Recently, Paul Krugman claimed that the threat of an invasion by space aliens could bring the US economy out of recession in eighteen months. I expect many readers of this site found that both funny and worrying. It reminded me of an excellent science fiction novel I read years ago, “The Forever War” by Joe Haldeman.
Most political movements try to present themselves as positive about humanity. But privately their supporters often admit to seeing “noble lies” and social engineering more positively than they would publicly say. I don’t think libertarians or classical liberals are completely immune to this. In “The Forever War” a leftist author criticises conservatives, but also allows himself to think through the consequences of the ideas of American leftists.
Novels about interstellar war are often quite macho and conservative. “The Forever War” was seen as a response to one of those books, “Starship Troopers” by Robert Heinlein. It begins with an attack by aliens on starships travelling from earth to colonize other planets. It then follows a soldier, Private Mandella, through the ensuing war against the aliens. It becomes clear much later that the start of the war had been a mistake by jumpy humans, not a hostile alien attack. That is rather like the “Gulf of Tonkin Incident” in the Vietnam war. Haldeman wrote “The Forever War” in the early 70s after his own service in Vietnam; the interstellar war he describes is eerily similar to the Vietnam war and clearly a commentary on it.
When the soldiers first return to earth an army captain comes to meet them, he says:
“I’m twenty-three, so I was still in diapers when you people left for Aleph … to begin with, how many of you are homosexual?” Nobody. “That doesn’t really surprise me. I am, of course. I guess about a third of everybody in Europe and America is.
“Most governments encourage homosexuality – the United Nations is neutral, leaves it up to the individual countries – they encourage homolife because it’s the one sure method of birth control.”
Over the course of the book that policy becomes stricter and heterosexuality comes to be seen as a mental illness. It’s interesting to consider if future governments will try strategies like this. As the story progresses it hints that governments have encouraged recreational drug use too for the same reason.
The captain continues:
“… the population of the world is nine billion. It’s more than doubled since you were drafted. And nearly two-thirds of those people get out of school only to go on relief”.
“Relief”, it turns out, is the dole. Here we have the “Gloomy Keynesian” idea that as technology progresses unemployment becomes much greater. It turns out that jobs are rationed and only certain people are eligible so there is a thriving black market in faking this eligibility. Haldeman supposes that the war provides the Keynesian solution to this problem: producing the technology to fight the war creates employment and stimulates output.
The main effect of the war on the home front was economic, unemotional – more taxes but more jobs as well. After twenty-two years, only twenty-seven returned veterans, not enough to make a decent parade. The most important fact about the war to most people was that if it ended suddenly, Earth’s economy would collapse.
And at the very end of the book when some ancient history is discussed:
… the old soldiers were still around, and many of them were in positions of power. They virtually ran the United Nations Exploratory an Colonization Group, that was taking advantage of the newly discovered Collapsar jump to explore interstellar space.
Many of the early ships met with accidents and disappeared. The ex-military men were suspicious. They armed the colonizing vessels, and the first time they met a Tauran ship they blasted it.
They dusted off their medals and the rest was going to be history.
You couldn’t blame it all on the military though. The evidence they presented for the Taurans having been responsible for the early causalities was laughably thin. The few people who pointed this out were ignored.
The fact was, Earth’s economy needed a war, and this one was ideal. It gave a nice hole to throw buckets of money into, but would unify humanity rather than dividing it.
Here we see the problems many leftists have with their own ideas. If Keynes is right about economics or if Malthus is right about population  then that has dark implications. Of course there’s nothing wrong with an idea that leads us to a dark place if that idea is right, but there’s no need to worry if it’s wrong.
Writing about the recent earthquake in Virginia, Steve Horwitz gave a very clear criticism of this kind of thinking:
… the problem with the ‘disasters are good for the economy’ nonsense, and GDP more generally, is that it confuses a flow with a stock. GDP measures a flow of activity, not a stock of wealth. Destroying things and then rebuilding them might increase economic activity in the area affected (by drawing resources from elsewhere), but leaves us with less wealth than we would have had without the disaster. That is the real meaning of the Broken Window Fallacy.
It’s a mistake to think that Keynesians want to waste resources in order to increase employment. Their argument is that it isn’t very important how efficient a spending project is during a recession. They would prefer it if the output of a project were useful because if it were, that would clearly be beneficial. But, they don’t require a project to be efficient; their view is that if no good spending projects are politically feasible, then bad ones will do. They believe that during a recession there are great spin-off benefits to spending on output. They believe that it will stimulate production and employment and make society wealthier in the long run.
Keynesian commentators often seem to believe that the level of GDP output proves that a certain amount of capital wealth exists to be used, so when GDP increases that means society is richer. GDP is certainly an indicator of wealth; output can only be produced because capital and labour exist to produce it. But, many different levels of output are possible with the same capital. The amount of existing stocks of goods that are processed into new outputs depends on the demand for those new outputs.
In the recent controversy over the Virginia earthquake some Keynesian commentators I’ve read have expressed the view that it’s all about “crowding out”. Crowding out is a macroeconomic idea often put forward by critics of the Keynesians. In its simplest form, the argument is that every pound the government tax from someone, or borrow from someone, is a pound that would have been spent on private sector output. So, according to this argument “stimulus” policies will have no beneficial effect. I agree with this idea to some extent. The problem with it is that the private sector doesn’t only sell GDP output; existing assets are also for sale, including financial assets such as bonds and share. That means a person may receive income and spend it on things that aren’t output. Also, once the seller of an asset receives the proceeds he may not spend them on output either; he may buy another asset. Eventually somebody in the chain will spend on output, though that may take a long time. This means a government could increase output by taxing people who are likely to spend their money on assets and using the proceeds to buy output goods.
I don’t think the crowding out explanation helps us very much. As Horwitz says, the important issue isn’t whether output falls, everybody know output falls during a recession. The important question is: what does a fall in output mean?
One possibility is that investors and businesses are being irrationally cautious. Instead of investing in new projects which could earn profits in the future for them and increase output to the benefit of everyone they rush into relatively secure investments such as money, bonds, blue chip stocks and gold. Keynesians are fond of the idea of the irrationality of the market because it supports this view (they aren’t particularly interested in disputing Austrian Business Cycle Theory as a cause of recessions). I think this possibility is a distraction; to the degree that markets can be irrational it’s close to impossible to say in which direction they’re being irrational .
There is an alternative view, though: investors may be making a sensible decision to avoid investing in new projects because the risk/reward ratio is too poor to make it worth their while. That decision may certainly reduce employment in the short-run, but that doesn’t show that it reduces society’s overall wealth. It may well be that this decision isn’t only sensible for investors. The processing of existing resources into new goods doesn’t necessarily add value from anyone’s point of view. Keynesian economists often assume that it’s always worthwhile to convert existing resources into output at the same rate that prevailed before a recession. There is no reason to think this is true.
– Those interested in the history of economic thought will notice the influence of Malthus. Thomas Malthus was good at coming to unsettling conclusions. He suggested that real wages will fall in the long-run to the minimum necessary for subsistence, consigning the human race to poverty in the long term. Malthus also proposed a macroeconomic theory similar to Keynes’s, long before him.
