, after applying Keynesian demand policies, this peculiar modification takes place in relative prices, and as a result, many entrepreneurs will modify their production strategies and will try new, less capital intensive (and therefore more profitable in relative terms given the new pricing structure) production strategies. This change in production strategies will result in a change in the composition of the demand for capital goods of those entrepreneurs, and will also reduce the aggregate amount of money devoted to buying higher-order capital goods in the market. Therefore, Hayek notes, many entrepreneurs will stop buying capital goods from their usual suppliers. As a result, these suppliers will lose part of their market and many will be forced to lay off workers or even to cease business. Hayek named this phenomenon the Ricardo effect. Thus, the change in relative prices caused by Keynesian demand policies will encourage a spontaneous process of disinvestment and, therefore, many of the business firms and jobs that were needed before to produce these specialized capital goods (which now will have significantly lower demand) will become useless. Hayek concludes that the demand policies proposed by Keynes will lead to an absolute reduction in the volume of employment. 

—David Sanz and Juan Morillo, “Hayek’s Hidden Critique of The General Theory,” in “Hayek, Keynes and the Crisis: Analyses and Remedies,” ed. Carmelo Ferlito, special issue, Journal of Reviews on Global Economics 4 (2015): 216.

Mises’s Theory of Capital Is a Theory of the Way Monetary Calculation Based on Financial Capital Helps Entrepreneurs Organize the Production Process

Capital, in Mises’s view, is a basic and indispensable tool of economic calculation used by entrepreneurs in capitalist economies, that is, in market economies. He clearly considers it as an historically specific concept:

The concept of capital cannot be separated from the context of monetary calculation and from the social structure of a market economy in which alone monetary calculation is possible. It is a concept which makes no sense outside the conditions of a market economy. It plays a role exclusively in the plans and records of individuals acting on their own account in such a system of private ownership of the means of production, and it developed with the spread of economic calculation in monetary terms. (Mises, 1949: 262)

 Monetary calculation based on capital is possible only under capitalism. Owing to the tools of capital accounting, entrepreneurs are able to compare the economic significance of their inputs and their outputs even in a complicated and dynamically “changing industrial economy” (Mises, 1949: 511). That is what distinguishes capitalism from other economic systems: “[O]nly people who are in a position to resort to monetary calculation can evolve to full clarity the distinction between an economic substance [capital] and the advantages derived from it [income], and can apply it neatly to all classes, kinds, and orders of goods and services” (Mises, 1949: 261). Mises’s theory of capital is a theory of the way monetary calculation based on (financial) capital helps entrepreneurs to organize the production process under capitalism. One could also say that his theory of capital is a theory of capitalism, a theory of how entrepreneurial operations are guided by capital accounting.

 —Peter Lewin and Nicolas Cachanosky, Austrian Capital Theory: A Modern Survey of the Essentials, Cambridge Elements in Austrian Economics (Cambridge, UK: Cambridge University Press, 2019), 45-46.

The Cause of Boom-Bust Asymmetry Is NOT Krugman’s Nominal Wage Rigidity But Mass Destruction of Productive Relationships

Paul Krugman (2013), by no means an adherent to Austrian economics, has drawn attention to the asymmetry problem of booms and busts: the phenomenon that increased unemployment occurs during the structural adjustments of the bust, but not during the structural adjustments of the boom, which he explains by reference to downward wage rigidity. During a boom period wages tend to rise, but during the bust they do not fall as much and as rapidly as they should in order to prevent increased unemployment. 

An alternative explanation is provided by Andolfatto (2013), who argues that the most obvious cause for asymmetry is not to be found in nominal rigidities, but rather in the mass destruction of productive relationships, which takes place during the bust. In his view, the labor market is a market for productive relationships, or what he calls relationship capital. Just like physical capital, relationship capital is redirected onto unsustainable paths during the boom. Relationships are built up, intensified, replaced or adjusted during the boom, merely to get destroyed during the bust. In his own words:

The basic idea is very simple. [. . . ] The labor market is a market for productive relationships. It takes time to build up relationship capital. It takes no time at all to destroy relationship capital. (It takes time to build a nice sandcastle, but an instant for some jerk to kick it down.) (Andolfatto, 2013)

—Karl-Friedrich Israel, “The Costs and Benefits of Central Banking: Modern Monetary Economics along a Methodological Dividing Line” (PhD diss., Université d’Angers, 2017), 250-251.

