The Euro – A Monetary Strangulation Mechanism

In my previous post I claimed that the ‘Greek crisis’ essentially is not about Greece, but rather that the crisis is a symptom of a bigger problem namely the euro itself.

Furthermore, I claimed that had it not been for the euro we would not have had to have massive bailouts of countries and we would not have been in a seven years of recession in the euro zone and unemployment would have been (much) lower if we had had floating exchange rates in across Europe instead of what we could call the Monetary Strangulation Mechanism (MSM).

It is of course impossible to say how the world would have looked had we had floating exchange rates instead of the MSM. However, luckily not all countries in Europe have joined the euro and the economic performance of these countries might give us a hint about how things could have been if we had never introduced the euro.

So I have looked at the growth performance of the euro countries as well as on the European countries, which have had floating (or quasi-floating) exchange rates to compare ‘peggers’ with ‘floaters’.

My sample is the euro countries and the countries with fixed exchange rates against the euro (Bulgaria and Denmark) and countries with floating exchange rates in the EU – the UK, Sweden, Poland, Hungary, the Czech Republic and Romania. Furthermore, I have included Switzerland as well as the EEA countriesNorway and Iceland (all with floating exchange rates). Finally I have included Greece’s neighbour Turkey, which also has a floating exchange rate.

In all 31 European countries – all very different. Some countries are political dysfunctional and struggling with corruption (for example Romania or Turkey), while others are normally seen as relatively efficient economies with well-functioning labour and product markets and strong external balance and sound public finances like Denmark, Finland and the Netherland.

Overall we can differentiate between two groups of countries – euro countries and euro peggers (the ‘red countries’) and the countries with more or less floating exchange rates (the ‘green countries’).

The graph below shows the growth performance for these two groups of European countries in the period from 2007 (the year prior to the crisis hit) to 2015.

floaters peggers RGDP20072015 A

The difference is striking – among the 21 euro countries (including the two euro peggers) nearly half (10) of the countries today have lower real GDP levels than in 2007, while all of the floaters today have higher real GDP levels than in 2007.

Even Iceland, which had a major banking collapse in 2008 and the always politically dysfunctionally and highly indebted Hungary (both with floating exchange rates) have outgrown the majority of euro countries (and euro peggers).

In fact these two countries – the two slowest growing floaters – have outgrown the Netherlands, Denmark and Finland – countries which are always seen as examples of reform-oriented countries with über prudent policies and strong external balances and healthy public finances.

If we look at a simple median of the growth rates of real GDP from 2007 until 2015 the floaters have significantly outgrown the euro countries by a factor of five (7.9% versus 1.5%). Even if we disregard the three fastest floaters (Turkey, Romania and Poland) the floaters still massively outperform the euro countries (6.5% versus 1.5%).

The crisis would have long been over had the euro not been introduced  

To me there can be no doubt – the massive growth outperformance for floaters relative to the euro countries is no coincidence. The euro has been a Monetary Strangulation Mechanism and had we not had the euro the crisis in Europe would likely long ago have been over. In fact the crisis is essentially over for most of the ‘floaters’.

We can debate why the euro has been such a growth killing machine – and I will look closer into that in coming posts – but there is no doubt that the crisis in Europe today has been caused by the euro itself rather than the mismanagement of individual economies.

PS I am not claiming the structural factors are not important and I do not claim that all of the floaters have had great monetary policies. The only thing I claim is the the main factor for the underperformance of the euro countries is the euro itself.

PPS one could argue that the German ‘D-mark’ is freely floating and all other euro countries essentially are pegged to the ‘D-mark’ and that this is the reason for Germany’s significant growth outperformance relative to most of the other euro countries.

Update: With this post I have tried to demonstrate that the euro does not allow nominal adjustments for individual euro countries and asymmetrical shocks therefore will have negative effects. I am not making an argument about the long-term growth outlook for individual euro countries and I am not arguing that the euro zone forever will be doomed to low growth. The focus is on how the euro area has coped with the 2008 shock and the the aftermath. However, some have asked how my graph would look if you go back to 2000. Tim Lee has done the work for me – and you will see it doesn’t make much of a difference to the overall results. See here.

Update II: The euro is not only a Monetary Strangulation Mechanism, but also a Fiscal Strangulation Mechanism.


If you want to hear me speak about these topics or other related topics don’t hesitate to contact my speaker agency Specialist Speakers – e-mail: or

More silliness from the tin foil hat Austrians

I love reading the normally good blog posts on written by clever economists such as George Selgin and Kurt Schuler. However, the Facebook page of very often fails to live up to the same good standards as the blog. In fact most updates are what I consider to be internet-Austrian nonsense.

Here is the latest example:

“If the dollar were suddenly to lose reserve status, the United States of America would face catastrophic inflation.”

