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Austrian Economics and Business Cycle Theory

Covers basic economic concepts and then an introduction to Austrian Business Cycle Theory.

Austrian Economics

on 15 September 2012

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Transcript of Austrian Economics and Business Cycle Theory

What is money? Direct Exchange (barter) Smith Jones Jones values the barrel of fish more than his bushel of wheat Smith values the bushel of wheat more than his barrel of fish An exchange occurs since each values what they receive more than they value what they give up, and both parties are better off, i.e. a WIN-WIN! What is wrong with barter?
Double coincidence of wants
Economic calculation impossible So how were the problems inherent in the barter economy solved? Indirect Exchange
Money Economy This is how a commodity becomes a money:
Let's say Smith wants to buy wheat, but Jones doesn't want fish (problem of double coincidence of wants)
Since Jones doesn't want fish, Smith must find something Jones does want- butter.
Smith buys butter not because he wants it directly, but because he can sell it to Jones in exchange for wheat.
As people develop confidence in a certain commodity's marketability, it will come into use as a medium of exchange.
A commodity in use as a general medium of exchange is called a money. We have just discovered an amazing truth about money:

It is a commodity.
It arises through exchange on the free market (it does not and has not ever arisen by government fiat).
A commodity develops into a money as it gradually becomes a widely accepted medium of exchange. What does the word dollar mean? All of the names for currency, "dollars", "francs", "marks", were originally unit weights of gold or silver.
The word "dollar" evolved from the name of a popular one ounce silver coin minted by a Bohemian Count named Schlick.
The Count of Schlick lived in the valley of Joachimsthal.
The coins were widely referred to as ""Joachim's thalers" or Schlichtenthalers, the shorthand for which was "thaler".
Human nature being what it is, these coins later became "dollars" in Spain and elsewhere.
This Spanish silver dollar, commonly divided into pieces or bits of eight, was the predecessor to the dollar as the currency of the USA as a coin containing 371.25 grains of pure silver (Coinage Act of 1792). What is interest? Interest is the premium or agio which present goods command over future goods. The interest rate indicates people's willingness to postpone current consumption in favor of future consumption, or their time preference. In the Austrian sense, the interest rate is a SIGNAL to entrepreneurs that coordinates production over time:

When interest rates are low, this reflects higher savings and thus a higher quantity of resources in the economy.

Because of this, entrepreneurs have incentive to embark on new projects, ones which might not have been profitable at a higher interest rate. As long-term projects are more interest rate sensitive, these new projects tend to be long-term (e.g. construction, equipment, raw materials). What is inflation? Inflation is simply expansion of the supply of money and credit. Think of inflation as water being poured into the economic pot of soup. It dilutes the soup! Inflation is commonly misinterpreted as rising prices.

Rising prices are a symptom, not the cause of inflation nor inflation itself.

Simple supply and demand tells us that as the quantity of money increases and thus the value decreases, its price has gone down in terms of other goods, i.e. it takes more units (dollars, euros) to buy goods. Expansion of the money supply. In fact, this is the very definition of inflation. It is incorrect to say this CAUSES inflation; expansion of the money supply IS inflation.

Money, just like every other asset, derives its value more or less from its supply in relation to the supply of goods in the economy as well as market participants' confidence in the said monetary unit.

In the case of the United States, the open market operations of the Federal Reserve are the primary cause (creating money out of nothing) What causes inflation? Compounding the inflationary problem is fractional reserve banking.

According to Modern Money Mechanics (released by the Federal Reserve Bank of Chicago), banks, which are required to keep an account with the Fed, are required to keep no less than 10% reserves. The Federal Reserve Note is no longer redeemable for natural money (silver or gold).

It is now "fiat" currency, meaning the government has decreed it to be money.

It is backed by the "full faith and credit of the United States"- i.e. it is backed by a promise.

In 1933, gold was made illegal to own by FDR and the US government.