Mises and Menger Are Outliers within the Austrian School When It Comes to Capital Since They Adopt the Financial Capital Concept

Ludwig von Mises never produced a work devoted solely to an exploration of the meaning of capital or its role in the economy. Other Austrian school economists such as Böhm-Bawerk (1890), Hayek 1941a), Lachmann (1956), and Kirzner (1966) all published books on the subject, in addition to numerous articles. Mises’s views must be gleaned from his remarks in works devoted to other specific or general topics. He did not enter into any “capital controversy” or specifically consider them. Yet, his views on capital are interesting and highly suggestive in a way that we believe has been generally underappreciated. In particular, Mises seems to be something of an outlier within the Austrian school when it comes to capital — though his position is arguably foreshadowed in a neglected article by Menger (1888).

Only very recently has the issue of a dissenting view on capital by the older Carl Menger been noted (Braun, 2015 a, b). In this article Menger opposed all attempts to define capital as something physical. He considered it necessary to stick with common terminology where capital relates to sums of money dedicated to the acquisition of income. But, having come this far, Menger does not do much more than criticize other definitions of capital, opting for the abandonment of physical capital concepts in economics. 

In particular, he does not indicate what a capital theory that is based on the financial capital concept he endorses would look like (Braun, 2015a: 91). 

Of the later Austrians, only Mises based his discussion of capital on Menger’s (1888) financial capital concept. Both in his treatise on socialism (Mises, 1922: 123) and in his magnum Opus, Human Action, Mises (1949: 262), he stuck to the more common understanding of capital and chose to orient his definition of capital to business practice. For him, capital is a sum of money which is determined by accounting. As previously quoted:

Capital is the sum of the money equivalent of all assets minus the sum of the money equivalent of all liabilities as dedicated at a definite date to the conduct of the operations of a definite business unit. It does not matter in what these assets may consist, whether they are pieces of land, buildings, equipment, tools, goods of any kind and order, claims, receivables, cash, or whatever. (Mises, 1949: 262)

To Mises, it is not physical characteristics that determine whether assets are part of capital or not. Of primary interest is rather which role they play in the operations of business units (Lewin, 1998). Thus, Mises, together with Menger (1888), deviates from the majority view of the Austrian school on capital. Different from Menger (1888), however, Mises (1920, 1922, 1949) actually contains several hints as to what a capital theory based on a financial capital concept would look like. 

 —Peter Lewin and Nicolas Cachanosky, Austrian Capital Theory: A Modern Survey of the Essentials, Cambridge Elements in Austrian Economics (Cambridge, UK: Cambridge University Press, 2019), 41-42.

“Regime Uncertainty” and “Big Players” Make the Economy More Dependent on “Animal Spirits” or “Confidence” Instead of “Economic Calculation”

The ‘rules of the game’ are the rules of economic exchange. They include tax law, the law of contract and regulations. If the rules of the game are ambiguous or changeable, investors experience uncertainty and ignorance of the future. If the rules of the game are known and stable, investors experience greater prescience. They have greater confidence in their guesses about the future. Irregular and arbitrary taxes, for example, make it harder to estimate the prospective profit of alternative investments; a simple regular and transparent tax code eliminates one source of uncertainty, helping investors to formulate a serviceable, if not perfectly strict, mathematical expectation of prospective yields. Robert Higgs (1997) has coined the term ‘regime uncertainty’ to describe situations in which the rules of the game are uncertain. As we shall see, regime uncertainty discourages investment (regime uncertainty is the cause, reduced investment the effect). 

Big Players are economic actors with three characteristics. Firstly, they are big enough to influence the market or markets in question. Secondly, they are largely immune from the discipline of profit and loss. Thirdly, they act on discretion and are not bound by any simple rules. Activist central bankers are paradigmatic Big Players. A private actor might be a Big Player, but only in the relatively short run or if it is a protected monopoly. As I argue below, Big Players are hard to predict. They reduce the reliability of economic expectations, which encourages both herding and contrarianism in financial markets. Big Player influence drives investors towards greater ignorance and uncertainty. For example, discretionary monetary policy makes it hard to estimate the future purchasing power of the currency and, therefore, the value of alternative investments: a simple monetary rule eliminates one source of uncertainty, helping investors to formulate a serviceable mathematical expectation of prospective yields. Koppl (2002) has developed the theory of Big Players and I will draw on that and related work in this monograph. 