The freebanking facebook page is quoting an article by Lawrence J. Fedewa. I have never heard about him before, but his article is a pretty good example of the kind of “the-world-is-coming-to-an-end” nonsense, which is floating around in cyberspace mostly written by tin foil hat Austrians.

But let me address the quote above.

First of all there are no signs that the dollar in any way is loosing its reserve status. In fact the dollar is more popular than ever. Hence, since the onset of the crisis in 2008 we have seen a massive increase in dollar demand – in fact that was what caused the crisis.

Or just ask yourself what currency is about to replace the dollar as the reserve currency of the world? The euro? I think not? Or the yuan? Think again you silly people.

I am presently vacationing in Thailand and I am pretty sure that if I wanted to pay any local street vendor here with dollars they would be very happy to accept it. But would they accept euros? Probably – there is a lot of German tourists in the area where we are vacationing so the locals are probably familiar with the euro.

But what if I tried to pay with yuan? I doubt the street vendors would accept that. So no the verdict is pretty clear from the Thai street vendors – the US greenback is what they prefer to any other currency (I nonetheless pays in Thai baht).

But lets get back to some more silliness. This is again from Fedewa’s article:

If the dollar were suddenly to lose reserve status, the United States of America would face catastrophic inflation. All the dollars that the Federal Reserve has been creating, at about $85 billion each month, would begin to be dumped right on our heads, and the dollar would become virtually worthless. A loaf of bread could cost $50, a basket of groceries could cost $500. Hyperinflation has happened to many nations, including post WWI Germany, France and Russia, and modern day Greece and Spain.

Note here this is the trick used by the internet-Austrians – “It might be that we do not have hyperinflation yet but it will comes once dollar demand collapses”. Fine, first of all there is unfortunately no real sign that dollar demand is declining and money-velocity in the US is still quite elevated.

Second, if dollar demand where to start declining it would be good news as it would mean that the world would becoming “normal” again. That the excessive demand for dollars driven by deflation fears were easing. That obviously would increase inflationary pressures. And that should be welcomed – after all there is still significant slack in the US economy and inflation continues to be way below the Federal Reserve’s semi-official inflation inflation of 2% and the reason the fed has had to massively expand its balance sheet is exactly the massive demand for dollars.

But ok lets say that out of the blue everybody suddenly did not want to hold US dollars – I still fail to see why that would be the case, but lets for the sake of the argument assume that to be the case. A collapse in dollar demand would of course effectively be massive US monetary easing. The impact of this would likely be a sharp increase in both real and nominal GDP – and inflation.

Would the Fed be helpless in this situation? No not at all. The Fed of course could just tighten monetary policy. It could of course easily shift quantitative easing into reverse by for example announcing that if would cut the money base by 100 or 200bn dollars per months until inflation expectations returned to (just) below 2% and given the fact that the Fed’s balance sheet has never been bigger it could cut the money base a lot. There is not limits to how easing or tightening a central bank can do. Only paleo Keynesians and tin foil Austrians fail to understand this.

It is too bad that there is so much nonsense about monetary policy floating around in cyberspace, but it is unfortunately only getting worse and worse. I don’t know why this is and these views have probably always been around, but I for one is sick and tired of listening to all is nonsense!

And finally, the US government is not about to default. The crackpots on the left are wrong when the claim that the US government would have to default had the debt ceiling not been raised (the US government could just have cut spending) and the crackpots on the right are wrong when they claim that the US government debt is out of control (the budget deficit is declining strongly and public debt levels have stabilized).

But of course that financial markets know that all this is just political hype in Washington. Just look at the S&P500 – it has gone up all though this show of US political dysfunctionality. Why? Because monetary policy dominates fiscal policy. It is the Sumner Critique stupid!

And now back to my vacation…

PS I have no clue whether Fedewa considers himself to be an Austrian. I use the term tin foil hat Austrian to describe a tendency or type of argument used by so many commentators rather than by people who actually read von Mises and Hayek. By the way I bet most of the people in cyberspace making what they believe to be “Austrian” arguments actually found these arguments on Youtube rather than by reading “Human Action” and other must-read Austrian classics. What I don’t understand is why Austrian scholars who actually did study von Mises and Hayek are not coming out much more aggressively and tell people like Peter Schiff that his arguments are nonsense. I would love to see a debate between for example Steve Horwitz and Peter Schiff.

PPS I just came to think of the Austrian version of Godwin’s law. Godwin’s law states that “As an online discussion grows longer, the probability of a comparison involving Nazis or Hitler approaches 1.” The Austrian version of this should read: “As an online discussion about monetary policy grows longer, the probability that an Austrian will mention Zimbabwe or the Weimar Republic approaches 1.”

