“Austrian” Business Cycle Theory and the Rate of Interest

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In an earlier essay, the present author explained “Austrian” Business Cycle Theory (ABCT) as an analogy to basic price theory, namely the specific law that a price ceiling for a specific good will lead to a shortage of that good. Here we will build on this analogy with an elaboration of what is meant by “the interest rate” with an additional emphasis that stresses the mismatch between the rate of saving and the rate of investing.

The reason for this new elaboration is that ABCT typically concentrates on “the rate of interest”, explaining the business cycle as an effect of “the market rate” of interest falling below “the natural rate”. This has opened “Austrians” up for criticism because any adherence to the pure time preference theory of interest runs into the problem of there being many “natural” rates for different capital goods and so we never know precisely which rate it is that is being undercut by credit expansion1. Moreover we might as well also point out that different borrowers pay a multiplicity of interest rates and that is dependent upon their specific contract so there is no, single “uniform” rate paid by every borrower.

What will be demonstrated here is that, while ABCT’s emphasis on interest rates is valid and is necessary to explain why particularly lengthier, roundabout projects will be engaged in, the most important aspect is that credit expansion simply permits borrowers to access funds for durations that lenders are not willing to lend for and it is this lack of harmony – made clear by our analogy to the results of price fixing – that is the key to unlocking the business cycle.

Robinson Crusoe Economics

In the situation where we have a lone human being (who, for argument’s sake, we shall call John), the fact of scarcity results in the necessity for John to choose which ends he will pursue and which he will discard. There are costs and benefits related to everything he does – such are the logical implications of the action axiom – but exchange of these costs and benefits is unilateral. If John decides to pick apples instead of picking oranges, the benefit he derives from picking apples comes at the cost of picking oranges. He cannot pursue both ends – he therefore exchanges picking oranges for picking apples, albeit unilaterally and in his own mind. This is the nature of basic, simple choices between presently available goods and services.

If John wishes to increase his consumption by investing in capital goods he must also make an exchange, but an exchange of a different nature. At any one moment John will have an array of resources available to him. His basic choice over these resources is whether to consume them now or to invest them to yield consumer goods in the future. It is plainly clear that John cannot do both at the same time – he cannot consume resources and invest them. If he wishes to invest the resources in a capital project that will yield consumer goods in one year’s time then he must be prepared to abstain from the consumption of the resources that he will invest in that project for one year’s time. If the period of investment will be two years then he must be prepared to abstain from consumption for two years, and so on. The precise length of time for which he will abstain from consumption and engage in investment is determined by his relative weighting of the value of time against the value of the quantity of consumer goods yielded – if the quantity of future consumer goods is more valuable to him than the waiting time then he will invest, wait and then enjoy the larger quantity of consumer goods when the investment project reaches its completion; if time is more valuable to him than the additional quantity of future goods then he will not invest but consume the lower available quantity of goods now. The result of such a valuation is summarised simply by the term “time preference”.

Is it possible for John, in his lonely world, to experience the unilateral equivalent of boom and bust? Will he experience a sudden spurt of investment followed by a downturn in his investment activity? The answer is yes, he could, because his capacity to keep on investing is connected solely to his willingness to carry on with the abstinence from consumption of the resources that are required for the investment project to come to fruition. If, half way through his investment project, he changes his mind and his desire for consumption increases so that he must divert resources away from the investment project then he will experience something of a bust – the project must now be liquidated as it has been starved of resources for completion. The viability of the investment project is wholly dependent upon his willingness to abstain from consumption and invest those resources that he could have consumed. The investment therefore turns out to be a malinvestment, unconnected to his consumption/waiting preferences as they are now revealed to be.

Bilateral Exchange

In an economy of more than one person, exchange of a simple good is now bilateral rather than unilateral but it is still based upon the same principles. We make a choice of what to receive in exchange and what to give in exchange. Normally, of course, we give money in exchange rather than a concrete good but we can think of the real cost as being other goods that the money could have bought. If, for example, I only have enough money to buy an apple or an orange and I choose to buy the apple, the cost of me buying the apple is the orange which I could have bought had I not purchased the apple. We can say that I exchanged the orange for the apple, even though the actual physical exchange involved not the orange but, rather, the money that could have been used to purchase it. It is clear, moreover, that I cannot have both the apple and the orange at the same time – or both the apple and the money used to buy it at the same time. I must choose between them because of the eternal condition of scarcity. Only an increase in wealth can alleviate this so that a person is in a position to be able to afford both an apple and an orange.

The market price of a good is the price at which the quantity of the good demanded is equal to the quantity supplied – in other words, it is the price where the number of willing buyers is equal to the number of willing sellers, the level where those who wish to give up in exchange equals the number of those who wish to receive. There is, therefore, not only a harmony of interests at the market price but also the market price regulates the amount of consumption of a certain good that is sustainable by the current level of wealth. Attempts at price controls interfere drastically with this harmony. Artificially lowering the price of, say apples, may, on paper, make it appear as though one now has enough money to buy both an apple and an orange rather than just an apple. The problem, however, is that at the new, sub-market price for apples, the number of willing buyers exceeds the number of willing sellers; the shrunk supply will be bought rapidly by the swollen demand and, therefore, shortages will ensue and there will be no apples left anywhere. This much is standard economic theory. What we can note, however, is that price controls are solely an attempt to allow people to have their cake and eat it – that, whereas at the market price, they could only afford an apple or an orange, the fixed, low price attempts to give them the ability to afford both the apple and the orange at the same time but without any corresponding increase in wealth. On our Robinson Crusoe island we noted that John could not enjoy apples and oranges at the same time because his wealth was insufficient to do this. Any attempt to do so would be at variance with reality and he would end up having to choose between them anyway. Exactly the same law operates in bilateral exchange. Simply trying to forcibly change the prices that emerge in bilateral exchange cannot defy reality and the whole scheme collapses precisely because the objective of providing more and cheaper goods cannot be sustained – you cannot have more of something without increasing wealth. People will find that all of the apples are gone and all that will be left is oranges so they are in the same position as before with only one fruit being available to them, except now without a choice of one or the other. Sustainable trade cannot exist under terms where the suppliers are not willing to offer goods for sale to the demanders.

A further feature of general buying and selling that we might note for our comparison with lending and borrowing that we shall explore in a moment is that every buyer pays the same price as every other buyer and every seller sells for the same price as every other seller. One buyer’s dollars are as good as any other’s and one seller’s good is interchangeable with another’s. In other words, except in cases where there is favouritism or prejudice for the individual personalities, there is insufficient qualitative difference between the different buyers and sellers to make an impact upon price.

Bilateral Investment

On our Robinson Crusoe island we noted that if John wished to increase his consumption in the future he had to abstain from the consumption of resources today in order to use them in investment projects that will yield consumer goods in the future. John’s level of investment was precisely correlated with the amount that he refused to consume and channelled into his project.

In the complex economy, where the abstinence (or saving) on the one hand and the investment on the other is carried out by different people the transaction is effected through the market for lending and borrowing. The market for money loans is actually little different from the sale and purchase of ordinary goods, except that what is being traded and at which prices is a little more difficult to understand. Specifically, what is being traded is not a hard good such as an apple or an orange; rather, it is the purchasing power over resources. A lender, in making a loan to a borrower, transfers his purchasing power over resources today in exchange for the borrower transferring an (at least nominally) higher purchasing power over resources at a point in the future. The market price for these loans – that is, the rate of interest that the borrower pays – is the price at which all willing lenders would be able to lend to all willing borrowers.