When there is Big Player influence or regime uncertainty investors become more ignorant, less prescient. As they grow more ignorant their investment decisions cannot depend as fully on strict mathematical expectation, since the basis for making such calculations is correspondingly weakened. They are more likely to follow the crowd and to base their decisions on an overall sense of optimism or pessimism rather than independent judgements of prospective yield. In these circumstances, the state of confidence becomes more arbitrary and more self-referential. More or less arbitrary swings of optimism and pessimism are now more likely. Regime uncertainty and Big Players make the economy look more Keynesian as it is more dependent on ‘animal spirits’ rather than economic calculation, which becomes more difficult. As we shall see, there is a sense in which Big Players and regime uncertainty reflect ‘Keynesian’ policies, which suggests the self-defeating nature of Keynesian macroeconomic policy: Keynesian policies tend to create a Keynesian economy.

—Roger Koppl, introduction to From Crisis to Confidence: Macroeconomics after the Crash, Hobart Paper 175 (London: Institute of Economic Affairs, 2014), 14-16.

Wicksell, Åkerman and von Stackelberg Carried on Böhm-Bawerk’s Theory by Dropping Several of His Restrictive Assumptions

Wicksell and Åkerman carried on von Böhm-Bawerk’s theory by successively dropping several of the restrictive assumptions mentioned above. K. Wicksell in his book Über Wert, Kapital und Rente [1893] introduced a second factor of production, land, and at the same time a second consumption good. In Vorlesungen über Nationalökonomie, Vol. I [1913] he used compound interest instead of simple interest calculation. This difference is important since in this case — contrary to von  Böhm-Bawerk’s model presented above — the length of the average production period is not independent of the interest rate. Consequently, Wicksell did not employ the concept of the average production period. 

While von Böhm-Bawerk and Wicksell were concerned with continuous-input-point-output models, Åkerman [1923/24] analyzed the point-input-continuous-output case which applies to the most important kind of capital goods, namely durable capital goods. 

We shall base our presentation on the further development of Austrian capital theory not on the contributions of Wicksell and Åkerman, but on an article by von Stackelberg [1941/43], which can be viewed as a culmination of the traditional Austrian theory. In this article not only the questions put forward by Wicksell and Åkerman are analyzed, but the problem of recycling of goods is dealt with as well. Despite its fundamental importance for the development of Austrian capital theory this article is, as far as we know, entirely unknown in the English speaking and almost entirely unknown in the German speaking literature. Since it appeared only in the German languarge, it will be inaccessible for most readers. For this reason, as well, it seems useful to present it here in greater detail. 

Von Stackelberg like von Böhm-Bawerk analyzed a stationary ecoomy. He dropped the last four assumptions of von Böhm-Bawerk’s model, A2.8-A2.11. Thus, he showed how recycling, durable capital goods and compound interest calculation can be taken into account and how the controversial concept of the average production period can be dispensed with.

—Malte Faber, Introduction to Modern Austrian Capital Theory, Lecture Notes in Economics and Mathematical Systems 167 (Berlin: Springer-Verlag, 1979), 20-21.

The First-Round Effect May Explain the Formation of Asset-Price Bubbles, E.g. the 2000s Real Estate Booms in Spain and in Ireland

The first-round effect may also explain the formation of asset-price bubbles since they are the best evidence that prices do not rise evenly and proportionally, as in Friedman’s notion of helicopter money, but rather unevenly and disproportionately, as described by Cantillon and Austrian economists. Indeed, if money was neutral and the quantity theory of money held, asset-price bubbles—meaning the relative overvaluation of particular asset prices—would not exist. They occur due to the expansion of credit and its continuous inflow to a given asset market, in line with the Cantillon effect. Importantly, there are strong arguments that asset-price bubbles threaten financial stability and that they can lead to a deeper recession in comparison to a business cycle not accompanied by a financial bubble. Meanwhile, central banks, including the ECB, do not take into account asset-price inflation, instead focusing on price stability narrowly defined as stability of the CPI. Hence, it seems that central banks should change their stance on this matter and also monitor asset prices—otherwise, there is a risk of conducting an overly loose monetary policy, leading to imbalances in the economy and financial instability despite stable consumer prices and thus an apparent neutrality of money (as the proposals for price stabilization are based on the notion of neutrality of money). 

This is exactly what happened in the euro area in the 2000s. Although the CPI rate did not significantly exceed the ECB’s target in the first half of the decade, the loose monetary policy of the central bank (interest rates too low for too long, at least for some countries of the euro area) led to a business cycle, and real estate booms in countries of the euro area where the growth in the money supply was the highest (or where the new money mainly went), in particular Spain and Ireland.