Spain’s quasi-depression – an Austrian ‘bust’ or a monetary contraction? Or both?

A couple of days ago I wrote a post on the behavior of prices in the ‘bust’ phase of an Austrian style business cycle. My argument was that the Austrian business cycle story basically is a supply side story and that in the bust there is a negative supply shock. As a consequence one should expect inflation to increase during the ‘bust’ phase.

My post was not really about what have happened during the Great Recession, but it is obvious that the discussion could be relevant for understanding the present crisis.

Overall I don’t think that the present crisis can be explained by an Austrian style business cycle theory, but I nonetheless think that we can learn something relevant from Austrian Business Cycle Theory (ABCT) that will deepen our understanding of the crisis.

Unlike Austrians Market Monetarists generally do not stress what happened prior to the crisis. I do, however, think that we prior to the crisis saw a significant misallocation of resources in some countries. I myself in the run up to the crisis – back in 2006/7 – pointed to the risk of boom-bust in for example Iceland and Baltic States. Furthermore, in hindsight one could certainly also argue that we saw a similar misallocation in some Southern European countries. This misallocation in my view was caused by a combination of overly easy monetary conditions and significant moral hazard problems.

This discussion has inspired me to have a look Spain in the light of my discussion of ABCT.

My starting point is to decompose Spanish inflation into a supply and a demand component. I have used the crude method – the Quasi-Real Price Index – that I inspired by David Eagle developed in a number of posts back in 2011. I will not go into details with the method here, but you can read more here.

This is my decomposition of Spanish inflation.

Spain inflation QRPI

The story prior to the crisis is pretty clear. Both demand and supply inflation is fairly stable and there are no real sign of strongly accelerating demand inflation. However, the picture that emerges in the “bust-years” is very different.

As the graph shows supply inflation spiked as the crisis played out and has remained elevated ever since and we are now seeing supply inflation around 5%. However, at the same time demand inflation has collapsed and we basically have had demand deflation since the outbreak of the crisis.

I would stress that my crude method of decomposing inflation assumes that the aggregate supply curve is vertical. That obviously is not the case and that likely lead to an overestimation of the supply side inflation. That said, I feel pretty confident that the overall story is correct.

Hence, the Spanish story in my view provides some support for an Austrian-inspired interpretation of the crisis in the Spanish economy. As the crisis in Spain started to unfold the Spanish economy was hit by a large negative supply shock, which caused supply inflation to spike. There is clearly an Austrian style argument to be made here. Investors realised that they had  made a mistake and therefore economic resources had to reallocated from unprofitable sectors (for example the construction sector) to other sector. With price and wage rigidities this is a supply shock.

A negative supply shock will not in itself cause a depression 

However, this is not the whole story. A purely Austrian interpretation of the crisis misses the main problem in the Spanish economy today – the collapse in aggregate demand. Despite the sharp increase in Spanish supply inflation headline inflation (measured with the GDP deflator) has collapsed! That can only happen if demand inflation drops more than supply inflation increases. This is exactly what have happened in Spain. In fact we have a situation where we have high suppply inflation AND demand deflation.

What have happened is that the Spanish economy has moved from the ‘bust’ phase to what Hayek called ‘secondary deflation’. The ‘secondary deflation’ is the post-bust phase where a negative demand shock causes the economy to go into depression and a general deflationary state. This is a massively negative monetary shock and this is the real cause of the prolonged crisis.

The ‘secondary deflation’ is not a natural consequence of an Austrian style boom-bust, but rather a consequence of a monetary contraction. In that sense the secondary deflation is more monetarist in nature than Austrian.

In the case of Spain the monetary contraction is a direct consequence of Spain’s euro membership. If a country has a freely floating exchange rate then a negative supply shock – the bust – will cause the country’s currency to depreciate. However, due to Spain’s membership this obviously is not possible. The lack of depreciation of Spain’s currency de facto is monetary tightening (process that plays out is basically David Hume’s Price-Specie-flow story).

In fact the monetary tightening in Spain has been massive and has caused demand inflation to drop from around 4% to today more than 5% (demand) deflation!

This obviously is the real cause of the continued crisis in the Spanish economy. So while my decomposition of Spanish inflation seems to indicate that there has been an ‘Austrian story’ in the sense that there Spain has gone through of re-allocation (the negative supply shock) the dominant story is the collapse in aggregate demand caused by a monetary contraction.

The counterfactual story – and why a Austrian style bust is not recessionary

The discussion above in my view illustrates a clear problem with the Austrian story of the business cycle. I my view Austrians often fail to explain why a reallocation of economic resources will have to lead to a recession. Yes, it is clear that we will get a temporary downturn in real GDP in the bust phase, but there is nothing in ABCT that explains that that will turn into a depression-like situation as is the case in Spain.