There are several key aspects of this market that must be highlighted. First, all loans contracts are for a specific duration which, for argument’s sake, we will say is three years. The lender here must be prepared to sacrifice his purchasing power over resources for three years. During this time, the borrower will use the resources purchased for his investment and will arrange himself to be in a position to transfer back purchasing power in three years’ time. More specifically, what this means is that the lender gives up his power to consume the resources that his purchasing power would afford him and transfers them to a person who wishes to invest them for a three year period that will yield consumer goods at the end of that period, thus earning him an income and the wherewithal to transfer back the purchasing power to the lender. This is the fuel of sustainable growth because the lender relinquishes consumption for exactly the same period as the borrower engages in investment. The basic theory is therefore nothing different from John on the Robinson Crusoe island. Just as John had to abstain from consumption for the duration of his investment project, so too must the lender be prepared to do the same so that the borrower’s project can be completed.

One notable difference of this market when compared to the market for simple, present goods, is that the rate of interest paid by different borrowers will be different rather than uniform for all borrowers. This is because the business of lending money contains an entrepreneurial element. The borrower is making a business decision that his investment will accrue enough income to enable him to pay back the capital and the interest. The lender, wishing to maximise the chance that he will receive his money back, shares this entrepreneurial burden and hence adjusts the rate of interest he charges to different borrowers. The riskiest borrowers – those whose entrepreneurial efforts appear the least likely to succeed – will pay higher rates of interest than the less risky borrowers. There are two possible ways of analysing this. Either we can say that there exists a single market for money loans which, all else being equal, every borrower would pay the same “core” interest rate determined by supply and demand for loanable funds with the difference between the actual rates constituting an entrepreneurial profit and loss element for the lender. Or, we could suggest that the qualitative difference between borrowers creates distinct markets for different categories of lending that attract different rates. In the markets for lending that contain the least risky borrowers the supply of loanable funds will be relatively high so interest charges will be low; in the markets with the most risky borrowers, however, supply will be relatively lower to demand resulting in higher interest charges to these borrowers. We shall use both analyses below although we will conclude with a preference for the latter – that of distinct markets that attract different rates. However, the most important fact that we need to concentrate on is that, whichever analysis we use, all lenders are prepared to fund all borrowers’ enterprises for the duration of their projects under whatever interest rate is agreed and hence these projects can be fully funded to completion.

The fact that the exchange between borrowers and lenders is facilitated by an intermediary – usually a bank – makes little difference to this situation. The bank simply borrows from the lender (or “saver”) at a certain rate and lends to the borrower at a slightly higher rate, the difference between the rates compensating the bank for its efforts in channelling the savings of ordinary people into the profitable projects of borrowers. The key aspect, again, is that there are real funds that can fuel all projects through to their completion under the terms agreed.

Credit Expansion

In order to understand the effects of credit expansion, let us first of all posit the case where a direct lender creates a mismatch with a borrower. Let’s say that a lender is prepared to lend for three years whereas the borrower thinks (erroneously) that he is borrowing for five years. The borrower’s project takes five years to complete and he needs purchasing power over resources for five years as his project will not earn an income to transfer back that purchasing power before five years is up. If, after three years, the lender, wishing to take back his purchasing power for present consumption, calls in the loan the borrower will have a shock. His project is only 3/5ths complete. Only two options are possible. Either the lender must change his priorities and save for the full duration of the investment project; or the borrower must liquidate the investment in order to pay back the lender2. If the latter option is necessary then we have a mini boom-bust between these two individuals; the investment is revealed to be a malinvestment as the borrower was not willing to lend purchasing power over resources for a time sufficient to complete the investment project. In order to create a sustainable investment project the lender must be prepared to advance purchasing power to the borrower for the full duration of the project. If he is not then the project cannot continue.

Now let us examine what happens when an intermediary bank engages in credit expansion and brings about effectively the same thing. The borrower is now a depositor of the bank and the borrower borrows from the bank rather than directly from the lender. Above we cited two possible analyses of the loan market – either there is a “core” rate of interest governed by supply and demand for loanable funds with individual variations in loan contracts representing the entrepreneurial risk that the lender takes; or, there are distinct markets for different types of loan, each of which attracts a different rate. We will use both analyses here.

On the eve of the credit expansion all willing lenders will have lent, through the bank, to all willing borrowers at whatever terms in the individual contracts. The willing lenders will be prepared to lend the funds for exactly the duration of the loans of the willing borrowers. Let us call these fulfilled borrowers Group A. When the bank expands credit, however, it gives the impression to unfulfilled borrowers – let’s call them Group B – that the supply of loanable funds has expanded. Under the first analysis, if the supply of funds expands then the “core” interest rate will reduce as the fresh funds have to find new, willing borrowers as those who were prepared to pay the highest charges have already been loaned to. This brings down the total amount of interest (“core” interest +/- the entrepreneurial charge) that Group B borrowers pay. Before credit expansion a core interest charge of (for example) 10% plus an entrepreneurial element of 5% would have given a Group B borrower a total interest charge of 15%, which may have been too high for him to take out a loan. Now, however, if the effects of credit expansion reduce the “core” interest charge to 5% leaving the entrepreneurial element unchanged then the total rate payable will be 10%, at which rate he may become a willing borrower. Hence the number of willing borrowers begins to expand. Under the second analysis, where there are distinct markets for different loans to different categories of borrower, expanding the volume of credit will expand the number of markets to which funds can be lent. As all of the Group A markets are fully lent to the new funds must seek out new, unfulfilled markets in Group B. This has the effect of bringing down the individual interest rates in these markets. Before credit expansion, the interest rate in these markets was infinitely high as supply in these markets was zero. Now, credit expansion has created supply that moves into these markets and depresses the interest rate to a level at it may reach demand. Hence loans will start to be made in these new markets.

To the present author, the second analysis seems preferential for visualising clearly the reconciliation between ABCT with the multiplicity of interest rates that are paid by borrowers. Indeed, while separating out the “core” rate from the entrepreneurial rate may be easy to conceptualise to a degree3, the idea of lowering rates is less straightforward to perceive when we think of the market as a unified whole. Conceiving them as separate rates in distinct markets which are individually depressed by credit expansion removes this conceptual difficulty4.

Under both analyses however, we can see that increased credit expansion leads to loans at rates that are lower than those that would be paid on the unhampered market. It is important to realise, though, that the contracted interest rates paid by borrowers in Group B – the new borrowers – may actually be higher than the rates paid by Group A. What we may observe is new borrowers in Group B paying what appear to be increasingly higher rates rather than increasingly lower rates. But the crucial point for ABCT is that the rates paid by Group B are lower than those that they would pay on the unhampered market. Such rates do not have to be lower than Groups A’s and thus it is still true to say that, overall, credit expansion has lowered interest rates.

How is it, though, that Group B borrowers, if they may pay higher rates than Group A borrowers, channel these funds into longer, more roundabout investment projects? Wouldn’t the interest rates have to be lower than Group A’s in order to accomplish this? The comparison to Group A’s rate is not relevant, however. It is still the case that extending loans to Group B will cause an overall lengthening of the structure of production as funds that previously were earmarked for consumption will now be channelled into investment5.