—Arkadiusz Sieroń, “Hayek and Mises on Neutrality of Money: Implications for Monetary Policy,” in Banking and Monetary Policy from the Perspective of Austrian Economics, ed. Annette Godart-van der Kroon and Patrik Vonlanthen (Cham, CH: Springer International Publishing, 2018), 157-158.

The Term “Neutral Money” Gained Recognition in the English Language Literature through Hayek’s Publications

The neutrality of money means the lack of effects of monetary phenomena on real variables.³ There are a few different notions of neutrality of money, depending on how one defines “monetary phenomena.” Probably the most important notion, which we call “dynamic neutrality,” implies that changes in the supply of money only affect nominal variables, while real variables, such as relative prices, production, or employment, remain unaffected. Conversely, the non-neutrality of money means changes in the money supply have an impact on real phenomena.

The concept of neutrality of money is a central economic issue widely discussed from the very beginning of economics as a science. It is sufficient to mention the quantity theory of money formulated at first by Locke, which basically states that the level of prices is always in proportion to the quantity of money. It was probably formulated and believed by classical economists as a reaction against mercantilists’ inflationism, but that reaction was exaggerated and hampered the genuine development of monetary economics. The quantity theory of money is true but only from the point of view of comparative statics. One economy with twice the money supply of another but with no other differences should have twice as high a general price level. However, it does not follow that doubling the money supply only leads to doubling all prices. For the neutrality of money to hold from the dynamic perspective, several conditions must be fulfilled.⁵

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³ The term “neutral money” gained recognition in the English language literature through Hayek’s publications. However, it was in use earlier among Continental economists.

⁵ According to Hayek (2008a [1935]), there are three conditions for the neutrality of money: constant total money stream, perfectly flexible prices, and long-term contracts based on a correct anticipation of future price movements.

—Arkadiusz Sieroń, “Hayek and Mises on Neutrality of Money: Implications for Monetary Policy,” in Banking and Monetary Policy from the Perspective of Austrian Economics, ed. Annette Godart-van der Kroon and Patrik Vonlanthen (Cham, CH: Springer International Publishing, 2018), 154.

A Serious Shortcoming of Böhm-Bawerk’s Theory of Capital Was Its Limitation to Circulating Capital Only

A serious shortcoming of Böhm-Bawerk’s theory of capital was its limitation to circulating capital only. Not surprisingly, several attempts were made by economists working in the Austrian tradition to overcome this limitation and to extend the analysis to fixed capital (see, in particular, Åkerman, 1923-24; Wicksell, 1923; and Hayek, 1941). Studying the problem of fixed capital within an Austrian framework of the analysis was also a major concern of John Hicks in Capital and Time (1973).

According to Hicks, fixed capital goods ‘are “durable-use goods”; their essential characteristic is that they contribute, not just to one unit of output, at one date, but to a sequence of units of output, at a sequence of dates.’ Because fixed capital gives rise to intertemporal joint production, the flow input-point output conception underlying Böhm-Bawerk’s approach to capital theory has to be replaced by that of ‘flow input-flow output’ processes. As Hicks put it:

While the old Austrian theory was ‘point output’ (its elementary process having a single dated output), we shall use an elementary process that converts a sequence (or stream) of inputs into a sequence of outputs. Our conception of capital-using production is thereby made much more general.

—Christian Gehrke and Heinz D. Kurz, “Hicks’s Neo-Austrian Theory and Böhm-Bawerk’s Austrian Theory of Capital,” in Capital, Time and Transitional Dynamics, ed. Harald Hagemann and Roberto Scazzieri, Routledge Studies in the History of Economics 96 (London: Taylor & Francis e-Library, 2008), 84.

Keynes’s Notion of a Productive Structure Consisting of ONLY Two Stages Leads Him into the Trap of the “Paradox of Thrift”

Hayek, in his detailed critique of both volumes of Keynes’s A Treatise on Money (1930), accuses Keynes of entirely ignoring the theory of capital and interest, particularly the work of Böhm-Bawerk and the other theorists of the Austrian School in this regard. According to Hayek, Keynes’s lack of knowledge in this area accounts for the fact that he overlooks the existence of different stages in the productive structure (as Clark had done and Knight later would) and that he ultimately fails to realize that the essential decision facing entrepreneurs is not whether to invest in consumer goods or in capital goods, but whether to invest in production processes which will yield consumer goods in the near future or in those which will yield them in a more distant future. Thus Keynes’s notion of a productive structure comprised of only two stages (one of consumer goods and another of capital goods) and his failure to allow for the temporal aspect of the latter, nor for the consecutive stages which compose it, leads him into the trap of the “paradox of thrift,” the fallacious theoretical rationale which we explained in chapter 5.⁷⁶