The last link to gold was cut in 1971 with the collapse of the Bretton Woods agreement. That is to say, the economy is on a series of unsustainable investment trajectories, a boom followed by a bust.

The bust is not bad- the damage is created during the boom. The bust is the process whereby malinvestments of the boom period are realized and liquidated as consumers reestablish their old patterns of saving and consumption. The prime example of this credit-induced boom followed by a bust is the recent housing bubble! How was the housing bubble created?

When the dotcom bubble burst, Alan Greenspan and the Federal Reserve cut the target Federal Funds Rate from 6.5% in January 2001 to 1% in June 2003.

This caused expansion of the money supply (right) Where does this leave us? The US debt-to-GDP ratio is about 91%.

If we account for the unfunded liabilities of Social Security and Medicare/Medicaid, that figure balloons to over 700%.

This is unsustainable. The United States government is now running a massive trade deficit and besides the national debt which is around $14 trillion, the additional promised entitlement spending of Social Security and Medicare/Medicaid brings the total debt of the US government to over $100 trillion. The only reason the US economy appears to be in good shape is due to:

A concerted effort to hide the effects of the increase in the money supply.

Other countries are buying our debt, i.e. our consumption is being paid for through borrowing.

Through overtaxation and stifling regulation, much of our productive capacity has been pushed to other countries, i.e. the US does not manufacture/produce anything.

This too is unsustainable. Picture 6 people on an island. Five are Asian. One is American.

Of the Asians, one fishes, one hunts, one gathers firewood, one forages, one cooks.

The American eats.

Who is getting the worse deal? Does this seem like a situation that will continue indefinitely? The Opportunity Silver is at historically low prices. "The major monetary metal in history is silver, not gold."

Nobel Laureate Milton Friedman The historic gold to silver ratio is 15:1.
When I started recommending silver and created this presentation in July of 2010, the gold/silver ratio was 68 and the price at ~$17.5.
Revision October: On (10/20/10) at 58:1, ~$23.
Revision June: On June 13, 2011 the ratio sits at 42:1, $34.

Even now, silver is immensely undervalued. This is not the time to be in the stock market (with few exceptions such as mining stocks)

In 1999, the Dow in gold dollars was 44.8 ounces. As of October 20th, 2010 the Dow is worth 8.27 ounces. So while the Dow is still around 10,000, the Dow has lost more than 80% in terms of gold.

In June 2001, it took 2,566 ounces of silver to buy the Dow. As of October 20th, 2010, 467.57 ounces of silver buys the entire Dow. In terms of silver, the Dow while at a nominal 10,000 and change has lost nearly 81% of its value. The flight to real value is about to hit high gear. What this means is that if you deposit $100 at the bank, the bank is required to keep only $10.

The bank can then loan out the remaining $90. This $90 loan is then deposited into another account.

Because of the 10% requirement, the bank is required to keep only $9 and can loan out the remaining $81. This $81 loan is then deposited into another account.

Because of the 10% requirement, the bank is required to keep only $8 and can loan out the remaining $73. By the time this process is completed, $900 are created out of thin air. This monetary expansion was channeled into the housing industry thanks to the moral hazard of Fannie and Freddie (whose loans were guaranteed by the government) and the housing bubble was created. Human Action Economics as defined by the founder of the Austrian School of Economics, Carl Menger, is the study of purposeful human choice. Economics is the best developed subdivision of praxeology; praxeology is the science of human action, a term first used by Ludwig von Mises.

Mises's magnum opus is titled Human Action. "Whether we like it or not, it is a fact that economics cannot remain an esoteric branch of knowledge accessible only to small groups of scholars and specialists. Economics deals with society's fundamental problems; it concerns everyone and belongs to all. It is the main and proper study of every citizen."