However, whatever the duration of a loan and whatever terms on which is it advanced the cardinal fact remains as follows: lenders are not prepared to devote real resources towards the investment projects of the borrowers for the entirety of their duration. Just as in the same way as price controls in our example above tried to give people the ability to have their cake and eat it – afford both one apple and one orange at the same time even though the level of wealth could not sustain these purchases – and just as in the same way that John on the Robinson Crusoe island not consume his resources and invest them at the same time, so too is credit expansion a societal wide attempt to indulge in both consumption and investment simultaneously. The borrower thinks his new money allows him to purchase resources for investment whereas the lender, not having relinquished his purchasing power, thinks that he can still use his original money for consumption. What happens in practice, of course, is that the credit expansion forcibly transfers purchasing power from the lender to the borrower. The increased money supply causes an increase in the prices of capital goods and a relatively weaker increase in the prices of consumer goods. The lender still loses out, therefore, as he must now pay higher prices for the things that he wished to consume – in just the same way as he would lose out from price controls when he sees that the shelves are empty. As the cycle gets underway, higher doses of credit expansion are necessary to maintain purchasing power in the hands of the borrowers as prices rise sharply and inflation premiums begin to be written into loan contracts. Once the inflation gets out of control and the credit expansion is halted or reduced funds are cut off to the borrowers in Group B as they must now rely upon the genuine saving of lenders. But lenders are not prepared to lend real purchasing power under the terms that these borrowers are willing to pay. Thus, starved of resources to complete their projects, Group B borrowers must liquidate their half-finished investments which are now revealed, after the true consumption/saving preference of lenders becomes apparent, to be malinvestments. The bust phase of the cycle therefore sets in.


What we have seen from this analysis, therefore, is that while the “Austrian” claim that “credit” expansion lowers “the interest rate” leading to the business cycle can be elaborated and defended to account for multiple rates paid by multiple borrowers, the primary fact is that lenders are not prepared to lend purchasing power over resources to the borrowers for the duration of their investments. It is this lack of harmony in the use of resources which is the key to understanding the start of the boom and the eventual collapse and this should be the focus of anyone wishing to understand and expound “Austrian” Business Cycle Theory.

View the video version of this post.

1See, for example, the relatively well known Hayek-Sraffa debate. “Austrian” economist Robert P Murphy has stated that “Austrians”, or at least those who ascribe to the pure time preference theory of interest, are yet to provide a sufficient answer to Sraffa’s objections. Robert P Murphy, Multiple Interest Rates and Austrian Business Cycle Theory, unpublished.

2We are, of course, ignoring the real-world possibility of refinancing.

3Although the length of time may itself be an element that is accounted for in risk.

4It is also the case that, even if all else was equal, there would not be one “core” interest rate in the loan market anyway as different lending periods would also attract different rates. Again, the second analysis overcomes this problem as different time periods would constitute individual markets.

5From a simple cost account point of view, the longer a particular business enterprise takes to come to fruition the harder it becomes to fund interest charges on the borrowing that has funded it. An uncompounded interest charge of 10% on a loan of $1m for a project that will last one year will result in a total repayment of $1.1m, something that might be manageable. If the same loan at the same rate was made for ten years, however, the borrower will to pay twice the capital – $2m – back at the maturity date; a cripplingly high cost for even the most profitable of projects. If the interest rate is reduced to 2%, however, the ten-year borrower would only pay back a total of $1.2m, which would be more manageable.


Some Common Objections to “Austrian” Economics

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“Austrian” economics is a heterodox school of thought – its theorems and, more crucially, its methods at arriving at those theorems are not embraced as mainstream by the majority of the economics profession. Economics is, like all academia, a largely government controlled and funded science and it is probably no surprise that a school of thought that lays bare the consequences of government action is met with little enthusiasm. Nevertheless it is appropriate to examine and rebut some of the substantive objections to “Austrian” economics so that proponents of this school of thought can more sharply attune themselves when responding to them.

“Austrian” Economics is Old!

The charge that “Austrian” economics is old or outdated rests on the fallacy that progress always moves in a single direction and that everything that is known today either contains or is built upon that which is known yesterday. Hence there is no need to examine the “old” stuff. Yet the history of knowledge has seldom been one of a continued and unbroken progress. Rather, crucial insights have been lost and areas of study have been shunted on to false and wrongheaded directions, both in the natural sciences and in the social sciences, with intellectual vested interests often replacing open minded hypothesising. The history of science abounds with false paradigms of which flat earth theory and the geocentric universe are only the most patently obvious; more recently, however, it has been suggested that the conclusions reached by the theory of relativity are better explained by traditional classical physics1, and libertarians themselves have pointed out that the conventional approaches to medicine in areas such as HIV/AIDs and cancer is more concerned with propping up the profits of big pharma than in developing a genuine scientific understanding of these ailments. This is not, of course, the place to validate any of these challenges but they do serve as a warning that what we might regard as absolutely true and correct today may not be and that we have led ourselves down a blind alley. Speaking more generally, the twentieth century was possibly the most bloodthirsty and unstable in history, contrasted with the less eventful and unfairly stigmatised “dark ages” where state power was less firmly entrenched. Democracy has become the leading orthodoxy whereas faith in earlier systems of government is at an all-time low, even though democracy’s ethical superiority is far from clear. In economics itself, Rothbard has suggested that the foundation of economic thought built by Adam Smith obliterated many important insights of the earlier thinkers such as Cantillon and Turgot, even going so far as to blame Smith for the injection into economics of the labour theory of value2. The revolution in Keynesian thought and positivist methodology in the first half of the twentieth century also pushed economics from a path on which it shared much in common with the earlier “Austrian” school. Indeed the curious and scarcely challenged acceptance of Keynes’ General Theory completely blew from the water the “Austrian” explanation of business cycles as it applied to the Great Depression. As Henry Hazlitt later quipped, “what is original in the book is not true and what is true is not original” and the entire tome was never properly debated – merely accepted3. Indeed, economics today suffers from a distinct splintering into hermetically sealed units that seldom interact with each other or acknowledge a common foundation. In addition to the wedge between micro and macroeconomics, we seem to have labour economics, industrial economics, oil economics, financial economics, international economics, and so on. Most of these bubbles are little more than statistic-gathering lobbying channels to favour key industries rather than areas of study that are influential upon core economic theory. Furthermore, intellectual thought has often had a dismal record at being ahead of reality – until the 1990s Marxism was rife in academic circles and as late as 1989 Paul Samuelson, in the 13th edition of his bestselling economics textbook, stated that the Soviet economic system was “proof that…a socialist command economy can function and even thrive”. To ignore an old area of thought, or to refuse to dust the cobwebs off long-ignored treatises is not necessarily an exercise that is conducive to the preservation and growth of knowledge and, indeed, more than risks violating the first duty of the scholar – to preserve that which is already known to be true. More Menger and Mises would do far more for the economics profession than 2014 journal articles by PhDs and Nobel Prize winners.

“Austrian” Economics is too Political!