 – This is the weakest form of the Efficient Markets Hypothesis.
The Quantity Theory of Money seems straightforward, but a little thought about it brings up many questions. Different economists have taken different approaches to it, so we have several Quantity Theories rather than one distinct Quantity Theory. In his many books Ludvig Von Mises discusses these theories extensively. He criticises some of them on various counts, for being too mechanical, for example. That doesn’t mean, though, that Mises doesn’t believe in any sort of Quantity Theory; he praises the general idea, saying that there’s a “core truth” in it. Mises rejected certain aspects of other Quantity Theories and embraced other aspects; he had his own Quantity Theory.
Anthony Evans and I have taken up this subject in a paper, we compare Mises version of the Quantity Theory to some others. Expectations of the future are closely related since they drive decisions to hold more or less money. We examine what Mises has to say about expectations and how this relates to his version of Quantity Theory. This puts the financial crisis of 2008 and it’s aftermath in a different light, something we discuss briefly.
The Theory of Money and Credit (1912) is a seminal book in the development of the Austrian school approach to monetary theory. We argue that Mises’ understanding of the quantity theory is distinct from both the Fisherian and Cambridge versions, and warrants recognition as a third, separate version. After supporting this claim we demonstrate how it can be utilised to make expectations the central channel of a quantity theory with microfoundations.
The draft paper is here:
Comments are welcome.
The most basic theory of (fractional-reserve) free banking concerns the supply of money and demand for money. At some times the public on net want to hold more of their assets as money, and at other times less. In the former case we say there has been a rise in demand for money holding, and in the latter case a fall in demand. If a fall in demand isn’t satisfied by a fall in supply, then prices will rise. That’s because people will spend their excess money holdings which will bid prices up. Similarly, if a rise in demand for money isn’t satisfied by a rise in supply then prices will fall. That happens because people will seek to increase their money holdings by keeping money they earn from income or sale of goods instead of spending it. The reduction in spending will cause prices to be bid down. The changes in price that come with a rise or fall in demand for money are costly.
Recently, I was involved in a discussion about free-banking. I’ll paraphrase my opponents arguments here ….
- There is an excess demand for money.
- So, profit could be made by issuing money. Any creation of money would be a loan to the issuer at a favourable interest rate.
- Why then are businesses not creating money? Surely even though free banking isn’t legal this is a flaw in free banking theory? After all, we have laws against drug dealing and despite them drugs are readily available in many places.
It’s useful to explain the term “excess demand for money”. In economics there are often “excess” supplies and demands. If there is an “excess supply”, that means that at the current price sellers of a good are being left with surpluses. As a result those sellers are going to reduce the price soon, and/or make less of the product. Similarly, “excess demand” means that at the current price buyers want to buy more than sellers have, that means the opposite, sellers are going to raise their prices soon, if possible, and/or sell more. So, in the excess supply case the price is being bid down, and in the excess demand case it’s being bid up. By analogy an “excess demand for money” means that the price level is being bid up by a rise in demand for money that hasn’t been matched by supply.
The person I was arguing here asks a good question: if there is an excess demand for money why hasn’t more fiduciary media been created by banks during the recession?
I agree that at least during the earlier part of the recession, though perhaps not now, there was an excess demand for money. This was shown by the period of deflation. I’m sure some of the 100% reserve advocates on this site will disagree with me about that, or argue that the demand should not be met using fiduciary media. My purpose here isn’t to argue about that, but to describe why the money supply didn’t expand in this case.
To begin with, we have to consider what money is. When economists and ordinary people talk about money they mean the medium-of-exchange, today that means notes and coins for small transactions and transfers of bank balances for large transactions. Things like “Bitcoins” are not really money, they are at the most an attempt to create a new form of money and not so far a successful one. This by itself explains why it’s not possible to make an analogy to drug-dealing. For drug-dealing to be practical it’s only necessary that a buyer can meet with a drug vendor. But, for a form of “money” to be actual money it must be widely accepted by a great many traders who accept it as payment. That can’t possibly be done outside the view of the police.
Notes and coins are relatively unimportant in today’s economy. In many countries the state has monopoly privileges on issuing them. This isn’t always true. In some places, types of local money have been created by private groups such as charities and federations of local businesses. Banks are generally not able to issue notes as they once did; as far as I know this applies to the US, UK and Europe. As Toby Baxendale often points out, normal companies must “keep their short-term creditors whole”. They can only produce a banknote if they hold matching short-term liabilities, so they have little or no incentive to create money. In Scotland, which is one of the last places where banks can still issue notes, the quantity of those notes is controlled by the Bank of England.
The local currency movement seems to be growing, though it’s difficult to get good figures. The question may be asked: why didn’t local currency issuers create more money? I think the answer lies in the dominant network effects of state currency. Now state issued notes and coins are accepted everywhere and most customers use them there is little incentive for either normal people or businesses to support alternative currencies. George Selgin has described the many problems with local currencies here. There isn’t just one “stable equilibrium” here though, as Scotland shows, if other types of banknote are important enough and safe enough then vendors will support them. Past historical examples show that when banks and other businesses are allowed to compete in the currency market then privately issued note and coins are likely to arise.
All this said, notes and coins are not as important today as they were. Our principal form of money today is the bank balance. Bank balances are created by fractional reserve banks which are private institutions. Normal businesses can create accounts for their customers and often do. The accounting law mentioned above means that normal companies have no more incentive to create balances for general use than they do to create notes or coins. This leads to the question: why didn’t the banks create more current account balances? In my opinion this is the interesting question.
In many countries, banks must be part of the central banking system. I don’t know if it’s still possible in the US to run a commercial bank that isn’t a member of the Federal Reserve system, but even if it is there are great disadvantages to doing that. The central banks limit the amount of money that the commercial banks can create through regulatory requirements, such as the reserve requirement and capital requirements. But this doesn’t give an explanation; at present and throughout the crisis the banks have held much greater reserves than necessary. The banks are not limited by the reserve requirement at present. In fact, as many commentators have pointed out, if they were to loan more then the money supply would quickly explode.
The reason the banks did not expand the money supply in 2008-2010, and are not doing so greatly now, is that their finances are very fragile. Before the crisis, many of them in the US, UK and Europe, invested in CDOs and CLOs that went bad. There were losses on conventional property loans such as those in Ireland and on loans to other banks involved in these investments. Since banks need assets to back current account balances this is a major problem.
During the boom the protection of current account holders by state-supported deposit insurance schemes was important. The existence of these schemes weakened the interest bank customers would otherwise have had in picking a solvent bank. Northern Rock, for example, was a very risky share even quite a long time before it went bankrupt. But to the ordinary bank customer’s point of view, this risk was minimal because of deposit insurance. In retrospect, this helped “soften up” the banks ready for the onslaught of bad debt ahead.
I’m an advocate of the Austrian Business Cycle Theory and I think it provides the best explanation of the last boom and bust. The toxic assets on the balance sheets of banks are the result of misallocation of capital. Some is due to the secondary effects of the ensuing recession too. In my opinion, to ask for the commercial banking system to deal with this is too much. Commercial banks can’t know for certain when monetary expansion is going to cause a bust. The market interest rate doesn’t easily provide information about the stance of monetary policy. If there is creation of money beyond demand for it, then that doesn’t immediately manifest itself in noticeable price inflation. As a result, banks can’t protect themselves from ABCT busts.