Ludwig von Mises Basic Economics
Austrian Business Cycle Theory When interest rates are high, this signals to entrepreneurs that the time preference of society is high, there are less real resources in the economy, (savings are low, many resources have been used up in consumption) and thus, that it is becoming less profitable to engage in long-term projects. To describe this process, Ludwig von Mises gave the example of the "master builder". The whole entrepreneurial class is...in the position of a master-builder whose task it is to erect a building out of a limited supply of building materials. If this man overestimates the quantity of the...supply, he drafts a plan for the execution of which the means at his disposal are not sufficient. He oversizes the groundwork and the foundations and only discovers later in the progress of the construction that he lacks the material needed for the completion of the structure. It is obvious that our master-builder's fault was not overinvestment, but an inappropriate employment of the means at his disposal.

Human Action
Chapter 20, Section 6 Benefits of Indirect Exchange
The development of indirect exchange via the use of one or a few commodities as "moneys" enabled the primitive barter economy to flower into an elaborate system of trade.
The use of money allowed for the division of labor and ease of profit/loss calculation on the part of entrepreneurs.
Money is the lifeblood of any advanced economy. "The emergence of money was a great boon to the
human race. Without money-without a general medium of exchange-there could be no real specialization, no advancement of the economy above a...primitive level. With money, the problems of indivisibility and “coincidence of wants” that plagued the barter society all vanish. Now, Jones can hire laborers and pay them in...money. Smith can sell his plow in exchange for units of...money. The money-commodity is divisible into small units, and it is generally acceptable by all."
-Murray N. Rothbard How does inflation redistribute wealth? Even though by the end of the process everyone has an increase in his/her money stock, the later receivers of the money incurred losses during the transition period when they were forced to pay higher prices without the rise in their money stock.

That is to say, inflation redistributes wealth from the poor and middle class to the first receivers of the newly created money. The first receivers gain purchasing power ONLY at the expense (by theft) of the later receivers of the money from whom they leech purchasing power. "The decrease in purchasing power incurred by holders of money due to inflation imparts gains to the issuers of money--."
St. Louis Federal Reserve Bank, Review, Nov. 1975, p.22 Why does man exchange at all? Clearly, men voluntarily exchange because both parties expect to benefit.

Without exchange, the economy
(and society) would not exist. What is economics and why should I know it? "Neither economics nor anything else is studied solely out of pure curiosity to know the truth for its own sake, but in order to provide a sound basis for appropriate action. But...it is not scientific to confound matters of fact with wishes and desires, and even less to distort the facts on order to justify one’s desires, however noble the latter may be. In the second place, there is no doubt that any schemes for reform that are based on erroneous beliefs can lead to nothing but disaster. One has to look the facts boldly in the face. Only the truth can serve as a basis for successful action. This is what makes modern critical economics a science. It does not give advice; it is concerned purely and exclusively with matters of fact brought to light by honest investigation and rendered coherent by reflection."
-Faustino Ballvé Created by Aaron Brown
Mises University 2010 Graduate
Mises University 2011 Graduate
Mündliche Prüfung Graduate
RadioFreeMarket.com Producer Primitive Economy What gives rise to the rate of interest? The aggregate time preference schedules of all individuals in society. Whoever has cash on hand demands, in exchange for the loan of it, a rate of interest that will yield him a greater advantage than he expects to gain by keeping the money. Whoever borrows money offers for it, by way of interest, an amount that he finds it less burdensome to pay than to wait until he obtains his own money. The outcome of the co-ordination of these mutual desires is the rate of interest. What we have just described is the mechanism in the individual case. However, as there is not just one person who has money and one who needs it, but many who have it and many who would like to have it, and since nobody will lend money to anybody else at a rate of interest lower than what a third party is prepared to pay, and vice versa, the market rate of interest is determined in the same way as all other prices on the market.

-Faustino Ballvé In short, in the free market,
more saving= a lower interest rate.
Less saving= a higher interest rate. This is the time to hunker down, secure the wealth you have by buying tangible assets.

Gold and silver are not investments. They are moneys.