The charge that “Austrian” economics is too political may at first appear surprising given that its primary theorist, Ludwig von Mises, was extremely clear on his support for the wertfrei science and only spoke of his passion for laissez-faire in his capacity as a citizen and not as an economist, or so he claimed. Although it is true that most of those who embrace “Austrian” economists are libertarians in one form or another, this charge is more likely to originate from the fact that “Austrian” economics leads to the radical and stark conclusions that government would not benefit the average citizen, nor would it succeed in doing anything that which most people want government to do. Such results are intolerable for government advocates and hence they try to paint “Austrian” economics as having a political bias. Unfortunately, such an attitude reveals the political bias inherent in their own schools of thought. Indeed, the entirety of the mainstream, with its experimental method and drive towards socially engineered outcomes, is inherently statist, normally considering only which government action is the right one. It seldom asks itself the questions whether any government action is appropriate at all. Most macroeconomic research is funded by the US Federal Reserve and it is hardly likely that such an institution, the actions of which are so central to the “Austrian” theory of the business cycle, will be willing to engage its critics on its payroll. A little more broadly, the defects in Marx’s economic thought – his misconception of economic classes and his inability to defend his labour theory of value against the uniformity of profit levels in capital-intensive and labour-intensive industries – can be attributed not the fact that not that he was simply a bad thinker but that his thinking was subservient to his political ends4. Indeed, one of his staunchest critics, Eugen von Böhm-Bawerk, still praised Marx as “an intellectual force of the very highest order” in the book where he laid waste to Marx’s labour theory of value5. At the very least, therefore, “Austrian” economics is no more politicised than any other school of thought.

Austrian Economics is not Empirical!

The familiar charge that “Austrian” economics is deduced from the action axiom and does not make use of experimentally tested hypotheses is one of the primary dividing lines between the “Austrian” school and the mainstream. The present author has recently explained the “Austrian” method and we will not repeat here what we have examined already. Rather, we will concentrate now upon a more subtle criticism which is that, although “Austrian” economics makes the claim to be a deductive science, it must nevertheless make use of empirical facts and that both Human Action and Man, Economy and State are rife with empirical assumptions. Aren’t “Austrians”, therefore, completely misstating their own method? This criticism, however, confuses core theory on the one hand, which is formal and deductive, with the application of that theory to substantive choices that humans have made on the other. The core of “Austrian” theory – actions, ends, means, choices and the laws that are derived from them such as supply and demand, marginal utility, and so on – are deduced from the action axiom. Yet the interest in our field of study is the effects of the complex phenomena that exist in the world and the existence of certain human choices need to be taken as empirical facts in order to analyse them. If we are to have a theory of money humans must have chosen to use money; if we are to have a theory of banking, the fractional reserve system and of business cycles, humans must have chosen to use banks; if we are to have a theory of production then humans must have chosen to engage in investment and roundabout production rather than leading a hand to mouth existence. Indeed, even the existence of other humans is an empirical fact (albeit a highly certain one) that is necessary for any theory of bilateral exchange. Examination of all of these areas, which make use of the empirically validated, substantive choices that humans have made, are nothing more than application of the core, deductive economic theory to real life situations simply because these are the things that we are interested in knowing about. The conclusions reached would still be true even if those choices had never been made, but the fact that they were made is what brings them to the forefront of our attention.

A related charge from the empiricist camp is that, as a deductive science whose truths are valid a priori, “Austrian” economics can only yield analytical truths – endless tautologies that are merely elaborated definitions of the original axiom. Hence it has nothing new to say and if we wish to learn synthetic truths about reality then we must go out into the world and observe. The so-called analytic-a priori/synthetic-a postierori distinction is a convenient way for methodological objectors to the “Austrians” to attempt to dispose of valid truths that they cannot otherwise refute. If, as it is claimed, nothing about reality can be known without empirical validation, then surely that epistemological claim, which is asserted as a law of reality, applies to itself? To be consistent with what it says, this statement too would have to be tested empirically to see if it is a true law of reality. Otherwise, by its own standard, it is merely an analytical assertion which, while it may be true in and of itself, says nothing of reality at all. Regardless of this however, the wider allegation that “Austrian” economics says nothing of reality is rendered false when we consider that the action axiom itself is a law of reality. Any action demonstrates an undeniable recognition of the harmony between means and ends as they exist in the universe. A human may deny that the matrix of means and ends constitutes reality but this action of denial, which must make use of them, demonstrates that he does not hold this to be so. In denying that the action axiom is a law of reality, the person is trying to create an end in the real universe using available means that are suitable for this purpose. If the action axiom says nothing about reality then neither too do the ends that he attempts to create have anything to do with reality and so they can safely be ignored. If he was in genuine denial that the nexus of means and ends constituted reality then he would keep his mouth shut and refrain from any action whatsoever. If, therefore, the action axiom is a law of reality then so too are the laws that are deduced from them also laws of reality. Indeed it is precisely because the “Austrian” method begins with action in the world that it is firmly grounded as a school that deals with reality and with phenomena as we find them. It is patently not an epistemology that babbles on about metaphysics, imaginary constructs and ethereal musings.

Austrian Economists do not make Predictions!

The previous objection – that “Austrian” economics can say nothing about reality – is joined at the hip with this final objection that we shall consider here, that “Austrian” economists do not make predictions. One of the more sophisticated guises of this objection runs something like this: if “Austrian” economics says absolutely and necessarily true things about reality, how is it possible, when it comes to applying them to a real world situation, their validity, or emergence, becomes contingent? How is it that these can be undeniably true laws about the world yet we do not know when they are going to make their appearance and cannot be used to make predictions?

The answer to this is that “Austrian” economics can be used to make predictions – it is just that the formal laws of human action are not sufficient to make those predictions about human behaviour. Such a limitation does not invalidate the necessary truth of those laws. The fundamental categories of action are necessarily true because we cannot conceive of a mode of action in which they would be untrue. We cannot, for example, ever imagine an action that is not the result of a choice to use ends towards means. Thus, the laws that are deduced from these fundamental categories must also be absolutely true.

Looking for a moment to the natural sciences, all scientific propositions are conditional statements of the “if-then” variety, the appearance of which in the real world is contingent upon the actual conditions they require being present. A chemist may be able to tell you that, provided that two atoms of hydrogen and one atom of oxygen are present under certain conditions then they will join to form a molecule of water. Undoubtedly this law will be very useful in making predictions as we now know what will happen when certain conditions are present. But to make a prediction of future events we also need to know whether such conditions will be satisfied at X point in the future – and this is an entirely separate question. The law by itself, therefore, is not enough to make a prediction. To make predictions, we first need to study the outcome that will result when a certain configuration of variables is present; and then we need to determine whether that precise configuration will occur at some point in time. The fact that we need to carry out both tasks has no bearing on the truth or validity of the law. Carrying out the second task – attempting to determine whether certain conditions will be present – may be more straightforward for a natural scientist to do, given that unconscious matter has no will of its own. But outside of controlled laboratory conditions, even predictions of this nature have proved immensely difficult. We cannot predict the weather accurately more than about a week in advance, nor earthquakes in time to evacuate affected populations. It has previously been predicted by scientists that a rocket would never be able to leave the Earth’s atmosphere; that rail travel at high speed would not be possible because passengers would die of asphyxia; and even Einstein once predicted that Nuclear energy would be unobtainable. All of this is before we even consider the science behind the whole climate change saga and the truly abysmal scientific predictions made in fields where human action has been a variable, such as “peak oil” and other resource depletion. None of these predictions has anything to do with what happens when certain conditions are present – rather, they are predictions about whether the required conditions will be present for a particular outcome.