I don’t want to rely too much on ABCT, though. Existing commercial banks suffer from a lack of good assets which prevents them from creating money. Why then don’t other businesses that own (or could access) safe assets start up commercial banks? The problem here is that the regulatory obstacles are large. In the US there are many regulatory bodies that must approve the creation of a bank. A Federal Reserve bank must obey Fed regulations, there are state banking regulations, FDIC regulations and regulations issued by the comptroller of the currency. There are also market issues, such as obtaining membership of transfer networks and creating a structure of branches. The problem any company faces is that they must fulfil their regulatory obligations before the recession is over and the opportunity disappears. Despite this, some have tried. Wal-Mart have tried several times to acquire a US banking license, but they’ve failed. The most plausible explanation for this is that incumbent banks have leaned on the regulators to prevent Wal-Mart from entering the market. This is interesting because of what it shows about US monetary policy. Many have argued that the Federal Reserve can’t expand because the commercial banks won’t expand lending. To the extent that this is true, it concentrates too much on existing commercial banks. If new entrants were allowed into the market, they would not be in the dire financial situation that the existing banks are. New entrants would be in a much better position to lend. If it were not for the bailouts, starting a new commercial bank would be simpler. A business wishing to start a new bank could buy a bankrupt bank and use it’s branch network and access to transfer networks.
The bailouts have caused a strange situation to develop. The existing commercial banks are perhaps not Zombie banks in the technical sense – banks with less than zero net worth – but they are in such a precarious situation that they can’t make many new loans. What preoccupies them is the performance of existing loans. Had they not been bailed out so extensively at the beginning of the crisis, this wouldn’t have happened.
A street in Vienna is called a gasse, strasse or platz. There are a few of them named after people who aren’t so popular on this site:
There’s also a Frederich-Engels-Platz and Marxergasse, though I’m not sure if the latter is named after Karl Marx.
Mises held his private seminar in his offices, afterwards the Mises circle would go to the Grüner Anker restaurant in Grünangergasse. When Ben Powell visited Vienna that restaurant had become the Ma Creperie. It’s now Tifli’s restaurant. A playwright, famous in German speaking countries, Franz Grillparzer lived on that street and there is a sign commemorating him there. Mises mentions him in “Human Action” and “Nation, State and Economy“.
To get to Grünangergasse I had to check a map, which gave me a surprise. About four hundred yards away there is this street:
I’d love an explanation for this. Preferably one that doesn’t require time-travel or Dan Brown style conspiracies involving the Cobden centre. The more I walk around Vienna the stranger it gets.
I’m currently in Vienna. I’ve spent a lot of time here enjoying cups of coffee in peaceful cafes, and I think I understand the success of the Austrian Economists better now; Vienna is a great place to think. Not everyone is in such a restful mood though. Yesterday evening I met a man who had just bought a gas-mask on the internet. He’d been watching the events in Greece and he thought they would spread to Austria. I’m not sure if he was planning to protect himself in a riot or join in. I gave him my opinion on the likely future of the EU and the euro.
The immediate problem for the EU is the three countries with the worst finances: Greece, Ireland and Portugal. In my opinion all three of these countries are as bankrupt as sovereign nations can be: they can’t possibly raise the taxes to service their debts. This view is hardly unique these days. Keynesian commentators have lamented the austerity measures put in place by the governments, which they fear will lead to a fall in aggregate demand and exacerbate recession. This is based on the idea that paying off debts (along with other forms of saving) doesn’t lead to an increase in investment spending. I could say a lot about this theory, but I won’t. Whether this Keynesian analysis is wrong isn’t important here since it’s unnecessary. The problem is much simpler: few investors will want to invest in these three countries right now. So if they were pay off some of their debts that will lead mainly to greater investment spending somewhere else in the eurozone.
The governments of these three countries should default as soon as possible, but politics and emotions prevent that. No national government wishes to be associated with default, each governing politician know it will likely lead to subsequent electoral defeat. It’s likely those politicians will feel like personal failures if default occurs. It will also lead to disrespect within the EU, which is concerning for established, older politicians who look towards the EU government to provide a lucrative job after leaving national politics. This leads to three strategies for managing the situation. The first is to try to negotiate lower interest payments on loans from the core eurozone countries. In my opinion it’s unlikely that France and Germany will agree to reduce interest rates on these loans far enough to make a difference. The second is to perform mini-defaults on small groups of creditors. Ireland has already done this on some of the bond-holders of nationalized Irish banks. The third strategy is to wait and hope another nation falls first. This is the main strategy.
The governments of Portugal and Ireland are waiting for Greece to default. If that happens then it will likely trigger the bankruptcy of several European banks*. This is the “Second Lehmann Brothers” the UK press have been discussing that could cause another financial crisis. I think such a crisis is likely to happen, but for political reasons more than economic ones. If one of the three countries I mention were to default then the ensuing crisis would give the others permission to do so. It would allow them to blame default on outside events. The politicians in the remaining two countries involved would then become heroes rather than villains. It’s quite likely that in this situation default could be popular since it could reduce taxes.
The cost of default is whatever conditions the core eurozone countries demand. If the first country to default is punished severely by the EU in the form of removed subsidies or exclusion from certain programs then that will make the others more cautious. On the other hand, if there is little punishment then the others will default quickly. The structure of the EU isn’t conducive to quick decision making, which makes it likely that there will be little punishment for defaulting states. This dynamic is also likely to affect whether countries choose to default or to leave the euro. The advantage of defaulting within the euro are obvious: it allows a country to stay within that currency bloc. The advantage of leaving though is that it allows the country to devalue. This would happen automatically during the flotation; were any of the Portugal, Ireland or Greece to float their own currency, it wouldn’t be worth much.
Such a flotation-and-devaluation is unlikely to make a country richer in the long run, but may well increase GDP and employment in the short-run. That could prevent further social unrest. If a state or two were to leave the euro that would cause political problems for the EU, but it would be a one-off problem for the ECB. The ECB would only have to deal with the transition with the countries involved. In our modern would where most money holdings are current account balances this would not be impossible. Changing the form of a current account balance would be quite technically simple (regardless of the legal and moral issues associated with a government doing that). Circulating paper euros and coins could remain euros but become a foreign currency on a specific changeover date. The government could arrange for future cash withdrawals from bank to be in the new currency from that changeover date. By passing laws for the banks to enact, a government could replace one currency with another even if large sections of the population were not too happy about that. However, I don’t think this is so likely to happen. It requires a level of organization that the government of Greece (and probably Portugal) would be stretched to reach. It also requires a willingness to ride rough-shod over the legal problems of converting all existing contracts in euros into another currency. Ireland, for example, may be able to organize a currency change-over in practice, but its high-court is likely to challenge the legality of some aspect of it.