Now is the time to realize your paper/digital profits. What is a central bank? A central bank issues the currency of a nation. Most countries in the world today have a central bank.

The Federal Reserve or the "Fed" is the central bank of the United States.

The US was one of the last major nations to adopt a central bank, with the creation of the Federal Reserve in 1913. The stated aims of the central bank (this from the Fed's website) are to promote effectively the goals of:

Maximum employment,
Stable prices, and
Moderate long-term interest rates. The central bank attempts to accomplish these goals by expanding and contracting the money supply. "When you or I write a check there must be sufficient funds in our account to cover that check, but when the Federal Reserve writes a check, it is creating money."

Boston Federal Reserve Bank in a publication entitled "Putting it Simply" The Fed for example, buys government paper (T-bills, etc.) and gives the government Federal Reserve Notes. This increases the money supply. When it sells government paper, the money supply contracts. Where does the central bank get these notes from? Amazingly, it doesn't have the money. It creates the money out of thin air. That is to say, the money given to the government by the Federal Reserve comes into existence at the moment the Fed writes a check on itself. Application to Present Day The Money Problem Austrian Business Cycle Theory As we discussed in the interest rate section, this signals to entrepreneurs to invest in new (predominantly long-term) projects.

But, the interest rate has been forced down artificially by the Federal Reserve. The savings/consumption ratio of the public has not shown any willingness to postpone present in favor of future consumption. For the last 20 years, the federal funds interest rate (the rate at which banks lend to other banks with accounts at the Fed) has been kept artificially low. Because the public has not decreased consumption spending (and in fact low interest rates might increase consumption) the resources used in consumption (lower order) industries are not released for use in the higher order stages of production, i.e. there are not enough resources in the economy to sustain the long-term investments spurred by the artificially low interest rate. This has led to massive credit expansion by the commercial banks, i.e. an increase in the money supply. So to recap:

The tech bubble was created by government intervention via the Federal Reserve (by expanding the money supply)
To solve the tech bubble, the government expanded the money supply, sowing the seeds of the housing bubble.
When the housing bubble burst in 2006, the government pushed interest rates down to 0% and the money supply was expanded again.
Furthermore, the government's multi-trillion dollar bailout and stimulus packages have pumped even more money into the economy. It is instructive to note that no fiat currency has ever stood the test of time.

Paper currency is everywhere and always overprinted until its overissuance causes a crisis of confidence and the money becomes worthless. What we should have seen after the dotcom bubble was a much deeper recession than we in fact experienced. However, by conjuring up money and injecting it into the economy, the Federal Reserve stopped the dotcom bust from fully happening, i.e. stopped the healthy process whereby the malinvestments that ail the economy are purged. This did nothing to address the underlying economic problems; it simply sowed the seeds for a bigger crisis down the road. If China ever wises up (and it appears it is) and the US government doesn't, the national debt will have to be financed somehow, and with no one else to borrow from the Federal Reserve will be forced to monetize the debt, i.e. print money. When this happens, as people begin to see the rapid inflation, the velocity of money will increase. Individuals will try to spend their bank notes as quickly as possible, knowing that the currency is sure to be worth less in the future. "If the credit expansion is not stopped in time, the boom turns into the crack-up boom; the flight into real values begins, and the whole monetary system founders."

Ludwig von Mises We can already see this "flight into real values". According to a March 15th, 2010 article in Bloomberg's BusinessWeek:

"China has been a net seller of Treasuries for three straight months, the longest such stretch since the end of 2007. Chinese officials have questioned the dollar's role as a reserve currency...

[If] China were to stop recycling its dollars into U.S. Treasuries, it could have dire implications for Main Street America..." The Certainty of Worsening Boom-Bust Episodes and High Inflation These are not new concepts.
They have been known for hundreds if not thousands of years. "Lenin is said to have declared that the best way to destroy the Capitalist System was to debauch the currency. By a continuing...inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security, but at confidence in the equity of the existing distribution of wealth. Those to whom the system brings windfalls, beyond their deserts and even beyond their expectations or desires, become 'profiteers', who are the object of the hatred of the bourgeoisie, whom the inflationism has impoverished, not less than of the proletariat. As the inflation proceeds and the real value of the currency fluctuates wildly...all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth-getting degenerates into a gamble and a lottery. Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.."