Natural scientists may give the appearance that both elements of prediction are a unified whole as they can predict both elements in their role as scientists by following the same method of empirical observation. When we turn to human action, however, the formal, qualitative laws of praxeology will bind human action within a certain framework. We can say that if X conditions are present then Y result will occur. These laws can be used to predict outcomes. But a whole and complete prediction of human action requires also a prediction of the substance of human choices and of the conditions in which humans will find themselves – about which, praxeology has nothing to say. Thus the praxeologist in his role as a praxeologist, does not, unlike the natural scientist, make predictions. Given the difficulty, as we just outlined, of making predictions about unconscious matter, how much more difficult must it be to make predictions of human behaviour where quantitative and substantive predictions concerning human action cannot be made with scientific certainty? The difficulty in predicting human behaviour, caused by the volition of human choice, does not, though, have any bearing upon the necessary truth of the laws of praxeology – and if anything, those laws are the mainstays in making such predictions. The fact also that the laws cannot be expressed quantitatively is also no bearing on their necessary truth – human action proceeds in whole, discrete steps and any change in conditions must be sufficient to make a change in a human’s rank of values. Whether and what point such a change will be made also cannot be reduced to scientific certainty but must, rather, be based firmly on our empathetic understanding of our fellow human beings and their response to the conditions in which they find themselves, which much also be predicted. If this was not true then profit would not exist in the world. For if every human desire and the consequent action was predictable with scientific certainty then every resource would be bid up exactly to the level of its cost. It is precisely the task of the entrepreneur to estimate future human desires and choices and to direct resources accordingly. Where he correctly estimates the conditions his application of the appropriate praxeological law will render his prediction correct.

Neither also is “Austrian” economics, however much its theorems may be necessarily true, not weaker because it lacks substantive prediction and quantitative measurement. The boundaries of science are that which can be known in the universe and “Austrian” economics restricts itself to formal, qualitative laws of action precisely because that is all that can be known with scientific certainty. To acknowledge the limits of scientific endeavour is simply intellectual honesty and not a weakness. It remains incumbent upon the mainstream to explain why they think that “science” is about making known that which is simply unknowable.

We can conclude this piece by stating that “Austrians” themselves sometimes, at the very least, give the appearance of making predictions in their capacity as “Austrian” economists. The forecasts of wild inflation and five figure gold prices that have not come to pass since the 2008 crash should remind “Austrian” economists who are desperate to display the truthfulness of their insights that these are entrepreneurial judgments and not scientific facts.

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1See, for example, Petr Beckmann, Einstein Plus Two

2Murray N Rothbard, An Austrian Perspective on the History of Economic Thought, Vol. I, Economic Thought Before Adam Smith, Ch. 16.

3Henry Hazlitt, The Failure of the New Economics – An Analysis of the Keynesian Fallacies, pp. 4-9.

4Murray N Rothbard, An Austrian Perspective on the History of Economic Thought, Vol. II, Classical Economics, p. 317.

5Eugen von Böhm-Bawerk, Karl Marx and the Close of his System, p. 77-78. In this passage, Böhm-Bawerk states that the belief of Marx, and of the classical economists, in the labour theory of value was a “cherished philosophical principle” that was not routed in strict, scientific analysis.


Economic Myths #11 – The Mixed Economy

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The world’s political systems today are, generally, neither fully despotic on the one hand, nor are they completely anarchical on the other. Instead most of us languish under so-called “social democracy”, a curious mixture in which a degree of sovereignty in the form of voting rights reside in the citizenry while political leadership and control remains distinct in the form of various functionaries such as Presidents, Prime Ministers, Congressmen and Members of Parliament. A libertarian might contend, of course, that such a social democratic system is worse for individual liberty than a dictatorship or monarchy, but the important point is that the ideological extremes have been blended into a kind of soup which is, at least from the de jure point of view, really neither total freedom on the one hand nor total despotism on the other. In exactly the same way, neither do our economic systems (which amount to pretty much the same thing as political systems) represent any ideological purity. We are neither fully capitalist nor are we completely socialised but, rather, have to put up with some kind of “mixed” economy with capitalistic and socialistic elements.

Although the relationship between economic and political systems is one joined at the hip, the justification of social democracy on the one hand and of the mixed economy on the other appears to come from different directions. Democracy, rightly or wrongly, is believed to a good and noble thing in its own right – a positive and independently justifiable improvement over any other option. The mixed economy, however, appears to be based on little more than the intellectually slothful adage that “the truth lies somewhere in the middle”. Capitalism, it is alleged, while bringing massive economic growth and improvement in the standard of living, leads to unstable business cycles and encourages greed, selfishness and extensive inequalities in wealth and income. Socialism, on the other hand, may make things “fairer” and more equal yet it totally decimates the productive capacity of a nation and the standard of living stagnates or even reverses. The “correct” system “must”, so the argument goes, lie in between these two points, somewhere that can seemingly take the best of both systems while avoiding the alleged pitfalls. Hence we end up with the mixed economy.

The first question we might as well ask when tackling this fallacy is that if we adopt a position somewhere in between these two alleged extremes what argument is there to suggest that we will end up with the “best” aspects of each system rather than the worst? In spite of the socialistic element income inequality and wealth concentration in the hands of a few elites seems to be worsening, not getting better; and in spite of the capitalistic element we have failed to have any meaningful growth since 2008. May be it is the alleged good parts of each system that are cancelling each other out and not the bad? The fundamental flaw, however, is that the assessment of the characteristics of capitalist and socialist economies that identifies their good and bad aspects are partly wrong and it is the wrongly diagnosed parts that are exaggerated in making the case for a mixed economic system. The good aspects of capitalism, private property and free exchange – such as economic growth and marked increases in the standard of living – are, as we know from “Austrian” economics, true; the bad aspects, on the other hand – selfishness, inequality, greed, the business cycle, and so on – are largely false or misstated. Capitalism does not encourage anyone to be greedy or selfish at all – it just gives you the freedom to be as greedy or altruistic as you like, provided that you fulfil those ends through voluntary trade and do not engage in outright theft or fraud. What opponents of capitalism don’t like is that people, when set free, usually choose to pursue their material welfare as the first priority, while also overlooking the fact that the resulting productivity usually reduces poverty anyway. Even if it didn’t, however, it confers upon people the wherewithal to be more charitable out of choice and it is no mystery that many of the great charitable foundations – such as the Salvation Army, the YMCA, the Scout Movement and the Rotary Club – were founded in the nineteenth century or early twentieth centuries, the relatively most capitalistic period in history. Moreover, the business cycle, as we know, is not an inherent feature of a free market economy, but is caused by credit creation, something that is only sustainable with government and central bank sponsorship. Yet when justifying the “mixed” economy it is these bad aspects that are cited and emphasised in an attempt to cajole people into accepting a blended economic system. Turning to socialism, we know that such a system would obliterate all productivity and the standard of living would sink far below that to which we are now accustomed. Its bad aspects are, therefore, all true. Yet the good aspects – greater equality, fairness, and anything that can be categorised under the current, in-vogue term of “social justice”, are all patently false. Socialism does not create any equality at all; it does not mean that every portion of wealth in existence will be carved up into equal shares for everyone to then enjoy. Instead, it transfers the power over whole resources from private producers, who must maintain their ability to satisfy consumers in order to retain that privilege, to politicians and bureaucrats. Nationalising an industry does not give you, the average citizen, any greater access to the goods and services tied up in that industry. Rather you are left even more at the bottom of the heap than before as the political lords and masters decide what that industry will produce, what prices you will pay, what level of service you will receive and you are stuck with whatever they decide to give you – providing that the inefficiency and waste of state run industries has anything left to give. The very reason why property rights and ownership exist is precisely because there is no agreement on how resources should be used. This problem exists under socialism as it does under capitalism and one person’s decision must, at some point, overrule all others; any equal “voting” influence that you might have in this regard may be restricted to a one off, catch-all election every four or five years and in the meantime you have to suffer whatever it is that the electoral victors throw down from their table. Under capitalism, however, your voting influence is felt all the time in a highly specific manner through your spending habits. If a producer fails to produce what you want at a price you can pay he loses you there and then. Not so under socialism where you have to put up with whatever the upper elite, controlling all resources, decides will be produced. Furthermore, providing social safety nets and welfare states in pursuit of some kind of “social justice” does not result in a society that is more caring and sharing. If anything, the adage “from each according to his means to each according to his needs” completely disintegrates any moral fervour. By separating individual productivity from individual reward, wealth creation is turned into an stockpile to which a person contributes that which he is able according to his “means” then takes out according to his “needs”. Unsurprisingly, every person seeks to minimise the amount he has to put in through toil and sweat and maximise what he can take out in goods and services that he can sit back and enjoy without effort. This results in a population that fails to cultivate its talents towards increasing wealth such as hard work, responsibility and self-reliance and replaces them with characteristics that make them needy and pitiful, with an added layer of laziness, corruption and freeloading. This is precisely the problem faced by our bloated welfare states today and why they are completely bankrupt – demand has swollen to such an extent while supply has been hopelessly dwindled. None of this is exactly the antidote to “greed” and “selfishness” that advocates of the mixed economy might expect. Additionally, the resulting scarcity usually spawns black markets and underground trade, increasing the scope of legally defined criminality and, in worst case scenarios, penalising the population for attempting to acquire what should be every day goods and services.