What would for example have happened if Spain had had its own currency and an independent monetary policy regime where the central bank had targeted nominal GDP – for example along a 6% NGDP growth path.

Lets say that the entire initial Spanish downturn had been cause by a bubble bursting (it was not), but also that the central bank had been targeting a 6% NGDP growth path. Hence, as the bubble bursts real GDP growth decelerates sharply. However, as the central bank is keeping NGDP growth at 6% inflation will – temporary – increase. Most of the rise in inflation will be caused by an increase in supply inflation (but demand inflation will not drop). This is temporary and inflation will drop back once the re-allocation process has come to an end. Hence, there will not be a deflationary shock.

Therefore, the drop in real GDP growth is a necessary adjustment to a bubble bursting. However, the drop will likely be rather short-lived as aggregate demand (NGDP) is kept “on track” due to the NGDP target and hence “facilitate” a smooth re-allocation of resources in the Spanish economy.

This in my view clearly illustrates why we cannot use Austrian Business Cycle Theory to explain why the crisis in the Spanish economy is as deep as it is. Clever Austrians like Roger Garrison and Steve Horwitz will of course agree that ABCT is not a theory of depression. You need a monetary contraction to create a depression. This is Steve Horwitz on ABCT:

Both critics and adherents of the ABCT misunderstand it if they think it is some sort of comprehensive theory of the boom, breaking point, and length/depth of the bust.  It isn’t.  As Roger Garrison has long insisted, the theory by itself is a theory of the unsustainable boom.  It is a theory that explains why driving the market rate of interest below the natural rate through expansionary monetary policy produces a boom that contains endogenous processes that will cause that boom to turn to a bust.  Again, it’s a theory of the unsustainable boom.

ABCT tells us nothing about exactly when the boom will break and the precise factors that will cause it.  The theory claims that eventually costs will rise in such a way that make it clear that the longer-term production processes falsely induced by the boom will not be profitable, leading to their abandonment.  But it says nothing about which projects will be undertaken in which markets and which costs (other than perhaps the loan rate) will rise, and it tells us nothing about the timing of those events.  We know it has to happen, but the where and when are unique, not typical, features of business cycles.

… The ABCT is not a theory of the causes of the length and depth of recessions/depressions, but a theory of the unsustainable boom.

…The ABCT cannot explain the entirety of the Great Depression.  It simply can’t.  And adherents of theory who make the claim that it can are not doing the theory any favors.  What ABCT can explain (at least potentially, if the data support it) is why there was a recession at all in 1929.  It argues that it was the result of an unsustainable boom initiated by an excess supply of money at some point in the 1920s.  Yes, the bigger the boom, cet. par., the worse the bust, but even that doesn’t tell us much.  Once the turning point is reached, there’s not a lot that ABCT can say other than to let the healing process unfold unimpeded.

I think Steve’s description of ABCT is completely correct and in the same way as Steve doesn’t believe that ABCT can explain the entire Great Depression I would argue that ABCT cannot explain the Spanish crisis – or the euro crisis for that matter. Yes, there undoubtedly is some truth to the fact that overly easy monetary policy from the ECB contributed  to creating a unsustainable boom in the Spanish economy (and other European economies). However, ABCT cannot explain why we still five years into the crisis are trapped in a deflationary crisis in the Spanish economy. The depressionary state of the Spanish economy – at this stage – is nearly fully a consequence of a sharp monetary contraction. The bust has clearly long ago run its natural cause and what is keeping the Spanish economy from recovering is not a necessary re-allocation of economic resources, but very tight monetary conditions in Spain.

Conclusion: ABCT provide important insights, but will not help us now 

So to me the conclusion is pretty clear – Austrian Business Cycle theory do indeed provide some interesting and important insights to the boom-bust process. However, ABCT only explains a very limited part of the crisis in the Spanish economy and the euro zone for that matter. Had monetary policy been kept on track as the re-allocation process started the adjustment process in the Spanish economy would likely have been fairly painless and swift.

Unfortunately that has not been the case and monetary policy has caused the Spanish economy to enter a ‘secondary deflation’ and clever Austrians know that that is not a result of a bust, but rather a result of a monetary disequilibrium resulting from a excessive demand for money relative to the supply of money. There is no reason to worry about about reflating a bubble. The bubble has been deflated long ago.

PS The purpose of this post has been to discuss ABCT in the light of the crisis in Spain. However, the purpose has not been to tell the full story of Spain’s economic problems. Hence, it is clear that Spain struggles with serious structural problems such as extremely damaging firing-and-hiring rules. This structural problem significantly contribute to deepen and prolong the crisis, but it has not been the cause of the crisis.

The Austrian bust: HIGHER inflation and relative deflation

I have been thinking about an issue that puzzles me – it is about inflation in an Austrian School style bust.

