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Learning monetary theory from Mises

As brilliant as I sound on most matters that I write about, my grasp of monetary theory—the financial markets, banking, lending, credit, securities, how the fiat money system skews them all—is, to be honest, embarrassingly weak. The deficit is largely in my understanding of financial jargon. I experienced a similar, frustrating barrier to understanding scientific literature when I first started reading and hearing it in college, but now I am more or less fluent in it. My primary non-softball-related goal over the next few months is to become nearly fluent in the language of monetary policy.

Naturally, this newfound motivation springs from the financial crisis that has shaken the world economy in 2008, that we’re all trying to understand and explain, that the Fed and Treasury have tried to fix but have with metaphysical certitude made worse, and that will lead to a depression similar in severity and length to the Great Depression. I have wanted to understand it all better before, but not badly enough to do anything about it.

Also naturally, the only economics I am interested in studying for now is the Austrian school of economics. All other schools I am aware of endorse or do not outright oppose State prohibition of voluntary transactions, and, as the existence of the State violates my moral philosophy, I am not interested in hearing the details of the other evil and hare-brained schemes concocted by those Statists. (Except to refute them.) (And, besides, I both hear about and experience them every day of my life, and suffice it to say their results don’t provide a ringing endorsement of their theories.) Secondly, the Austrian economists are the only ones I’ve read about who can explain the boom–bust cycle of economies, who predicted and explained the housing bust, who explained and offered reasonable corrections for the current American financial crisis, and who have explained why the State solutions to State-caused problems will plunge the world into a second Great Depression and have offered real, substantive countermeasures, not quick fixes or patches or delays. (Then again, it is possible that other semi-libertarian-minded economists, who don’t call themselves Austrians, perhaps Bryan Caplan, for example, have offered the same predictions, explanations, and corrections, and I’m just LRC/Mises–biased. Well, a libertarian solution is a libertarian solution, by any name.)

I have understood the Austrian theory of the business cycle for a long time, but that was about the most complicated financial concept I had a good grasp of. The Austrian theory of the business cycle posits: An artificial expansion of credit (i.e., by a central bank) via lowering of interest rates encourages loans or investments that wouldn’t be prudent in a free market, which creates a boom, but when these loans or investments don’t yield a positive return or are otherwise deemed to be a bad idea, the money is reallocated away from those risky ventures and back into more prudent investments (or nothing), and this is the bust.

So, the point is, I was reading the section on credit expansion in Interventionism: An Economic Analysis by Ludwig von Mises, which was recommended by Jeffrey Tucker. Mises gives several blockquote-worthy explanations regarding money, interest, and credit:

What the advocates of inflation desire and the proponents of sound money oppose is not the ultimate result of inflation, namely, the increase of the money quantity itself, but rather the effects of the process by which the additional money enters the economic system and gradually changes prices and wages. The social consequences of inflation are twofold: (1) the meaning of all deferred payments is altered to the advantage of the debtors and to the disadvantage of the creditors, or (2) the price changes do not occur simultaneously nor to the same extent for all individual commodities and services. Therefore, as long as the inflation has not exerted its full effects on prices and wages there are groups in the community which gain, and groups which lose. Those gain who are in a position to sell the goods and services they are offering at higher prices, while they are still paying the old low prices for the goods and services they are buying. On the other hand, those lose who have to pay higher prices, while still receiving lower prices for their own products and services. If, for instance, the government increases the quantity of money in order to pay for armaments, the entrepreneurs and workers of the munitions industries will be the first to realize inflationary gains. Other groups will suffer from the rising prices until the prices for their products and services go up as well. It is on this time-lag between the changes in the prices of various commodities and services that the import-discouraging and export-promoting effect of the lowering of the purchasing power of the domestic money is based.

Because the effects which the inflationists seek by inflation are of a temporary nature only, there can never be enough inflation from the inflationist point of view. Once the quantity of money ceases to increase, the groups who were reaping gains during the inflation lose their privileged position. They may keep the gains they realized during the inflation but they cannot make any further gains. The gradual rise of the prices of goods which they previously were buying at comparatively low prices now impairs their position because as sellers they cannot expect prices to rise further. The clamor for inflation will therefore persist.

I have a feeling this desire for continual inflation is more relevant to money and lending markets than to selling food or shoes. I’m going to understand the details of why soon.