The consequences of default are different. The EU project itself would be harmed much less by default than it would be by nations leaving the euro, but the ECB would be placed in a difficult situation. As things are the ECB acts like a central bank within a nation state. The only main difference is that the member states issue bonds themselves. Once a default occurs, all this changes. In a modern central banking system open market operations are used to change the interest rate and money supply, and these are performed by the buying and selling of government bonds. At present, the ECB can buy the government bonds of any member state. That will no longer be possible if a state were to default, as the possibility of that happening again would be clear and the ECB would be forced to be more careful. There are several new structures the EU and ECB could adopt. Most would increase the power of the EU and ECB.
I expect readers understand I’m not condoning any of the things that I’ve described here. I’m just giving my opinion on what the future is likely to hold. I doubt anyone will reintroduce a gold standard. It doesn’t seem likely even that central banking practices will improve. But, these events in Europe help the case for monetary reform in the long run.
* Some have said that the ECB itself may go bankrupt if Greece defaults. This is technically possible, but it it were to happen the core eurozone countries would certainly bail it out.
At any given time, a few Keynesian economists and Austrian economists can always be found arguing on the internet. Recently, Don Boudreaux of Cafe Hayek has clashed with Daniel Kuehn on Keynes’ “Marginal Efficiency of Capital”. This argument brings up the Keynesian view of the economic long term, making it more interesting than the usual ones.
Don Boudreaux writes:
I’m sorry, but I do believe that on matters of economics Keynes was indeed a simpleton. I offer here but one quotation, from page 220 of The General Theory, as evidence of Keynes’s simple-mindedness on matters of economics: “I should guess that a properly run community equipped with modern technical resources, of which the population is not increasing rapidly, ought to be able to bring down the marginal efficiency of capital in equilibrium approximately to zero within a single generation.”
Keynes here argues that capital can be made non-scarce (and, as he puts it in the preceding paragraph, that one key to making it non-scarce is “that State action enters in as a balancing factor to provide that the growth of capital equipment shall be such as to approach saturation-point….”). These are the words of an economic simpleton ‚Äì a simpleton about the nature of capital, about the nature of scarcity and human wants, and about the nature of the state and “State action.”
Daniel Kuehn replies:
Don Boudreaux is wrong.
I don’t know why these things even pass the smell test for people, but apparently they do. Does Keynes come across as a utopian? He doesn’t come across as a utopian because he’s not a utopian.
The marginal efficiency of capital is not the same thing as the marginal cost of capital or the marginal productivity of capital. Keynes defined the marginal efficiency of capital as the discount rate at which the price of capital was just equal to the present value of the stream of benefits proceeding from that capital. So the marginal efficiency of capital could be zero at a time when the marginal cost and the marginal benefit of capital were both very, very high (but equal). A high marginal cost and marginal benefit of capital, of course, means that capital is scarce. A lower marginal efficiency of capital is associated with more capital, to be sure – because a lower discount rate means more investment becomes viable, driving down the marginal benefit of capital. So certainly a more capital-rich future is part of the Keynesian vision. But “non-scarcity”? Of course not. He never says that anywhere, and the marginal efficiency of capital is not the marginal cost or the marginal productivity of capital. The point is this – since the level of investment is determined by the interest rate (through the marginal efficiency of capital – what investments are viable at what interest rates), capital owners commanded a return simply by virtue of the scarcity of capital (or – put another way – by virtue of artificially high interest rates). A low interest rate and potentially even a zero marginal efficiency of capital was Keynes’s way of separating out the rentier from the entrepreneur.
And in Keynes’s vision there were entrepreneurs. Why? Because capital is still scarce and the expertise of the entrepreneur was still needed.
Before Keynes the “Marginal Efficiency of Capital”, or MEC, wasn’t a common term. Keynes gave a definition of it in his “General Theory”, but he doesn’t just give one clear definition, as Hazlitt notes .
Keynes gives the following definition first. In this article I’ll use this definition as it seems the one preferred by Keynesians.
Over against the prospective yield of the investment we have the supply price of the capital-asset, meaning by this, not the market-price at which an asset of the type in question can actually be purchased in the market, but the price which would just induce a manufacturer newly to produce an additional unit of such assets, i.e. what is sometimes called its replacement cost . The relation between the prospective yield of a capital-asset and its supply price or replacement cost, i.e. the relation between the prospective yield of one more unit of that type of capital and the cost of producing that unit, furnishes us with the marginal efficiency of capital of that type. More precisely, I define the marginal efficiency of capital as being equal to that rate of discount which would make the present value of the series of annuities given by the returns expected from the capital-asset during its life just equal to its supply price. This gives us the marginal efficiencies of particular types of capital-assets. The greatest of these marginal efficiencies can then be regarded as the marginal efficiency of capital in general.
The reader should note that the marginal efficiency of capital is here defined in terms of the expectation of yield and of the current supply price of the capital-asset. It depends on the rate of return expected to be obtainable on money if it were invested in a newly produced asset; not on the historical result of what an investment has yielded on its original cost if we look back on its record after its life is over.
This first thing to note is that the MEC is similar to accounting concepts used to compare the profitability of projects such as the internal rate of return and minimum acceptable rate of return. But, it isn’t the same. In any commercial calculation the starting point is the price that capital assets can be bought on the market, but the MEC doesn’t consider this. It deals in the “supply price”, which isn’t necessarily the prevailing market price.
It is simplest to discuss this initially without involving entrepreneurship…. Suppose I own a machine we’ll call the “very simple machine” (VSM) because anyone at all can operate it and maintain it. Suppose too that I bought my VSM at what Keynes calls the “supply price”. The VSM produces 1000 widgets per year and widgets sell for £100 each. The cost of my labour and inputs is £50 per widget, so I make £50 profit per widget and £50K per year. I expect my costs and the selling price will remain the same for the next 5 years and the VSM itself lasts for 5 years. Suppose that the VSM costs £220K. In this case if the interest rate is less than ~4.4% then according to my expectations of the future I will make more by buying the VSM and running it than I would from a bank account. But, if the rate of interest is greater than ~4.4% then I’ll be better off putting my £220K in a bank account and taking £50K per year. In this case the MEC for the VSM is 4.4%.
Let’s suppose that the interest rate is indeed less than 4.4%. The VSM is very simple, which means anyone can buy one and make widgets. We can suppose too that my expectations aren’t unusual — other market participants expect the same selling prices and costs as I do. In that case, others will buy VSMs and consequently they will rise in price. Since the profit opportunity is so clear here, the market price of VSMs will rise quickly to extinguish the difference between the rate of return from buying a VSM and the interest rate, Bohm-Bawerk emphasised this. But, Keynes’ MEC takes as it’s starting point the “supply price” which is “the price which would just induce a manufacturer newly to produce an additional unit of such assets”. So, if the market for widget producers becomes saturated quickly then this profits the manufacturers of VSMs instead. The price of a VSM may rise much higher than its manufacturing cost or its “supply price”. But, in this case the MEC remains high. The MEC only begins to fall if one of two things happen. Firstly, the price of inputs to the VSM manufacturers will eventually rise because of increased demand. Secondly, the price of widgets will fall because of increased supply. Keynes explicitly mentions both of these cases later. Since we are assuming that entrepreneurship isn’t an issue we must assume that building a company to manufacture the VSMs themselves is also simple, which means that market will quickly saturate too, just as the one for widgets did.
