An Austrian View to Financial Crisis

Quah, Chee Heong, P.hD.

Senior Lecturer,

Faculty of Business and Accountancy,

University of Malaya.

July 2014

2

The views expressed in the following material are the

author’s and do not necessarily represent the views of

the Global Association of Risk Professionals (GARP),

its Membership or its Management.

Austrian School of Economics

• Free markets and laissez-faire capitalism

• Carl Menger, Ludwig von Mises, and Nobel laureate Friedrich Hayek

• Also Murray Rothbard and US presidential candidate Ron Paul

• Chicago School, similar, - Nobelists Milton Friedman and Gary Becker.

Contents

1. Cause 1: Central Banking

2. Cause 2: Fractional-reserve Banking

3. Solution 1: Full-reserve Banking

4. Solution 2: Fractional Reserves Free Banking

Central Banking The Cause to Financial Crisis

Adapted from a presentation given by Will Geary, Duke University

Source: sites.duke.edu/urbaneconomics/files/2010/12/Geary-

Presentation.ppt

Part ONE

Austrian Business Cycle Theory• Genuine recession is responded by money

supply expansion/lowering of interest rates by central bank.

• Lower interest rates drive firms to borrow the newly expanded bank money and invest it in future projects/ capital goods.

• Lower interest rates drive consumers to take loans and purchase things than other wise (houses, cars, etc).

Austrian Business Cycle Theory

• Easier lending leads to rapid expansion, spending and investment, i.e. a “bubble”

• Not due to increased productivity but an expanded credit supply.

• Resources such as labor and capital goods are misallocated to stimulated sectors.

Austrian Business Cycle Theory• For a period of time, nominal Incomes rise,

businesses are able to acquire capital and people are able to live above their means.

• When the coverage of bank reserves over loans/liabilities falls too low, interest rates must be raised, credits be contracted.

• Or the central bank eventually realizes the bubble it has created and thus raises interest rate to curb its growth.

• Consequently, the unfinished investments must be abandoned.

Austrian Business Cycle Theory

• People begin demanding their money back from banks,

• individuals default on their loans,

• lenders slow or even stop lending, and

• companies go bankrupt due to a lack of capital to finance previous bad investments

• This is known as a “credit crunch”

Austrian Business Cycle Theory

• In response to the bubble burst, the credit crunch and the resulting recession, the central bank may lower interest rates again to expand the credit supply and encourage borrowing

• Remember it all began with artificially low interest rates in the first place!

• By right, resources and labor should be let to return to where they should have been.

• This entails short-run unemployment in labor and resources. They need time to move back to the right places.

Empirical Finding:US Housing Bubble 2001-2006

• US housing prices skyrocketed, until plummeted in July 2006

• Fueled by historically low interest rates (Alan Greenspan bubble) intended to ease the blow of the tech bubble crash in 2000.

(blue) = what interest rates theoretically should be, or would be if it weren’t for the Fed

(red) = what interest rates actually are in the presence of the fed

Source: research.stlouisfed.org

Positive blue line = Fed has set interest rates lower than they would/should be

Negative blue line = Fed has set interes rates higher than they would/should be

Gray bars represent recessions

10-Year Gov’t Security Interest Rates – Federal Funds Effective Rates

Housing Bubble

• Low interest rates mean more borrowing, more spending and less saving

• Higher demand for housing and rising home prices

• Homeowners act wealthier when the value of their homes increases.

• Economic activities stimulated.

Housing Bubble

• Artificially low interest rates create a price distortion that leads to a false sense of security and a higher appetite for risk

• Since home prices are skyrocketing, bankers could always count on selling off homes for a profit if their risky subprime loans were to default

Housing Bubble

• Eventually, the Fed realizes the bubble it created and wants to slow it down

• In 2006, Fed raises interest rates from 1% to over 5.25%

• Result: credit contraction, people default on mortgages, etc.

• Investment banks (Lehman, Bear Stearns) that made huge bets on subprime industry are hit hard.

References

• Bocutoglu, Ersan, and Aykut Ekinci. "Austrian Business Cycle Theory and

Global Crisis." Mises.org. Ludwig von Mises Institute, 5 Feb. 2010. Web. 29

Nov. 2010. <http://mises.org/daily/4072>.