But on the other hand inflation cannot continue indefinitely. As soon as the public realizes that the government does not intend to stop inflation, that the quantity of money will continue to increase with no end in sight, and that consequently the money prices of all goods and services will continue to soar with no possibility of stopping them, everybody will tend to buy as much as possible and to keep his ready cash at a minimum. The keeping of cash under such conditions involves not only the costs usually called interest, but also considerable losses due to the decrease in the money’s purchasing power. The advantages of holding cash must be bought at sacrifices which appear so high that everybody restricts more and more his ready cash.
[...]
It is claimed that in times of a grave emergency the use of means may be justified which in normal times would not be considered. But who is to decide whether the emergency is grave enough to warrant the application of dangerous measures? Every government and every political party in power is inclined to regard the difficulties it has to cope with as quite extraordinary and to conclude that any means for combatting them is justified. The drug addict, who says he will abstain from tomorrow on, will never conquer the drug habit. We have to adopt a sound policy today, not tomorrow.
[...]
Inflation, the issue of additional paper money, and credit expansion are always intentional; they are never acts of God which strike people, like an earthquake. No matter how great and how urgent a need may be, it can only be satisfied from available goods, by goods which are produced by restricting other consumption. The inflation does not produce additional goods, it determines only how much each individual citizen is to sacrifice. Like taxes or government borrowing, it is a means of financing, not a means of satisfying demand.
[...]
It is a fundamental fact of human behavior that people value present goods higher than future goods. An apple available for immediate consumption is valued higher than an apple which will be available next year. And an apple which will be available in a year is in turn valued higher than an apple which will become available in five years. This difference in valuation appears in the market economy in the form of the discount, to which future goods are subject as compared to present goods. In money transactions this discount is called interest.
[...]
Interest does not have its origin in the meeting of supply and demand of money loans in the capital market. It is rather the function of the loan market, which in business terms is called the money market (for short-term credit) and the capital market (for long-term credit), to adjust the interest rates for loans transacted in money to the difference in the valuation of present and future goods. This difference in valuation is the real source of interest. An increase in the quantity of money, no matter how large, cannot in the long run influence the rate of interest.

No other economic law is less popular than this, that interest rates are, in the long run, independent of the quantity of money. Public opinion is reluctant to recognize interest as a market phenomenon. Interest is thought to be an evil, an obstacle to human welfare, and, therefore, it is demanded that it be eliminated or at least considerably reduced. And credit expansion is considered the proper means to bring about “easy money.”

There is no doubt that credit expansion leads to a reduction of the interest rate in the short run. At the beginning, the additional supply of credit forces the interest rate for money loans below the point which it would have in an unmanipulated market. But it is equally clear that even the greatest expansion of credit cannot change the difference in the valuation of future and present goods. The interest rate must ultimately return to the point at which it corresponds to this difference in the valuation of goods. The description of this process of adjustment is the task of that part of economics which is called the theory of the business cycle.

[Long explanation of the business cycle...]

The true meaning of the argument of unused capacity, unsold—or, as it is said inaccurately, unsalable—inventories, and idle labor, now becomes apparent. The beginning of every credit expansion encounters such remnants of older, misdirected capital investments and apparently “corrects” them. In actuality, it does nothing but disturb the workings of the adjustment process. The existence of unused means of production does not invalidate the conclusions of the monetary theory of the business cycle. The advocates of credit expansion are mistaken when they believe that, in view of unused means of production, the suppression of all possibilities of credit expansion would perpetuate the depression. The measures they propose would not perpetuate real prosperity, but would constantly interfere with the process of readjustment and the return of normal conditions.

A lot of my left-libertarian blagging colleagues out there aren’t so keen on the LRC/Mises crowd anymore, but I think it must be admitted that they thoroughly understand the financial crisis we are in the midst of and they offer the correct explanations and corrections for this State-created mess (i.e., elimination of the Federal Reserve, a non-monopoly on currencies, and the institution of free-market currencies backed by gold). Most are not Statists; they are almost all anarchist libertarians. They are in a very good position to teach both libertarians and the Statist masses about Austrian monetary theory and explain how the Treasury and Federal Reserve created the unstable financial environment we live in, and furthermore how the State’s “solutions” are leading us into a second Great Depression and the removal of the dollar as the world’s reserve currency.

I have no objection to hearing people extol the brilliance of left-libertarian philosophers like Proudhon, Tucker, and Spooner, but they were not economists and none of their writings offer any explanation of the business cycle or monetary policy, that I’m aware of.

Posted in Economics