We can then think of the following situation: initially capital assets are scarce and the MEC is greater than the interest rate. Then the difference between the MEC and interest rate incentivizes producers of both investment goods and consumer goods. Output of both then rises and as it does so the MEC falls towards the interest rate.
In the quote, Boudreaux criticises Keynes’s supposition that over a long period the MEC will tend towards zero. Here is a fuller quote:
On such assumptions I should guess that a properly run community equipped with modern technical resources, of which the population is not increasing rapidly, ought to be able to bring down the marginal efficiency of capital in equilibrium approximately to zero within a single generation; so that we should attain the conditions of a quasi-stationary community where change and progress would result only from changes in technique, taste, population and institutions, with the products of capital selling at a price proportioned to the labour, etc., embodied in them on just the same principles as govern the prices of consumption-goods into which capital-charges enter in an insignificant degree.
In the example above, if the interest rate is lower than the MEC of the VSMs then the market for widgets saturates and then so does the market for producing VSMs. This could then happen across all industries, but would that reduce the MEC to zero?
Here we must reach for the time-preference theory of interest. In my opinion the most defensible version of this theory is that time-preference defines a “floor” below which the interest rate can’t fall. As I understand it, this is Hayek’s interpretation in his paper “Time-Preference and Productivity: A Reconsideration” (reproduced here). In my example above I compared the interest from a bank account to the return on buying a VSM. In some ways this begs the question because it assumes that the owner of capital will invest. On the contrary, the owner of capital must be induced by the payment of interest to invest rather than consume. This means that the supply curve for capital slopes downwards like other supply curves.
It seems possible that that Keynes didn’t recognize that time-preference would determine interest rates if productivity did not. Hayek made that mistake in the first edition of “The Pure Theory of Capital”. He considered only productivity interest following Fisher and Knight. Hayek later reconsidered his position in the paper I mention above. But, even before that, Hayek’s view was that in hypothetical states of equilibrium internal rates of return and the interest rates could fall to zero and remain there, not that this was possible in the real world.
Since the supply of savings falls as interest rates fall does that mean that the supply of savings dries up if the interest rate is zero? Well, not necessarily, there a three reasons why it may not. Firstly, as Keynesians point out in their “liquidity trap” argument, it’s worth holding a money balance that earns 0% if you think that you will soon be able to invest it in something that earns more. We can agree with Keynesians about that without agreeing with the rest of the liquidity trap argument. However, this only deals with the short-run situation where the interest rate is 0% for a small period of time and it’s believed that it will rise soon. The more general question is if a situation can occur where the interest rate stays at 0% for a more extended period so we have to abandon that argument when considering the long term. The second issue is that banks supply services as well as paying interest. People put money in zero interest current accounts because doing so allows them to perform transactions more easily than they could with cash, and in most developed economies these services are free to the customer. So, there is a portion of the interest rate that is paid in services which the money interest rate doesn’t accurately represent. (For this reason most “0% interest rates” that have occurred during the crisis or in Japan have not really been 0%). Lastly, there is the issue of “intertemporal-substitution”. If all consumer goods lasted forever and could be stored for free then the interest rate could never fall to zero for a great length of time. That’s because if it did then any owners of capital could simply spend it all on consumer goods and store them. However, in the real world that may not be possible. It may be that a saver is interested in consuming services in the future, or can’t store consumer goods cheaply or at all. For that reason a saver may accept an interest rate that is zero or negative because it allows some capital to be transferred into the future that can’t be transferred there otherwise. So, even if interest rates did fall to 0%, there would be some supply of savings. I’m not convinced that this latter effect has much relevance outside exceptional situations such as war, extreme government or central bank behaviour. Though it does explain why people who have a high time-preference sometimes save.
Whether Keynes is wrong or not is a matter of interpretation. If all markets were saturated as I describe then the rate of interest may fall to a very low level, perhaps “approximately to zero”. If the economy is progressing and there is no expansion of the money supply beyond demand then prices will gradually fall with increasing productivity. In that case, even though the money rate of interest is zero, its real rate may be positive. It seems doubtful though that Keynes meant that, since he praises the beneficial effects of inflation elsewhere. I’m perhaps being too generous to Keynes here.
It may also be that what Keynes was thinking of here was something slightly different, not the MEC itself but the difference between the MEC and the rate of interest. This is an entirely different matter. At this point it’s useful to bring back entrepreneurship. We’ve assumed so far that machines and businesses are very simple and gathering expectations about them is very simple. In the real world they are far from simple, and for that reason competition doesn’t always work as quickly as I described above. A real business may require great skill to direct and may be very difficult to replicate. For this reason the internal rate of return of a business (and therefore the MEC of it’s assets) may remain above the interest rate for a long period of time. This is entrepreneurial profit and it’s necessary for economic progress.
But, an important issue for critics and supporters of capitalism is whether this is always entrepreneurial profit. It isn’t possible to answer that question concretely, but we can answer it more generally. In a particular environment we may have a market interest rate that is above the time-preference rate of the capital owning community. In that situation very few capital owners asks themselves “shall I invest what I earn tomorrow or consume it”. The interest rate is high enough that they concentrate on deciding what to invest their capital in. Of course, capital owners aren’t all the same, so we can only talk about generalities here. In this case I mean that the average time-preference (weighting each capital owner by the amount of capital they own) is far below the real market interest rate. It could be said that we have a “productivity interest” situation here. We can contrast that with the “time-preference interest” situation that prevails if capital is more plentiful and there are few business opportunities. In that case lending and borrowing occurs because different people have different time-preferences. In a hypothetical evenly-rotating economy (or general equilibrium), this is all that can happen since the definition of even rotation precludes entrepreneurship and increasing productivity. The difference between the two situations I describe is only a conceptual one; no direct empirical measurement of it can be possible because the rate of time-preference of individuals is a matter of psychology.
The MEC as Keynes defines it doesn’t really help us much with this differentiation. Keynes defines the MEC of capital in general as the greatest of the MECs of particular assets, but entrepreneurship makes this problematic. The greatest MEC will be that of a business with a unique product or production process which allows it to be exceptionally profitable and gives an exceptionally high internal rate of return. At any time or place this will apply. Giving “a generation” of Keynesian government policies as Keynes suggests can’t prevent it. Entrepreneurship always exists because new opportunities always exist. Any change in market relations creates new opportunities.
Keynes doesn’t specify any “who” in his definition of the MEC for an asset. If he means “any entrepreneur” then the previous paragraph applies. But if he means any capital owner, even someone with no knowledge of business, then things are different. Does the MEC make more sense in this case? We can suppose that an asset exists which is very easy to exploit and pays more than the interest rate. In that case the MEC for that opportunity will be high and will quickly fall as businesses and investors join in the rush to exploit it. At the beginning there will be “rentiers” who earn a quick profit without much risk* that profit will quickly disappear and it will disappear because of the market, not the government. But, as we observed above, the MEC isn’t the same as the internal rate of return because it involves the hypothetical “supply-price”. If the supplier of the asset is making a profit because the market selling price for the asset is above the minimum he would be prepared to sell it for, then the MEC remains above the interest rate even if the earnings of owners of the asset has fallen to the interest rate. However, in many situations the manufacturer of the asset will be making a profit from his or her earlier entrepreneurial decisions. So even this alternative from of the MEC would not fall to the interest rate or to zero. At least not in a real economy, and Keynes seems to be discussing a real economy, not a hypothetical case.