John Maynard Keynes of 'Keynesian Economics' fame in his book "The Economic Consequences of the Peace" (1920). "I am firmly of the opinion...that there never was a paper pound, a paper dollar, or a paper promise of any kind, that ever yet obtained a general currency [as money] but by force or fraud, generally by both. That the army has been grossly cheated; that the creditors have been infamously defrauded [some closed their shops to prevent being paid off with worthless paper money]; that the widows and fatherless have been oppressively wronged and beggared; that the gray hairs of the aged and the innocent, for want of their just dues, have gone down with sorrow to their graves, in consequence of our disgraceful depreciated paper currency."

-John Adams The economic mechanism is intricate and its parts interdependent, and has suffered the shocks and jars incident to abnormal demands, credit inflations, and price upheavals. The normal balances have been impaired, the channels of distribution have been clogged, the relations of labor and management have been strained. We must seek the readjustment with care and courage…All the penalties will not be light, nor evenly distributed. There is no way of making them so. There is no instant step from disorder to order. We must face a condition of grim reality, charge off our losses and start afresh. It is the oldest lesson of civilization.
-Warren G. Harding This next video will show you the explanatory power of the Austrian Theory of the Business Cycle. This individual, Peter Schiff, is only one of those who were able to predict the collapse using the Austrian framework.

Sadly, the US government and other governments are resorting to the solutions put forth by those who did not see the crash coming and are conducting wild Keynesian experiments on the economy that will and ARE simply adding to the discoordination. Since its inception in 1913 the Federal Reserve System has presided over the crashes of 1921 and 1929, the Great Depression of 1929-1939, recessions in the years 1953, 1957, 1969, 1975, 1981, 2001, and 2008, and a stock market Black Monday in 1987. Chairman Bernanke Think of it this way... Central planner of interest rates Where does money enter the system?
The government.
The banks.

From this analysis we can conclude inflation redistributes wealth from everyone (primarily the poor and middle class) to the government and to the banking industry. “Paper money eventually returns to its intrinsic value ---- zero.”
Voltaire (1694-1778) “We are in danger of being overwhelmed with irredeemable paper, mere paper, representing not gold nor silver; representing nothing but broken promises, bad faith, bankrupt corporations, cheated creditors and a ruined people.”
Daniel Webster, speech in the Senate, 1833 “I sincerely believe...that banking establishments are more dangerous than standing armies, and that the principle of spending money to be paid by posterity under the name of funding is but swindling futurity on a large scale.”
Thomas Jefferson to John Taylor, 1816 "Of all the contrivances for cheating the laboring classes of mankind, none has been more effective than that which deludes them with paper money."
Daniel Webster "Gentlemen, I too have been a close observer of the doings of the Bank of the United States. I have had men watching you for a long time, and am convinced that you have used the funds of the bank to speculate in the breadstuffs of the country. When you won, you divided the profits amongst you, and when you lost, you charged it to the bank. You tell me that if I take the deposits from the bank and annul its charter I shall ruin ten thousand families. That may be true, gentlemen, but that is your sin. Should I let you go on, you will ruin fifty thousand families, and that would be my sin. You are a den of vipers and thieves. I have determined to rout you out, and by the Eternal, I will rout you out."
Andrew Jackson to a committee asking him to restore the Second Bank of the United States Proverbs 11:1
A false balance is an abomination to the LORD,
but a just weight is his delight. Leviticus 19:35-36
35"You shall do no wrong in judgment, in measures of length or weight or quantity. 36 You shall have just balances, just weights, a just ephah, and a just hin:I am the LORD your God, who brought you out of the land of Egypt." Deuteronomy 25:13-16
13 "You shall not have in your bag two kinds of weights, a large and a small. 14 You shall not have in your house two kinds of measures, a large and a small. 15 A full and fair weight you shall have, a full and fair measure you shall have, that your days may be long in the land that the LORD your God is giving you. 16 For all who do such things, all who act dishonestly, are an abomination to the LORD your God." Proverbs 16:11
A just weight and balance are the LORD’s;
all the weights in the bag are his work. Even newly created money showered down upon every individual in equal amounts all at once would cause relative prices to change.