A further fallacy is the assertion that private enterprise does some thing” better than government while government does other things better than private enterprise and we should look to the “evidence” to decide who should do what. But by what standard do you conclude that something is being done better by one or by the other – and by what standard do we judge whether a certain activity should be carried on at all? Private enterprises make this judgment through the profit and loss test; the quantity and quality of resources devoted to production of a good and service is rationed by its ability to make a profit, indicating the height of its demand by consumers. A service will be of low quality or unavailable to certain sections of the population simply because consumers are not willing to support a more extensive level of production in that particular industry. The reason why broadband internet was not, in the UK, extended to all rural communities without the force of government was not evidence of “market failure”. It simply meant that the more extensive resources necessary when compared to urban areas were required more urgently to produce other goods and services that people wanted to buy. Any “evaluator” who determines from the “evidence” that government is needed for rural broadband cabling is necessarily substituting his own value judgments for everyone else’s, denying them the goods that they really demanded and giving them those that are not. Nor can we fall back on the assertion that government should run “essential” industries for there is no such thing as an “essential” industry. Humans do not evaluate goods and services in whole, homogenous concepts such as “fire services”, “health services”, “utilities” and so on – rather they are demanded in specific quantities in specific times and places. What is most highly valued by an individual changes from moment to moment. While we may think of “medicine” as “important” we can easily imagine ourselves in a situation where we would prefer to do something “unimportant” like watch television rather than produce another bottle of penicillin – and some people may not want medicine at all if they maintain their health. Precisely the point where we stop devoting resource to the production of penicillin and move them towards producing televisions can only be judged by the profit and loss test of the free market. Any other judgment is necessarily arbitrary and at variance with the demands of consumers. In any case, as libertarians, we might also ask if an industry is really critical why on earth would you want it in the hands of the government where it can be royally screwed up? And why would it even need to be? If it is heavily in demand then profit opportunities will abound and private entities will have no problem meeting it – it is the unessential industries with low demand that struggle to stay afloat without government support.

The real reason, of course, why we have ended up with this system is, in fact, pragmatic rather than intellectual. Capitalism is the goose that has laid the golden egg and any decimation of capitalism would very quickly destroy the standard of living of the citizenry, prompting a swift revolution. Yet government yearns for power and control and cannot be content with letting things be; it therefore has to paint capitalism as this necessary evil which, like a dangerous pet, somehow brings good things when controlled in the right way. Ironically, of course, it is government interference in an attempt to provide a socialistic element that brings about the chaos and injustice that is blamed on capitalism. We have boom and bust because of government-sponsored credit creation, and the rich are getting richer and the poor poorer because the government bails out these cronies from the resulting disarray at the expense of the rest of us. Indeed, having a “safety net” against the alleged “sink or swim” nature of capitalism has turned out very well if you are an investment banker. None of this would happen in a genuine, capitalist economy.

The mixed economy is therefore nothing but an unjustifiable charade, built upon alleged weaknesses of capitalism and supposed strengths of socialism that simply do not exist.  Genuine economic prosperity for everyone in a fair and just society populated by morally healthy individuals can only come through unfettered private property and free exchange – not through government’s attempt to meddle with it.

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Fractional Reserve Banking – The Ethics and Economics

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Fractional reserve banking is a prime topic for study on the part of libertarians on the one hand and of “Austrian” economists on the other. For not only is the practice, in the way it is carried out today, deeply unethical it also creates macroeconomic instability and is one of the causes of economic crises such as that which we are enduring currently. This essay will explore in particular the ethical and economic consequences of the legal framework imposed by government fiat that breathes life into this practice, concluding that it is government that is at the heart of its unethical nature and causes the endurance of its bad effects.

What is Fractional Reserve Banking?

A bank engages in fractional reserve banking if it retains as reserves only a fraction of its liabilities that can be redeemed on demand – most often, this means money that is held in current or “checking” accounts where you are entitled to withdraw your money at a moment’s notice. If customers have deposited in the bank £10 million of cash and the bank’s reserve requirement (or its internal practice, depending upon the regulatory regime) is 10% then the amount of cash held by the bank for withdrawal by those customers is a mere £1 million. This may be easier to visualise when deposited money consisted not of paper but of gold and other precious metals. When you deposited your gold in a bank, you were issued with a paper warehouse ticket stating the amount of your deposit (say, 10oz) and the fact that you were entitled to withdraw it on demand. If your bank engaged in the practice of fractional reserve banking then only a portion of this gold would actually be in the bank ready for you to withdraw. Incidentally, these warehouse tickets were the origin of paper money – a £10 banknote issued by the Bank of England still states “I promise to pay the bearer on demand the sum of £10”, £10 originally meaning 10 pounds in weight of sterling silver. Indeed, all of the monetary denominations such as pounds, dollars, francs and marks were originally fixed weights of precious metal. These days, of course, the note is backed by no commodity whatsoever and statements of account at banks merely indicate a promise to pay the sum stated in paper money which has, to all intents and purposes, replaced metals such as gold and silver.