Is there any way that we can tell if we have “rentiers”? Personally, I can’t think of one, and certainly not one that’s measurable in practice. Keynes may not have been a utopian, but in this case, as in many others, his economic theories are careless.
 “Failure of the New Economics” p.156, Van Nostrand, 1959. This book is available in PDF from the Mises Institute
, who also sell a new edition in print.
 Economica, February 1945. Reproduced as an Appendix in later editions of “The Pure Theory of Capital”.
* – Even in this case the opportunity must be spotted, which requires at least some alertness to entrepreneurial opportunities.
One of the most important questions about politics we must ask ourselves is: How should we live in a state we don’t approve of?
I’m a classical liberal, as I expect most of the Cobden Centre readership are. I have yet to hear of a classical liberal or libertarian who isn’t irritated by modern western states – particularly their petty regulations and high taxation – and I’m no exception. What should we do about that though? One thing we should do is to change opinion and that’s one of the things the Cobden Centre is about. But what about at a personal level? Should our political view affect how we do our jobs, for example, or our tax arrangements?
It could be argued that we should be more diligent in our own work for the sake of the generations after us. Since the state in it’s current size will cause many problems in the future, we can offset them by creating more capital now. The problem with this view is that it considers long-run economics without considering long-run politics. Suppose a government increases redistribution by taxing and spending more and a large proportion of citizens decide to work harder or just as hard as they were before. If that happened the case could be made that redistribution doesn’t affect economic output, or at least it doesn’t affect it as much as was thought. This sort of behaviour aids the political case for socialism. It’s also unsustainable, it’s likely that future generations will not understand the rationale behind it, or for various reasons won’t continue acting this way. That means the negative consequences of government policies will be delayed rather than prevented, and may be worse when they occur. During major wars governments have encouraged citizens through propaganda to work their hardest, and in some cases citizens have worked harder. Certainly this has been positive in justifiable wars. But for the more historically common unjustifiable wars it has been counter-productive and has only funnelled greater power to some of the worst states.
At the opposite extreme is the view that it’s legitimate to cheat the state or anybody else. From an ordinary moral point of view, it’s unacceptable to cheat the state and clearly unacceptable to cheat other citizens. But a large part of economic thought and libertarian thought is focused on challenging traditional ideas of morality (Walter Block’s “Defending the Undefendable” for example). Is this an indefensible idea that should be defended? I don’t think so. Firstly we must remember that laws protect us all and that society couldn’t exist without them. If others see us flouting laws because of our political ideas then they will be encouraged to do the same to aid their political ideas. In this case it’s worth remembering that we’re a minority. This point is made very well in Robert Bolt’s play “A Man for all Seasons”. Another good reason comes from Hayek and is easiest to explain with an example. Suppose a property developer bribes local politicians to grant him planning permission for new buildings. He reasons that the government is unfairly standing in his way with it’s labyrinthine planning laws and denying him profit. He may be correct about those planning laws, but he isn’t correct to think that he’s compensating himself for what the state have denied him. In the absence of planning laws it’s not clear that he would make more profit. Other property developers may out-compete him. What the developer is doing here isn’t to get compensation for his business being damaged, rather he is guessing what compensation he is entitled to and awarding it to himself (and enriching a politician to boot).
A further problem occurs when redistribution is involved. Suppose instead a businessman persuades the state to subsidise his industry. Can this just be compensation for the high taxation he must pay? No, because the state are providing the subsidy by taxing others. Notice this argument is also wrong for the first and second reasons above. If the subsidy is wide, to a whole industrial sector, that means the businessman in question must still compete against others in his industry, but the subsidy still betters the whole sector at the expense of other sectors.
It could be argued that all wealth today is irretrievably muddled. That is, in the past various groups benefited from redistribution by the government or from preferential treatment. Those groups then passed some of their ill-gotten wealth to their family and spent the rest. That wealth has been passed around to others, often unknowingly. So, all wealth is tainted and nothing that is earned can be certainly “honest”. This is true and also beside the point. If we were all to refrain from trading because all wealth is tainted in this way then mankind would be sent back into the state of primitive autarchy. That would clearly be a worse outcome than the world economy continuing to function and everyone receiving “unjust” incomes. The first error in this argument is requiring perfect retrospective justice, something that can never be achieved in practice. Like everything else, justice has diminishing returns: after some point the costs of it outweigh the benefits. Some critics accuse supporters of Capitalism of being the exclusive defenders of this idea. This is confused. All social theories and proposals to change society (whether in a small way or a radical way) don’t offer any of us a just recompense for how we have acted in the past. What they claim to offer is what their proponents believe is a better future. Even Marx was reluctant to ethically approve of his revolution of the proletariat. Instead he framed it as an inevitable development of the human race.
More importantly, the argument for free markets is that they provide incremental improvement for all classes of society. When markets first become more free that will unjustly impoverish some and enrich others. But, the long term growth that they generate serves the common good. In time, wealth generated in the market era comes to dominate that inherited from before. Of course during this time state actions will continue to unjustly redistribute wealth, I’m not denying that. We must compare free markets to other economic systems. Is there any other system that can justly apportion wealth and also ensure progress? I don’t think there is. So, we should limit our concern about long-run wealth redistribution. We should only be concerned in situations where the issue is direct and recent. For example, suppose a man takes gifts from someone he knows is benefiting from government privileges or someone who has in the recent past. In that case there’s a good case to criticise him.
In my opinion we have quite a lot of latitude to act against statism on a personal basis. If taxes are set high enough to discourage me from working as many hours as I would otherwise, then I accept that. I don’t plot violent revolution, but I do work less and enjoy more free time. I don’t see anything wrong with avoiding taxation by legal means. Modern states are currently taxing almost every working person much more than the cost of basic services. Today “tax planning” is mostly a matter of preventing income from being redistributed. There’s a lot we can do to oppose the current state of the world, but we should be careful not to go too far.
As I expect many readers of this site will know, a debate has begun between the Austrian Economist Robert Murphy and the “Quasi-Monetarists” Scott Sumner, David Beckworth and Bill Woolsey. I encourage Cobden Centre readers to have a look at the contributions of both sides; both contain a great deal of insight, and unlike debates with Keynesians, this one is generally civil. My own view is a bit different to that of either side, but that’s not what I’m writing about here. Some commentators think that the argument can be resolved by looking at the “barrenness” of money. Unfortunately, life isn’t so simple.
Money is Barren
Money plays no direct role in satisfying human needs, for this reason the Classical Economists would say that money is “barren”. This is best explained with a hypothetical example. Consider a closed economy that uses only gold coins as money, perhaps an isolated island hundreds of years ago. Suppose that initially there was one ton of gold on the island; long ago all of it was mined out and made into coins. All of the prices on the island could be stated in ounces of gold. Then over time this economy grows and the wealth of the island’s inhabitants changes.