These relative price changes are amplified by the fact that in the real world, fresh money enters the system at specific points. As the newly created money enters into the economy, prices rise. So let us say at the end of the process, when the newly created money has had its full effect on the economy, everyone's money stock has increased by 20% and prices have also gone up. Some prices have risen, but everyone has 20% more money.
So what's the problem? Remember what we learned in the section on interest rates? If individuals decide to save more, thus increasing the supply of funds able to be loaned and increasing the supply of real resources in the economy, ceteris paribus the interest rate will go down.

Another way of saying this is that the public has voluntarily increased their savings/consumption ratio or that their time preference has decreased, i.e. society on the aggregate is willing to consume less in the present. Notice how right at the moment (in Jan '01) the Federal Funds Target rate (the BLACK line) begins to plummet, the money supply explodes. The body of economic knowledge is an essential element in the structure of human civilization; it is the foundation upon which modern industrialism and all the moral, intellectual, technological, and therapeutical achievements of the last centuries have been built. It rests with men whether they will make the proper use of the rich treasure with which this knowledge provides them or whether they will leave it unused. But if they fail to take the best advantage of it and disregard its teachings and warnings, they will not annul economics; they will stamp out society and the human race.

-Ludwig von Mises in Human Action This is probably the most important section as you might have guessed since it is also the title of the presentation. In case my explanation simply doesn't strike you as anything special or if my explanation doesn't fully elucidate the topic, please see Roger Garrison's excellent presentation at:


Another great presentation of the subject is Thomas Woods's speech on Mises.org of "Why You've Never Heard of the Great Depression of 1920". Legalize competing currencies through abolition of legal tender laws

Abolish the Federal Reserve

Eliminate taxes altogether and replace them with nothing

Abolish Social Security and Medicare/Medicaid

Abolish entire departments of the Federal, State, and local governments (BATFE, Department of Energy, Department of Education, Department of Homeland Security, SEC, etc.)

Phase out the compulsory elements of Federal, State, and local governments on a large scale.

In short, outlaw theft and legalize private property.

For further reading on the subject, a few titles you may consider are "Meltdown" and "Rollback" by Thomas Woods, "How an Economy Grows and Why it Crashes" by Peter Schiff, "What Has Government Done to Our Money?" by Murray Rothbard, and "America's Great Depression" by Murray Rothbard. Most of these titles (and many others) are available FOR FREE at Mises.org. The Solution The US "dollar" is not a dollar, although we call it that, it is a Federal Reserve Note. It is fiat currency, which is "money" backed by nothing and protected from competition by legal tender laws.

A legal tender law is a government decree that you must accept Federal Reserve Notes in exchange for goods and services. You can accept spaghetti if you like; but you cannot reject Federal Reserve Notes. It is interesting to note that even ancient religious texts discuss the matter of money. This postponement of current consumption is called "saving".
To save necessarily implies a restriction of consumption. This is not to say a restructured Fed or a new management team is needed, but that the very idea that any one person or group of people is capable of centrally planning the money supply and interest rates needs to be reexamined.
See the writings of F.A. Hayek concerning knowledge in society.
(http://mises.org/daily/3229) If you have questions on this presentation, I would be happy to discuss it with you via Skype.
Please e-mail me at AustrianPerspective@gmail.com, subject header "Austrian Prezi". Some people get the money first.
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