• "Effective Federal Funds Rate." St. Louis Federal Reserve. 2 Nov. 2010.

Web. 29 Nov. 2010.

<https://research.stlouisfed.org//fred2/data/FEDFUNDS.txt>.

• "Flow of Funds Accounts of the United States." Federal Reserve. N.p., 17

Sept. 2010. Web. 29 Nov. 2010.

<http://www.federalreserve.gov/releases/z1/Current/data.htm>.

• Kliesen, Kevin. "The 2001 Recession: How Was It Different and What

Developments May Have Caused It?" St. Louis Federal Reserve. N.p., Sept.-

Oct. 2003. Web. 29 Nov.

2010.<https://www.research.stlouisfed.org/publications

• Murphy, Robert. "Did the Fed, or Asian Saving, Cause the Housing

Bubble?" Mises.org. Ludwig von Mises Institute, 19 Nov. 2008. Web. 29

Nov. 2010. <http://mises.org/daily/3203>.

Part TWO Fractional-reserve Banking as A Cause To

Crisis

Fractional-reserve Banking and Business Cycle

• Maturity Mismatching (Bagus, 2010)– As a normal yield curve would predict, due to

expected risks, short-term interest rates are generally lower than long-term rates.

– Banks offer greater interest rates to obtain short-term financing from depositors.

– Creation of long-term loans above the level actually saved, made possible through fractional-reserve banking, gives a distorted signal to businesses that their long-term financing will be rolled-over over the period of the projects.

• Deviation from Reality (Hulsmann, 2003)– It increases the deviation between market’s

perception about the reality and the reality.

– Every individual would think that his deposits are always there with the banks and readily cashable.

– Nevertheless, this is not true for all individuals as a whole.

– The economy as a whole hence tends to indulge in excessive spending and investment than otherwise.

Fractional-reserve Banking and Business Cycle

• Unrestrained Credit Expansion– Banks can collude, trade reserves, and clear

accounts over longer period despite the need for precautionary reserves of base money (Bagus and Howden, 2010).

– The necessity of precautionary reserves could also be diminished during a credit expansion when that expansion has earlier increased general prices including the prices of bank assets (Rallo, 2009).

Fractional-reserve Banking and Business Cycle

• Distortions in Production– Different from actual channeling of savings to

investment, the issuance of credit based on fractional reserves finances investment or expenditure without prior savings or sacrifice of present satisfaction on the part of the ultimate lender (Cochran and Call, 1998).

– As a result, the optimal amount of technical and commercial output cannot be achieved because the financing of the related investments is not due to their intrinsic worth but artificially low interest rates (Block and Garschina, 1996).

Fractional-reserve Banking and Business Cycle

• Distortion in Production– Increase in production depends on the

consumption pattern of the initial recipients of the newly created money at the expense of those who receive the increased flows later (Cochran and Call, 1998).

– Amongst the biggest initial recipients is non other than the government (Huerta de Soto, 1995).

– The greater the misallocation of resources, the longer the recovery time after bust.

Fractional-reserve Banking and Business Cycle

Part THREESolution 1:

Full-reserve Banking

• Though moving to a 100-percent reserve system would not eliminate the financial augmentation of the business cycle, those effects can be at least diminished (Krainer, 2012).

• Non-bank financial institutions and investors engaging in volatile asset markets will still face the fluctuations.

Full-reserve Banking

Full-reserve Banking

• As a medium of exchange, money adjusts its purchasing power when the quantity of money is altered (Rothbard, 1991). Hence, more money does not stimulate economic activity.

• When people save, purchasing power is increased, and vice versa.

• There will be natural short-run inflation and deflation due to preferences of the public.

Full-reserve Banking

• Without production of virtual money, full-reserve banks can be profitable by just charging customers for various services.

• Banks can be the intermediary for private entities and the government that would like to invest or lend out their funds and that would not withdraw the funds for a certain period of time.

Full-reserve Banking

• As Say’s law states, all goods are bought by other goods (Hoppe, Hülsmann, and Block, 1998).

• An increase in the demand for money is not just about the demand for money per se, but also entails the demand and supply of something else.

• If one were to increase his demand for money, he must increase the supply and/or reduce the demand of something else so that the real and the monetary market are aligned.