Now, suppose that instead of one ton of gold the initial stock had been two tons and again all of it was minted into coins. In this case would the development of the island’s economy have been different? Clearly prices would be different but that doesn’t mean that anything else would be. Money isn’t an input to any production process. Nothing is made out of money; each person receives money, keeps it for a while and passes it on. As Toby Baxendale often reminds us, wealth is only created when businesses make more or better goods and services. So the absolute amount of money isn’t important. For metallic money there are issues of practicality if coins must be very small or very large which can cause extra costs in handling money. But apart from that, nothing else can cause a difference between the path the economy would take with one ton and that with two. This barrenness applies to all types of money. It doesn’t apply to commodities that can be used to mint money, though. Gold isn’t barren since it’s an input into many industries. The use of money instead of barter confers many advantages on society, the lowering of transaction cost, for example. If the island had started out with no monetary economy then it would not have done as well, but if there is a monetary economy then money is barren in the sense described here. Mises explains all this in several places, for example in “The Theory of Money and Credit” p.238-239.
Fluctuations in the quantity of money are a more complex subject, as are fluctuations in prices and demand for money. The fact that money is barren doesn’t tell us everything we need to know. Let’s suppose that our island economy adopts a central bank and that it changes to using fiat currency rather than gold. The Central Bank decide on an unusual monetary policy. At the beginning of the first month the price level is 100. The Central Bank raise it to 200 by the end of the third month. They then make it fall back to 100 by the end of the sixth month. The Central Bank forces the price level to follow the graph below:
The Central Bank don’t tell anyone about their plan, they just start issuing new money at the beginning of the first month. What I want to ask here is: could this have no direct effect on the economy? The money that the central bank creates isn’t the input to any production process but its injection into the economy does change incomes and prices, and its subsequent withdrawal does too. In the previous example there was no proper change at all in the quantity of money. In the first case there was one ton of gold at the start and in the second there were two tons, but there was no transition between there being one and two. The examples were conceptually separate.
If monetary changes are very, very gradual we could expect little effect, but we can’t expect that if they aren’t. Roger Garrison gives a useful analogy here. Suppose that someone saws a plank of wood into pieces. The sawing may stir up sawdust into the air and make people cough, but once the sawing is done the dust will settle again. At the beginning when the plank is whole there won’t be any sawdust in the air, and all the sawdust will be on the floor soon after the cutting has finished. But, no one can prove that sawdust isn’t a problem by pointing to the time before the sawing and then pointing to another time afterwards.
Two Reasons for Changes: Price Changes and Redistribution
Redistribution is perhaps the most obvious consequence of money creation. If a government creates new money it can spend it as it likes, enriching certain groups while diminishing the value of existing stocks of money. Some economists hold that in an unhampered economy redistribution would be the only effect, though that redistribution would have negative consequences later. According to this view there would be no immediate fall in output. I would like the reader to look at the graph above and think about it using common sense rather than any economic theory they’ve learned. How could this “Monetary Policy” not cause chaos? And how could it not cause real output to fall soon after it began?
The issue here is that prices take time to change. This simple fact seems to cause an enormous amount of stress in discussions about economics. Some people call it “price stickiness” and say it’s a “market failure”. Others deny that price stickiness can occur in an unhampered economy. The only way that prices could change to immediately reflect all new information would be if every trade involved haggling. Thankfully, this isn’t the way things happen: when I buy a cup of tea in a cafe I don’t have to bid for it. One reason for this is that auctions are costly and changing prices is costly. Changing prices isn’t just costly in terms of physical resources; more importantly, it takes time for the entrepreneurs, managers and customers involved, time that may be better spent on other things. To some extent delays are cumulative: when a business input prices change it generally won’t change it’s output prices straight away, so if there are many stages of production a change will take longer to feed through.
None of this damages the argument against state support of Trade Unions. Cafes charge fixed prices for drinks because nobody would go to a cafe where they have to haggle. Jobs usually pay fixed hourly wages or salaries because employees prefer the security of those systems to piece-rate or other systems. Businesses that provide some stability in their prices may in many cases do better because of the predictability this provides to the customer and the cost saving to the business. All of the situations mentioned here are competitive. If more rapidly or more slowly changing prices would work better, then competition would provide them. But if a government supports a union, by banning employers from sacking striking workers for example, then they are tilting the scales of competition in order to benefit members of the union at the cost of everyone else.
What would happen if a Central Bank followed the policy above is that there would be a short lived boom at the beginning before everyone realises they have to increase their prices. Austrian Business Cycle Theory indicates that this boom would be unsustainable if it continued. But before it has a chance to get to that stage, the Central Bank starts reducing the price level, and then a bust will occur. The temporary boom occurs because prices can’t rise quickly and the bust because they can’t fall quickly. Neither will be beneficial and both will harm the economies ability to economize on scarce resources (On this see Mises’ essay “The Non-Neutrality of Money”).
Money is said to be “non-neutral” because monetary forces can have an effect on output. Money isn’t a “veil”. Despite what Keynes wrote, most of the economists who studied the business cycle before him didn’t think that it was. If prices can have an effect on output then changes in both directions must have an effect, both price inflation and price deflation. If the crazy monetary policy described above would change output then so would any smaller, more normal change that occurs in real life. The difference is one of degree. Deflation, especially if it is large, can’t be exclusively good.
Some Austrian Economists believe that if there is deflation after a bubble of some sort has burst, then this provides “purging” and aids restructuring. I don’t agree with that theory, and it would take too long to go into that here. But what the analysis above tells us is that for deflation to be beneficial in this case, any benefits from the purging must outweigh the costs caused by the problems of deflation identified here.
To put it another way, if the creation of money to counteract a fall in prices causes misallocation and that’s a cost, then there are two costs to consider. The cost of that misallocation must be compared against the cost of deflation. No analysis is complete without accounting for both.
As the bailout of Ireland begins in earnest, many in the media are asking “What went wrong?”, and coming to some dubious answers. The circumstances are well known. Ireland saw a long boom before the financial crisis. That boom was accompanied by a large rise in house prices and a boom in building construction. After the financial crisis and ensuing world-wide recession, many Irish banks were bailed out by the government or nationalised. The Irish government practised austerity policies, increasing taxes and reducing expenditure. But, as the cost of the bailouts increased, so did the budget deficit.
Many commentators are now claiming that Ireland’s membership of the Euro was the underlying problem (for example, Peter Oborne. In this argument many sound economic ideas have been mixed with careless ones.
One argument is that if Ireland had not been part of the Eurozone it would have been able to devalue it’s currency. It’s true, that if Ireland still had the Punt then this would be possible but not as significant as many people believe. In today’s world with floating fiat currencies controlled by central banks there is no clear concept of “devaluation” any more. The economic prospects of the region encompassed by each currency and the policies of the central banks are taken into account by the exchange rate market, and the exchange rate fluctuates minute by minute. This means there are two different arguments. The first, which focuses on the private sector, is that when a country enters recession the value of it’s currency falls allowing a growth in exports. This is a dubious argument, but whatever its merits it could not have seriously improved the financial situation of the Irish banks or the Irish government. The second argument is that in a crisis the state’s central bank may create money and use it to pay debts and finance bailouts.