The obvious question, then, is where on Earth has this money gone? If it is not in the bank then where is it? And more importantly, why is it not in the bank? Have the bankers taken your money and used it to purchase luxury consumption goods, hoping that you will never come back for it? Not quite; the answer is that the bank has loaned the money to borrowers, usually for the long term to people who wish to take out a mortgage, for example, in spite of the fact that all of the bank’s liabilities are payable on demand. In this practice of “borrowing short to lend long” the bank takes a gamble that two conditions will be met. First, that it will only ever need the fraction of deposits kept as reserves in order to meet the number of withdrawals by its depositors that are likely to be required at any one time; and second, that a sufficient number of the borrowers will pay back the money that has been lent out. The primary motivation for this is, of course, to earn interest on the sums lent. This is why most banks do not charge their depositors a fee for their services – they are using your money deposited to earn an income from other people.

Fractional Reserve Banking – Fraudulent or Legitimate?

The question of whether fractional reserve banking is fraudulent is a matter for debate in libertarian circles. Could not, for example, two persons agree to engage in the practice? If I know, for example, that my bank will only keep a fraction of the money as reserves and I know it is at risk of the bank’s insolvency then is there any breach of the non-aggression principle?

The answer to this question lies in the consequences of the terms upon which such an arrangement could be made and the also in the legal and regulatory context. There are two basic possibilities; either one’s deposit of money in a bank is a bailment, in which case the bank acts as a custodian of your money (like a warehouse or storage facility); or, the deposit takes the form of a loan to the bank and the bank is simply your debtor. In the former case, you retain proprietary title to the money and it is ring fenced from the bank’s own assets. If the bank goes bust then its creditors cannot get their hands on your money. Your bank statement is not a statement of account but, rather, an inventory of property deposited in the bank for safekeeping. In this scenario, but for one important qualification that we will mention below, the statement of account (or the warehouse ticket for gold deposits) is defined as the cash on deposit – in other words, it is the same thing. That is why people accepted paper tickets in trade when they were titles to gold. These transactions are not payments of money at all; they are transfers of the bank’s obligation to redeem cash on demand from one person to another. Because the obligation to pay is a full, proprietary title the transfer of this obligation is as good as the cash itself. Under this banking arrangement, fractional reserve banking would be fraudulent. If the bank loans out the money to a third party then it is required to grant full proprietary title over the money to the third party debtor in exchange for a promise to pay back the sum lent once the maturity date of the loan is reached. But the bank cannot legally divest itself of a title that is not in its possession. In essence the bank would be selling property which it does not own. It is exactly the same as me purporting to sell your house or your car to someone else and pocketing the cash – or a storage warehouse loaning out the furniture that you have deposited there for safekeeping. In practice, what happens is that the bank creates two simultaneous titles to the cash on deposit – one for you as the original depositor and one for the borrower. Both of you are under the delusion that you have exclusive title to the cash on deposit whereas in reality it could be claimed by the other person. In the second case, however, where the deposit takes the form of a loan to the bank, if this is agreed and understood by both parties in a genuinely free legal and regulatory environment then all well and good – there is certainly no breach of the non-aggression principle for libertarians to complain about. If the bank goes bust with it goes any claim to your money. However, one important aspect is that what is now in the depositor’s possession – a mere promise that you will receive payment in cash on demand rather than a full, proprietary title to cash – is a markedly different good from cash or a proprietary title to cash. Hence, we are now talking about two different goods – money on the one hand and a loan agreement on the other, something that is below the quality of money as the most marketable commodity. While it therefore may be a perfectly legal arrangement and people may be able to trade these loan agreements in exchange for goods and services (as we do today when we make electronic transfers) we would expect a loan agreement to trade at a discount compared to real money. Should this be doubted, even under full reserve banking the paper ticket to warehouse deposited gold was regarded as a distinct commodity by the trading public; when gold coins were stamped with a dollar value equal to the dollar value of a paper ticket, even though redemption of that paper ticket would guarantee payment of the same dollar value in coin, Gresham’s law came into effect and the paper tickets were traded while the coin was hoarded1. Under a system with genuine market pricing, therefore, we would expect warehouse receipts to gold to trade at a discount compared to real gold. If this is so then clearly loan agreements – far less secure than 100% warehouse receipts – would trade at a discount even lower than this.

All of this would be fine from a libertarian point of view and nobody can stop anyone else from accepting loan agreements freely in exchange for goods and services if that is what they want. The problem with today’s banking system, however, is that there is no genuine choice between these two arrangements. The fact that in today’s world “everybody” uses fractional reserve banks and “everybody” generally accepts mere loan agreements in settlement of debt without a premium does not mean that this arrangement has the full, unbridled consent of the public. First, legal tender laws force the public to accept as payment the government’s own monopoly brand of money and are unable to consider alternative media of exchange. Second, under the guise of “anti-money laundering” (in other words to try and stop drug traders, “terrorists” and other underground operations that are of the government’s own creation) the legal and regulatory regime has all but abolished cash transactions of any significant quantity, thus forcing people to direct their financial needs through banking institutions. Third, government schemes such as the Financial Services Compensation Scheme in the UK or Federal Deposit Insurance in the US (which basically means that the taxpayer is forced to foot the bill if the bank loses your money) provide a positive incentive to use these banking institutions and prevent either the hoarding of cash by the public or any “maverick” banker from splintering away and establishing a full reserve bank2. Fourth, these institutions have been completely cartelised under the aegis of the central bank, meaning that the only institution available for people to use for their banking amounts to little more than a single, fractional reserve bank splintered off into different brand names such as HSBC or Barclays in order to give the illusion of competition in the banking industry. Indeed, the force of government, either in the form of direct enforcement of fractional reserve banking or by forcing the taxpayer to bail out the consequences, has always been required to sustain the practice for any extended period of time as genuine competition between freely standing banks has always restricted their ability to issue large quantities of unbacked notes. The precise effectiveness of this point is debated between “Austrians”. The Mises-Rothbard orthodoxy emphasises that competing banks will swiftly call upon each other for redemption in the event that one bank takes possession of another’s notes. For example, if I deposited gold at Bank A and received for it a paper ticket stating that I had gold deposited in Bank A, I could use this paper ticket to buy goods and services from, say, a grocer. But if the grocer banks at Bank B, he will deposit my note from Bank A with Bank B, but Bank B will call upon Bank A to redeem its note in gold. Hence Bank A would be restricted from over issuing unbacked notes as whenever they fell into the hands of the customers of other banks those other banks would call upon Bank A for redemption in gold. Mises, moreover, also emphasised that the bank’s reputation with its own customers for being able to meet redemption on demand was a decisive limit upon the expansion of unbacked notes3. However, when all banks are issuing the same notes everywhere, with all gold deposited centrally in a monolithic bank (or no gold at all, as under our current regime) then this clearly isn’t possible and all banks would be able to expand together in concert. Later writers, however, have pointed out the importance of interbank lending in neutralising the effectiveness of banking competition, with banks that have over-issued notes borrowing from banks that are under-issued in order to meet redemption demands. In other words banks will not necessarily call upon each other for redemption and will seek instead to earn an interest profit through mutual lending4. However, all we need to conclude here is that people today do not have a genuine choice as to whether they should meet their financial needs through fractional reserve banks. We can, though, still see the difference between payments in cash and other methods of payment in certain limited circumstances. Debit and credit card payments are inherently less secure than hard cash and the risk to the merchant is that the card issuing bank will not honour the transaction after the customer has left with the goods – in just the same way as a deposit bank may be unable to honour a paper ticket to warehouse deposited gold. Acquiring banks and card issuers therefore levy a charge upon merchants in order to guarantee – or at least improve – the security of the transactions and some merchants pass this charge on explicitly to their customers as an additional fee. This results in two prices – a lower price for payment by cash and a higher price for payment by card. It is reasonable to assume also, therefore, that given a genuine choice people would also regard hard cash and deposits in fractional reserve banks as distinct goods of different value. Finally, if the lack of genuine consent of the public in using fractional reserve banks should be doubted, then try asking any banker whether he would be prepared to look his customers in the eye and tell them their money is not really in the bank. The experience of the present author suggests that this is enough to close a debate on the matter with bank employees who actually know how the system operates.