Here is the story. If we think about a stylized Austrian school boom-bust then the story more or less is that easy money leads to an unsustainable boom that eventually – for some reason – will lead to a bust.

What people often fail to realize is that the Austrian business cycle theory basically is a supply side story.

Austrians will hate it, but you can tell much of the story within an AS/AD framework. The graph below is an illustration of this.

AS AD - AS shift rightwards

What happens is that the central bank cuts interest rates below the Wicksellian natural interest rate. Investors are tricked into thinking that it is the natural interest rates that has fallen and as a result investments are increased. Austrians will of course object by saying “it is not a overinvestment theory, but a malinvestment theory”. Yes, that is right, but that is not relevant for the question I want to look at here.

The boom happens not because of higher demand, but because of over (and mal) investment. The production capacity of the economy is hence expanded – the AS curve shifts to the right during the Austrian boom and production increases from Y1 to Y2. We ignore the demand effects – so we keep the AD unchanged – as the Austrians really are not paying much attention to this part of the story anyway (and yes, I am aware the there is relative demand story – private consumption vs investments).

Notice what happens with the price level initially. Prices drop from P1 to P2. Obviously that would not necessarily have to be the case if the AD curve also have shifted to the right as well (but that is not important for the story here). However, this pretty well illustrates the Austrian story that “headline” inflation will not necessarily increase during the boom. What happens – and we can obviously not realize that by just looking at AD and AS curves – is that we get what Austrians call relative inflation. Some prices rise, but the aggregate price level does not necessarily increase.

So far so good. I know Austrian economists would say that I told the story in the “wrong way”, but I guess they will agree on the main points – Austrian Business Cycle Theory is mostly about the supply side of the economy and that the aggregate price level will not necessarily have to increase during the boom phase.

Now we turn to the bust phase…

At some point investors realise that they have made a mistake – the natural interest rate has not really dropped. Therefore, what they thought were good and profitable investments are not really that great. So as a result investors cut back investments – after the “bubble” have bursted a large part of the production capacity in the economy is worthless. This is a negative supply shock! The AS shift back leftwards.

AS AD - AS shift leftwards

What is the result of this? Well, it is simple – the price level increases from P2 to P1. We get higher inflation. This might seem counterintuitive to most people – that the bust leads to higher rather lower inflation – but remember this is due fact that the Austrian boom-bust cycle primarily is a supply side story.

‘Benign’ inflation should be welcomed

And this brings me to what I really wanted to say. An increase inflation should be welcomed if it reflects a rational and undistorted reaction to investors realising that they have made a mistake. That is exactly what happens in an Austrian style bust. We might get relative deflation/disinflation, but the aggregate price level increases due to the negative supply shock.

Therefore, when Austrians often argue that the bust should be allowed to play out without any interference from the government or the central bank then that logically mean that they should welcome an increase in inflation in the bust phase of the business cycle. That obvious is not that same saying that monetary policy should be eased in the bust phase, but inflation should nonetheless be allowed to increase as we get “benign” inflation.

However, in my view that would mean that it would be wrong from an Austrian perspective for the central bank to tighten monetary policy in response to rise in (supply) inflation during the bust. Those Austrian economists who favour NGDP level targeting – like Anthony Evans and Steve Horwitz – would likely agree, but what about the “internet Austrian”? And what about Bob Murphy or Joe Salerno?

Obviously the story I have told above is a caricature of the Austrian Business Cycle theory, but I think there is a relevant discussion here that need to be addressed. Is the aggregate price level likely to rise in the bust phase as natural consequence of market forces being allowed to run it cause?

The reason that I think this debate is important is that some Austrians spend a lot of time arguing that the deflationary tendencies that we see for example in Europe at the moment are a natural and necessary bursting and deflating of a bubble. However, IF we indeed were in the bust phase of a Austrian style business cycle then we would not be seeing deflationary tendencies. We would in fact be seeing the opposite – we would see HIGHER inflation, but at the same time relative deflation.

Obviously this is not what we are seeing in the US and Europe today – inflation in both the US and the euro zone is well-below what it was during the “boom years”. That mean that we are not in the bust phase of an Austrian style boom-bust. There might very well have been a boom-bust initially (I believe that was the case in some European countries for example), but we have long ago moved to another phase – and that is what Hayek termed secondary deflation – a downturn in the economy caused by an monetary contraction.

PS Take a look at what happened in the US in 2007-8. Overall inflation did in fact increase as the economy was slowing, while we at the same time had relative deflation in the form of falling property prices. However, starting in the Autumn of 2008 we clearly saw across the board deflationary tendencies – here it is pretty clear that we entered a secondary deflationary phase caused by a monetary contraction. This is consistent with an Austrian interpretation of the Great Recession, but it is not a story I have heard many (any??) Austrians tell. And of course it is not necessarily the story I would tell – even though I think there is a lot of truth in it.