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⁷⁶ It is important to remember that John Maynard Keynes himself explicitly and publicly admitted to Hayek that he lacked an adequate theory of capital. In Keynes’s own words:

Dr. Hayek complains that I do not myself propound any satisfactory theory of capital and interest and that I do not build on any existing theory. He means by this, I take it, the theory of capital accumulation relatively to the rate of consumption and the factors which determine the natural rate of interest. This is quite true; and I agree with Dr. Hayek that a development of this theory would be highly relevant to my treatment of monetary matters and likely to throw light into dark corners.

—Jesús Huerta de Soto, Money, Bank Credit, and Economic Cycles, trans. Melinda A. Stoup (Auburn, AL: Ludwig von Mises Institute, 2006), 560-561, 561n.

The Central Problem: How the Existence of Non-permanent Resources Increases the Permanent Income Stream

The non-permanent nature of all ‘wasting assets’ creates a problem which is not dealt with in the theory of timeless production. These assets cannot be directly used to contribute to the output of the time when they have ceased to exist. Insofar as their existence does help to maintain output permanently above the level at which it could be kept with the help of the permanent resources alone, it must do so in an indirect manner. If the fact that we have command over resources which remain useful only for a limited period of time did not help us to use the services of the permanent resources more effectively, it would be quite impossible to keep our income permanently above the level where it would stay if these non-permanent resources had never been available. We might stretch their use over a longer period of time, but ultimately we should inevitably exhaust them and should then have to be content with what services the permanent resources could render by themselves. It is this problem of why the existence of a stock of non-permanent resources enables us to maintain production permanently at a higher level than would be possible without them, which is the peculiar problem connected with what we call capital.

—F. A. Hayek, The Collected Works of F. A. Hayek, vol. 12, The Pure Theory of Capital, ed. Lawrence H. White (Indianapolis: Liberty Fund, 2007), 74.

Hayek Also Distinguishes Between (a) Factors that Yield Fixed Streams of Service Each Period and (b) Factors Whose Use Today Diminishes their Future Usefulness

The second important distinction is between (a) factors that yield fixed streams of service each period—namely, simple labor and permanent non-labor input sources—and (b) factors whose use today diminishes their future usefulness and raises the problem of maintenance. The first group of factors, apart from labor, can be called economic “land” goods, whether given by nature (David Ricardo’s “original and indestructible powers of the soil”) or manmade (Hayek’s example in The Pure Theory of Capital was a railroad tunnel that will need no maintenance once excavated). The second group encompasses all impermanent capital goods, from one-use blasting caps to depletable natural resource deposits to imperfectly durable machines. The simplified production model of Prices and Production treated all value-adding inputs, being applied in consecutive stages to advance intermediate goods toward final consumption, as coming from type (a) factors. The model reduced type (b) factors, impermanent capital goods, to intermediate goods. Knight’s model neglected impermanent capital goods in a different way. Its construct of a perpetual capital stock implied that the maintenance or replacement of any impermanent tools is automatic, embodied in the decision about the permanent level of future consumption.

—Lawrence H. White, ed., editor’s introduction to The Collected Works of F. A. Hayek, vol. 11, Capital and Interest, by F. A. Hayek (Chicago: University of Chicago Press, 2015), xxv.

Hayek Distinguishes Between (a) INHERITED Capital Goods and (b) Intermediate Goods or Capital Goods TO BE PRODUCED

For Hayek’s model there are two important distinctions among factors of production. The first distinction is between (a) inherited capital goods, or goods already existing at the moment that a production plan is being made, and (b) intermediate goods, or capital goods (of greater or lesser permanence) to be produced as part of a sequence of production steps leading to final output. Hayek’s exposition in Prices and Production neglected inherited capital goods. It depicted the first production stage as involving only land and labor, which created intermediate goods that then progress through subsequent production stages toward final sales. Knight’s model, by abstracting from roundabout production, abstracts entirely from intermediate goods. It offers only undifferentiated capital (the inherited Crusonia plant), which instantly yields consumption.

—Lawrence H. White, ed., editor’s introduction to The Collected Works of F. A. Hayek, vol. 11, Capital and Interest, by F. A. Hayek (Chicago: University of Chicago Press, 2015), xxv.