• In a 100-percent-gold-backed international monetary system, the amount of gold in every nation is determined solely by market forces (Yeager, 1952).

• The gist of the idea is that Individuals, rather than governmental policies, could determine the distribution of gold across countries optimally.

• Individuals know better about how much they earn and how much they should spend. If spending is less than income, the balance can be saved or invested.

Full-reserve Banking and International Balances

Part FOURSolution 2:

Fractional Reserves with

Free Banking

Fractional-reserve Free Banking

• Core reference: Selgin and White (1994).• Three major types of monetary system in a pure

free market: 1. Unregulated monetary and banking system

using one base money such as a precious metal whereby deposits and notes issued by private banks are redeemable in base money.

2. A system with many parallel non-commodity base monies.

3. Competitive payment mechanism without any base money at all.

• Present fractional-reserve banking system is regulated and protected, not what a true free market would prescribe.

• The historical record of Scotland, Canada, Sweden, Switzerland, and New England has evidenced that the freedom to issue notes by private banks is workable.

• The demand for money would be the demand for substitutes of base money.

Fractional-reserve Free Banking

– It could automatically adjust the supply of money whenever there are changes in the demand for money.

– Larger demand for a bank’s notes and deposits, less redemption against its reserves of base money at clearinghouse.

– Greater reserves, greater expansion of credit.

– Excess reserves released as part of loans. This draws down excess reserves.

Fractional-reserve Free Banking

– Yes, in the long run, changes in the purchasing power of money can work to satisfy changes in the demand to hold money.

– Higher demand for real cash balances, lower spending, lower prices, greater cash balances in real terms.

Fractional-reserve Free Banking

– When prices are downward rigid, greater holdings

of money by the public mean lesser funds to be

channeled to the financial markets.

– This raises interest rates than otherwise would have

been if prices are flexible (Horwitz, 1996).

– Consequently, reduced supply of loanable funds

might lead to a recession.

– Thus, flexible money supply could do better than sluggish price change.

Fractional-reserve Free Banking

References• Bagus, P. (2010). Austrian business cycle theory: Are 100 percent reserves sufficient to prevent a

business cycle? Libertarian Papers, 2, 1.• Hulsmann, J. G. (2003). Has Fractional-Reserve Banking Really Passed the Market Test?

Independent Review, 7(3), 399-422.• Bagus, P., & Howden, D. (2010). Fractional reserve free banking: some quibbles. Quarterly

Journal of Austrian Economics, 13(4), 29-55.• Rallo, Juan Ramón. 2009a. “George Selgin: La Irrefrenable Iliquidez del Descalce de Plazos.”

Instituto Juan de Mariana. • Cochran, J. P., & Call, S. T. (1998). the role of fractional-reserve Banking and financial

intermediation in the money supply process: Keynes and the Austrians. Quarterly Journal of Austrian Economics, 1(3), 29-40.

• Block, W., & Garschina, K. M. (1996). Hayek, Business Cycles and Fractional Reserve Banking: Continuing the De-Homogenization Process. The Review of Austrian Economics, 9(1), 77-94.

• Huerta de Soto, Jesus. 1995. “A Critical Analysis of Central Banks and Fractional-Reserve Free Banking from the Austrian School Perspective”, Review of Austrian Economics, vol. 8, no. 2, 25-38.

• Krainer, R. (2012). Economic Stability under Alternative Banking Systems. Available at SSRN 2147888.

• Rothbard, M. N. (1991). The Case for a 100 Percent Gold Dollar. Auburn, Ala.: Ludwig von MisesInstitute.

• Hoppe, H. H., Hülsmann, J. G., & Block, W. (1998). Against fiduciary media. Quarterly Journal of Austrian Economics, 1(1), 19-50.

• Yeager, L. B. (1952). An evaluation of freely-fluctuating exchange rates (Doctoral dissertation, Columbia University.).

• Selgin, G., and White, L. H. (1994). How would the Invisible Hand handle money? Journal of Economic Literature, 32, (4), 15-56.

• Horwitz, Steven. 1996. “Capital Theory, Inflation, and Deflation: The Austrians and Monetary Disequilibrium Theory Compared.” Journal of the History of Economic Thought 18, no. 2: 287–308.

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