PPS The graphs above could indicate that both production and prices shifts back to the initial starting point during the bust. That obviously would not have to be the case as I here have ignored the shift in the AD curve and as any Austrian would note the AS/AD framework is not telling us anything about relative prices.

Mario Rizzo on Austrian Business Cycle Theory

Mario Rizzo has an excellent post on Austrian Business Cycle Theory (ABCT). I think Mario do a good job explaining what ABCT is and what it is not.

At the centre of Mario’s discussion is that monetary policy is not neutral, but that the important think is not inflation, but rather “relative inflation”. Here is Mario:

The Austrian theory rests, not on a catalyzing effect of core inflation or headline inflation, but on changes inrelative prices that cause resources to be allocated in ultimately unsustainable ways. The Great Depression was not preceded by much inflation because productivity improvements allowed for increases in bank credit without increasing (by much) the price level. Hayek said repeatedly that the price level aggregate can hide the distortions basic to the cycle.

This point is especially important in the early stages of recovery when there is so much unused capacity and previous investment pessimism that expansions in bank credit (not meaning base money) may be returning to sustainable levels and inflation in the usual sense is unlikely. Nevertheless, as the recovery proceeds, there is a danger that maintenance of low interest rates by the central bank for long periods can induce a distorted character of investment, even as the total amount of investment measured throughout the economy has not recovered.

The policy-relevant point is that if the central bank decides not to allow interest rates to rise until aggregate investment has recovered to boom levels, it will have waited too long. The character of the investment will be distorted. Malinvestments will set in – even without inflation.

I do not think that the Austrian theory says anything unique about inflation – in the sense of increases in the aggregate price level – beyond the warning that aggregates of this sort can conceal the theoretically-relevant magnitudes for understanding business cycles.

I think this is a completely fair and accurate description of Austrian Business Cycle Theory (at least the Hayek-Garrison version of ABCT). That said, I do have serious problems with ABCT as a general business cycle theory. First of all while I don’t think the so-called Cantillon effect is completely irrelevant I don’t think it is very important empirically and the Cantillon effect seems to be based on the assumption that some agents have adaptive or static expectations and/or asymmetrical information (these assumptions are highly ad hoc in nature). Second, ABCT is also based on the assumption that credit markets are imperfect – that might or might not be the case in the real world, but Austrians often fail to state that clearly. I hope to follow up on these issues in a later post.

That said, unlike some other Market Monetarists I don’t think Austrian Business Cycle theory is irrelevant. Rather, I think that (variations of) ABCT will be helpful in understanding the “boom” in for example certain euro zone countries prior to 2008 – and it certainly helped me in my own research on for example Iceland and the Baltic States during the “boom years” of 2006-7. However, empirically I think that both the US and particularly in euro zone are in the secondary deflation phase of the business cycle (in the sense that NGDP has fallen well below the pre-crisis trend), which as Mario notes ABCT has little to say about. As a consequence I don’t think that monetary easing in at the present state of the cycle is likely to lead to a Austrian style boom with distortion of relative prices – at least not if monetary easing is conducted with-in a clear rule based set-up like NGDP level targeting.

In a sense one can say that my biggest problem with ABCT is not so much ABCT in itself, but rather that many Austrian economists today seems to believe that we are in necessary “bursting of the bubble”-phase of the cycle rather than in the secondary deflation phase.

Concluding, while I do not think that ABCT is a general theory of the business cycle and I would certainly also stress the “secondary deflation” part of the cycle much more than the “boom” phase of the cycle I nonetheless think that Mario’s description of Austrian Business Cycle Theory is excellent and I hope that Austrian and non-Austrians alike will read it.


Suggested reading on ABCT:

Hayek’s Price and Production

Garrison’s Time and Money (I linked to a PDF of Garrison’s book, but do yourself a favour and buy a hardcopy)

See my earlier post on the Rothbardian version of ABCT and Steve Horwitz excellent reply to that post. Steve’s reply to me was very much in line with Mario’s views.

Guest post: Cantillon and Central Banking (by Justin Merrill)

Lately there has been somewhat of a debate between some Market Monetarists and some Austrians about the so-called Cantillon effect. I have not participated in the debated – last time I wrote about the Cantillon effect was actually in my Master thesis on Austrian Business Cycle theory in the mid-1990s and to be frank I have not made up my mind entirely on this discussion. Therefore, I am happy Justin Merrill have written a guest post for my blog on the topic.

As it is always the case I do not necessarily agree with what the authors of guest posts on my blog write, but I always hope that guest posts can help further the debate about monetary policy and theory issues. I believe that Justin’s post is doing exactly that.