A modern state can easily create new money without having additional assets. If Ireland had kept the Punt, it’s own fiat currency, then the government could have bailed out the banks using newly created money. But, that would simply be a hidden tax. Inflation would ensue then holders of money and money-substitutes would see the real value of those assets fall. Holders of assets denominated in money such as loans and bonds would see those fall in value in real terms too. The tax would be paid by the people through this loss of purchasing power. Any permanent increase in the stock of money must lead to inflation, though there may be a time lag until it becomes noticeable. A temporary increase could only be achieved by withdrawing money from circulation afterwards, and that could only be done with taxation. That governments can create money to get themselves out of sticky situations is beneficial to governments, but not to the people they’re supposed to serve.
Critics of the Euro also claim that the Eurozone currency area could not have worked. According to this view the ECB must run monetary policy to suit the core Eurozone countries. But interest rates that are a good fit for Germany and France will cause problems in other Eurozone countries. There is some truth in this. In the years before the crisis, the ECB ran low interest rates to stimulate the northern European economies, particularly Germany and France which were struggling with rigid labour markets. A side-effect of that policy was the building booms in Southern Europe and Ireland which weren’t sustainable. Though there is some truth in this view, it’s still confused. The idea that labour market problems can be successfully compensated for by reducing interest rates is from Keynesian economics. The idea that central banks reducing interest rates to excessively low levels causes unsustainable booms is from Austrian economics. These views can’t be mixed because they come from conflicting theoretical starting points. It isn’t possible that Keynesian economists are right in France and Germany but Austrian economists are right in Ireland and Portugal. In my view the ECB’s low interest rates may have been an attempt to stimulate the Northern European economies, but that policy wouldn’t have worked under any circumstances. The ECB’s policy came at a cost to Ireland and the Southern European countries when the property bubbles burst, but that cost doesn’t reflect any benefit to the Northern European countries.
It’s true that a Central Bank faces greater problems if the currency area that it regulates spans many countries with different conditions. But, as we have seen, Central Banks can’t avoid recessions and crises even if they only regulate the currency of a single sovereign nation.
Many countries have found themselves facing the consequences of the bad decisions made by Central Banks. Ireland isn’t unique in that respect. What makes Ireland unique is the extraordinary lengths that the government have taken to support banks and property developers. In September of 2008 the Irish government guaranteed for two years all bank accounts with Irish banks and almost all loans to those banks. This September, when that guarantee was due to expire, it was extended for another three months. The government decided that rather than risk paying out on that guarantee they would bail out banks as and when they needed it. They nationalised the worst-affected bank – Anglo Irish Bank in 2008. So far, through several bailouts Anglo-Irish Bank has cost the Irish government €22.9 and the other banks have cost ~€10.1, though the extent of losses hasn’t been fully recognized and will probably be much greater. It is these debts that have caused Ireland’s budget deficit to rise much more than those of other countries.
There have been many rumours about corruption in the Fianna Fail and in Anglo-Irish bank. The actions of the former board of Anglo-Irish bank are under investigation by financial regulators and the police, the former CEO has been declared bankrupt. There are close links between the ruling Fianna Fail party and many property developers, that was the subject of jokes long before the crisis. The previous Taoiseach Bertie Ahern was investigated for receiving bribes from property developers. I think there’s probably some truth in these allegations of corruption. But the politicians that form the government had many ways they could abuse their power for personal gain. A politician has many ways he can make a little on the side without bankrupting his country.
It’s ideas rather than corruption that have created such a great crisis for Ireland. The government thought that the resources the state could lay claim to were inexhaustible. They believed that if the state guaranteed bank accounts that this guarantee alone would satisfy the markets. The Finance Minister Brian Lenihan once called the guarantee the “cheapest bailout in the world so far”. The government forgot that the power of the state isn’t magical. A government can transfer the liabilities of banks onto the taxpayers, but they can’t abolish them. Back in 2008, the government were worried that the failure of a bank would harm Ireland’s reputation, but in the long run their cure was worse than the illness.
As Phillip Booth wrote, the first step the Irish government, the IMF and the EU should take is to end the guarantees.
The Irish government may have discovered a fatal flaw in the Eurozone central banking system – the discount window.
In 2008 the Irish government bailed out Anglo-Irish Bank and effectively nationalized it. Since then they have been periodically supplying more bailout funds to it as losses have emerged. Because of this, together with the bailouts of other Irish banks and loss of tax revenues the Irish state’s finances are very bad. Currently the interest rate on Irish bonds is 8%, much higher than the Eurozone interest rate, indicating that the market considers the possibility of default to be high.
Many commentators have pointed out that having separate states issuing their own bonds and using their own tax policies within one currency area is destabilizing. But the current crisis in Ireland has revealed a problem that may be much bigger in the long run – the European Central Bank’s discount window.
The ECB, like most central banks, controls the rate of interest by two methods. They perform OMOs which are the buying and selling of bonds in exchange for base money. If the central bank buys a bond using base money then it increases the amount of base in circulation as reserves between the commercial banks. The central bank is also the lender-of-last resort. As part of that role the bank makes short term loans to the most marginal, that is most unstable, commercial banks. This is the “discount window” which the European central bank calls the marginal lending facility. The central bank can alter the rate of interest by offering discount window loans at higher or lower rates, though modern central banks don’t generally do this, they use OMOs instead.
The problem the ECB now faces is that it must make discount window loans to Irish banks that are owned by the Irish state. The ECB is, in effect, lending to the Irish government. As Ambrose Evans-Pritchard wrote yesterday: “…the ECB is already propping up Ireland and Club Med by unlimited lending to local banks that then rotate into their own government debt in an internal ‘carry trade’.” Since the ECB discount window rate is 1.75% and the interest rate on Irish government bonds is ~8% that means that Ireland is getting a good deal.
The ECB could stop this lending any time, and probably will. The problem, though, is the impartiality necessary in central banking. In the 19th century the Bank of England would occasionally lend to commercial banks having problems; it was the lender of last resort. But, as Bagehot pointed out, many problems were caused by the central bank playing favourites. Commercial banks with good connections at the Bank of England got loans and other banks without connections didn’t. So, it became a policy that the central bank should offer discount window loans at a rate higher than the prevailing interest rate to all commercial banks if they posted good collateral. Later central banks began performing regulatory probes into banks that borrowed from the discount window facility, thereby increasing the disincentive for banks to use it. The advantage of this system to the central banks was that the market knew that any commercial bank could borrow from the discount window, and that reduced the risk the banks took when lending to each other. This made monetary expansion much easier for the central bank to initiate than it had been before.
In the current situation, though, the ECB must play favourites. The ECB could justify that if it decides that the assets posted as collateral by the Irish banks are not satisfactory, and therefore that those banks are insolvent, not merely illiquid. But that would be mean that the ECB would be effectively judging that the Irish state is insolvent. Politically speaking, can a central bank make that judgement? If the ECB allows Ireland to continue borrowing from the discount window then the other wobbly Eurozone countries will follow Ireland — they will nationalize banks and use them to access the discount window. But if the ECB cut off lending to Ireland then this increases uncertainty for other Eurozone banks and states greatly.