Please enjoy.

Lars Christensen

Guest post: Cantillon and Central Banking
by Justin Merrill

Much has been written recently on the topic of Cantillon effects. I risk alienating myself by potentially disagreeing with everyone, but I hope I can persuade others to see it my way. At the extremes there are two points of view. The rational expectations view basically asserts that money is neutral when inflation is expected, and therefore the Cantillon effects can largely be ignored. On the other end of the argument is the exploitative theory of state money, whereby the issuer of the currency, the banks, the politically connected, and the government employees and contractors benefit at the expense of everyone else. While both of these have nuggets of truth, they also have flaws that make them inapplicable to our current monetary system.

After a careful rereading of Sheldon Richman’s article, I agree with it almost entirely with the exception of one part:

“Since Fed-created money reaches particular privileged interests before it filters through the economy, early recipients—banks, securities dealers, government contractors—have the benefit of increased purchasing power before prices rise.”

Cross out “government contractors” from the above sentence and it is true. This is because contractors are paid out by the Treasury, which gets the vast majority of its funds from taxation and financing. This confuses fiscal transfers with monetary ones. Since the Treasury does not print money directly a la greenbacks, the government does not receive a 100% seigniorage from central bank operations. A lot of Rothbardians also make the mistake of assuming that all bank credit expansion represents a windfall gain to the issuing bank and the borrower, but this ignores that banks have to pay interest to their depositors and it is not costless to expand.

But are the Market Monetarists right that there are not Cantillon effects from open market operations since primary dealers are selling bonds to buy reserves? Not quite. The primary dealers do benefit by getting the privilege of selling securities at a premium to the market rate and buying at a discount. The gain might be small, but it exists; otherwise PDs would not have an incentive to participate in OMOs. This is effectively a risk free arbitrage that doesn’t arise out of entrepreneurial awareness, but political connectedness and size. Libertarians may overstate the size of this privilege, but it shouldn’t be ignored. Interest paid on reserves to banks and Federal Reserve profits turned over to the US Treasury are also direct injections of new money. The total amount is roughly $100 bil a year (Fed’s reported profits plus its deposit liabilities times .25%), not including the unknown arbitrage gains that PDs make from trading.

Imagine that we are on a gold standard and the price of gold is $1,000/oz. A gold miner may have a cost of production of $990/oz. He therefore earns $10 of purchasing power by adding to the outside money supply.

Now imagine that in our current system a PD buys a security for $990 and sells it to the Fed for $1,000, he also earns $10 of purchasing power.

In both cases of base money expansion, there are Cantillon effects, but the second one is largely due to legal privilege. Once the outside money enters the banking system, there are secondary Cantillon effects. Banks’ cost of capital is lowered, increasing their profit margins. They may increase their investments, benefiting prior holders of said investments, or they may increase their lending, putting new money in the hands of the borrower and shortly into the hands of the person selling the financed asset.

The way that monetary policy transmits can be difficult to predict through the credit channels. Different firms have varying access to capital markets. Small businesses rely on bank and trade credit, while large firms may be able to issue commercial paper at extremely low rates. In a credit crunch, small firms will be cut off from credit even if the Fed is aggressive with monetary policy. The beneficiaries, relatively speaking, will be primary dealers and issuers of commercial paper that can borrow near zero and lend through trade credit at high rates of interest.

This is one reason I am skeptical of NGDP targeting. I do not think output and asset prices can be kept in equilibrium through central banking. Even though I prefer NGDP targeting to inflation targeting, I think stable NGDP is a probable outcome of monetary equilibrium, not an end in itself. The transmission mechanism between reserve creation and output and inflation is messy and unpredictable.

In summary:

1) Don’t confuse fiscal and monetary transfers.

2) Austrians may sometimes be inarticulate at explaining Cantillon effects in our current system (a person counterfeiting money in his basement is not the same as OMOs) but it still exists.

3) Cantillon effects will exist in any system, but their magnitude and consequences are dependent on the institutions.

4) Money is not injected in a “helicopter drop” and should not be assumed neutral through rational expectations.

5) Non-neutral money can create malinvestment through the banking system and credit channels and it matters what the central bank buys and its impact on the yield curve.


Inside the Black Box: The Credit Channel of Monetary Policy Transmission by Bernanke and Gertler

Steve, George and Bryan debate Austrian economics and empirics

I am a huge fan of Here you find good insightful and intellectual debates amount classical liberal, libertarian and conservative scholars on a number of topics. The quality of the pieces on Cato Unbound is always very high. That is also the case for the latest “debate”. As always there is a “Lead Essay” and a number of “Response Essays”. This time the topic is “Theory and Practice in the Austrian School”.

The lead essay is written by Steve Hortwiz and the response essays are by George Selgin and Bryan Caplan.

Fundamentally Steve’s claim is that Austrian method – praxeology – is not as strict anti-empirical as it is often said to be. In his essay “The Empirics of Austrian Economics” Steve makes an heroic attempt to argue that there is no real conflict between praxeology and empirical studies. Everybody who know me would know that I have greatest respect for Steve and I think he is a very open-minded Austrian. However, sometimes Steve’s attempt to defend Austrian economics goes too far. Fundamentally Steve is making up a version of Austrian economics, which never really existed – or rather the Austrian economics that Steve describes is not really Austrian economics, but rather it is how Steve would like to think Austrian economics should be. And I certainly admit I that I prefer Hortwizian economics to Misesian-Rothbardian economics and Steve certainly knows (much!) better than me what “Austrian economics” really is. However, his essay did not convince me that Austrians are as methodologically open-minded as he claims. Neither has he convinced Bryan Caplan and George Selgin.

Both Bryan and George are well-known friendly critics of Austrian Economics. My own feelings about Austrian economics are similar to those of Bryan and George. To me the world of economics would be very empty without Austrian economics. The contributions to economics by Mises, Hayek and Kirzner etc. can certainly not be overestimated. But I also share the view of particular Bryan who rightly notes that it is too bad that Austrians tend to marginalize themselves and the contributions of Austrian economics by their eagerness to not speak in language of mainstream economics. It is hard not from time to time to feel that Austrian economics is a cult. That is sad because it means that far to many economics students around the world are never introduced to Austrian economics (if you are one of them get a copy of Human Action and start reading NOW!).

Furthermore, I share George’s view that empirical research can be useful in understanding what is important and what is not important. Empirical research is also useful in figuring out the magnitude of a certain economic problem. We can deduct from praxeology that an increase in minimum wages will increase unemployment, but praxeology is not telling us anything about how large that the increase in unemployment will be if minimum wages are increased by X dollars. Both Mises and Rothbard were negative about this kind of empirical analysis – Steve tries to argue that that is not the case, but George shows that his arguments for this is rather weak.

Anyway, the three gentlemen have much better arguments than I have on these issues so read their pieces yourself:

Steve Horwitz: “The Empirics of Austrian Economics”

Bryan Caplan: “Horwitz, Economy and Empirics”

George Selgin: “How Austrian Is It?”

Update – follow-ups:

Selgin just punched the 100-percent wasp’s nest again

One day George Selgin is picking a friendly fight with the Market Monetarists, the next day he is picking a fight with the Rothbardian Austrians. You will have to respect George for always being 100% intellectually honest and behaving like a true gentleman – something you can not always say about his opponents. His latest fight is over the old story of fractional reserve banking versus 100% reserve banking.

Personally I never understood the 100%-crowd, but I am not going to go into that debate other than saying I agree 100% with George on this issue. However, I want to do a bit of PR for George’s posts and the response to his posts.

Here is George’s first post: 100-Percent Censorship?

Here is  Joseph Salerno‘s response to George: The Selgin Story  (Warning: This is typical Rothbardian style)

And George’s response to Salerno: Reply to Salerno

When you read an exchange like this you will realise why Rothbardian style Austrianism is completely marginalised today and George is a well-respected monetary historian and theorist.

Larry White also has a good post on fractional reserve banking – and why it is the true free market outcome in an unregulated market economy.

If you are interested in this discussion then you should have a look at Larry and George’s classic article “In Defense of Fiduciary Media – or, We are Not Devo(lutionists), We are Misesians”.

Related post: I am blaming Murray Rothbard for my writer’s block

Update 1: The fist fight continues – here is a not too clever attacks on George from the comment section on Economic Policy Journal (which has nothing to do with a Journal) and here is George’s response: More Dumb Anti-Fractional Reserve Stuff

Lorenzo and Horwitz debate Austrian economics

Back in April our friend Lorenzo did a interesting post on Austrian theory. That has now triggered a response from Steve Horwitz who defends the Austrian position. It is excellent stuff. It is a debate between two clever debaters and I have very strong sympathies for both gentlemen. However, I don’t have time today to go through the entire debate, but I will strongly recommend to my readers to take a look at this very interesting debate.

See here:

Lorenzo: About Austrian Economics

Steve’s response: Thoughts on Lorenzo on Austrian Economics

Lorenzo’s feedback to Steve: Response to Dr. Horwitz’s thoughts

Again, this is excellent stuff. Read it! We can all become more clever by debates like this. Thanks guys.

How can you tell an internet “Austrian”?

Here is Lorenzo from Oz in a comment on Scott’s blog:

Q: How can you tell an internet “Austrian”?
A: They have successfully predicted 10 of the last 0 bouts of hyperinflation.

Lorenzo is a genius!

HT Michał Gamrot


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