All of this suggests that people do not wish their banking arrangements to be managed with fractional reserves, given a genuine choice. Indeed the entire backbone of Mises’ thesis in The Theory of Money and Credit is that money and what he called “fiduciary media” (notes issued unbacked by gold) are distinct concepts and where people trade fiduciary media at a par with money or backed notes they only do so because they believe that they are not fiduciary media and are, instead, fully backed notes with redemption on demand all but certain. Something to pull the wool over the public’s eyes is needed in order to achieve this. In our world today it is the force of government sustaining fractional reserve banking and compelling people to use it which is the illegal and immoral element. This should be the focus of libertarians in their moral opposition to its practice.

Fractional Reserve Banking and Economic Instability

In addition to the moral element concerning fractional reserve banking, the practice in the way it is carried out today is also economically destabilising. As we know from “Austrian” Business Cycle Theory, the creation of credit that is not supported by any real saving forces the economy onto a path of malinvestment that must collapse once the credit creation stops. Fractional reserve banking is the primary method through which this credit creation occurs. Nevertheless, once again this issue is intricately connected to the legal and regulatory framework in which fractional reserve banking operates and it is this factor that will be emphasised in the treatment below.

Let us posit a first scenario where banking consists of deposits of gold and precious metal in exchange for paper warehouse certificates, certificates that are a legal title to money and do not represent merely a loan to the bank that would permit the latter to do with the gold whatever it likes. If, therefore, A deposited 100oz of gold in a bank the bank would issue a 100oz paper ticket to A and the gold would remain locked up in the bank’s vault ready for A to come and collect at a point in the future when he deems fit. In this instance 100z of gold in the economy has been replaced by a warehouse ticket to 100oz deposited in the bank When this ticket is used and accepted in trade it is “as good as gold” and people will trade the paper as though it was gold, although, as we noted earlier, with the possibility that it may trade at a minor discount compared to the real thing. At this point, the money supply has not altered; rather 100z of money proper has been replaced by a 100z “money substitute”. In this environment, if the bank engaged in fractional reserve banking it would print new paper tickets which represent full, legal titles to gold without any corresponding increase in gold on deposit in its vault – in other words, pure fiduciary media, in Mises’ terminology. Let’s say that the bank lends an unbacked 100oz ticket to a borrower, B. There is now, therefore, 100oz of gold deposited in the bank but 200oz of paper tickets that can be exchanged in trade. The supply of equally homogenous money substitutes that are deemed to be as good as money and are traded as money has therefore doubled. This method of fractional reserve banking (which, we might recall, is also the fraudulent one) will therefore cause economic instability and lead to the business cycle as it has channelled a new supply of money unsupported by real saving through the loan market. The new supply will lower the interest rate on money and will incentivise borrowers to invest in longer term investment projects than are sustainable under the pool of available savings5.

Let us now examine a second scenario where banking does not consist of deposits of gold and precious metal in exchange for paper warehouse certificates but, rather, gold is deposited on loan to the bank that is redeemable on demand. The money is legally the bank’s to do with whatever it likes but the lender may call for redemption at any time, taking the risk that the bank may not have sufficient reserves to meet the redemption. Furthermore let us assume that this arrangement is entirely voluntary and agreed to, with no government impetus or the force of law compelling its use. If A therefore makes such a loan of 100oz to the bank he will receive a paper ticket or a statement of account stating that he has loaned money to the bank that is redeemable on demand. A may be able to trade these “loan agreements” either in paper ticket form or electronically – either way it doesn’t really matter as both would be a transfer between individuals of the bank’s obligation to pay. 100oz of gold has been deposited in the bank and a 100oz loan agreement has been released into the economy. If the bank now engages in fractional reserve banking and makes a loan of 100oz to B by creating out of thin air another paper ticket (that in and of itself constitutes only a loan agreement and not a proprietary title to hard money), we now have 100oz of gold still in the bank but 200oz of paper loan agreements to gold issued in the economy. On the face of it, it would again appear as though the money supply has expanded through credit creation. Wouldn’t this lead to economic instability and ultimately to the business cycle? However, this is unlikely to be the case. For the crucial aspect in starting the business cycle is that the interest rate on money is lowered through people’s inability to perceive money that represents genuine savings and money that has been created out of thin air. In this case, however, it is possible to distinguish between money proper and mere loan agreements to money that are redeemable on demand. An expansion of the latter does not lead to an expansion of the former. While the “interest rate” on the loan agreements may fall as a result of the their expansion, so too would their discount compared to money proper as the increasing abundance of these loan agreements makes the security of redemption less likely. The effect of the increased discount would be raise production costs to borrowers which would offset the reduction of interest rate and prevent the business cycle from occurring.

Let us now fast forward to the situation that we have today. Now, the paper ticket itself has replaced gold as the item that is deposited and as we stated above everyone is either forced or cajoled into using fractional reserve banks under the aegis of a single, central bank. The expansion occurs through the increasing of deposit balances on account – i.e. the numbers on your bank statement. If you deposit £100 worth of Bank of England notes in your account you can transfer the bank’s obligation to pay electronically. If the bank then creates a loan out of thin air by creating another deposit account, both you and the borrower then have the ability to spend these digits in the economy. But, unlike the difference between money proper and mere “loan agreements” that was plainly obvious in the second scenario we explored, here, nobody knows which of the digits being spent represents genuine savings and which have been conjured out of thin air. Hence, the interest rate on money will fall, longer term investment projects will be stimulated and the business cycle begins with its “boom” phase.

It could be alleged that the inherent instability of this arrangement could be countered with the “prudence” of the banker – the idea that an expert fractional reserve banker will be able to loan wisely to only those borrowers who are most trustworthy and will keep on hand enough reserves to meet redemption requirements. This is beside the point. Apart from the fact that it is the least prudent bankers and borrowers who post the highest profits during the boom phase, leaving any conservatives way behind, the fundamental problem for economic stability is that no inter-temporal transaction has occurred – in other words there has been no a trade of present goods for future goods. In normal saving and lending, in order to make loan to the borrower for, say, one year the lender must save for a year. The lender in this instance has given up consumption for one year and freed real resources in the economy to the borrower so that the latter may use these resources in an investment that will come to fruition at the maturity date of the loan in one year’s time, allowing the borrower to pay back the loan to the lender so that the lender can then purchase consumption goods that have come into existence as a result of the borrower’s year-long investment. This is what makes real, sustainable economic growth possible – the harmony of temporal interests over goods between those with short time horizons and those with long. With fractional reserve banking, however, no such harmony exists. The lender – that is, the depositor – does not want to relinquish consumption for a year. He maintains his cash balance in a demand deposit account because he wishes to call upon those funds for current consumption and not consumption in one year. He may, of course, leave the funds in his deposit account for a year but the crucial point is that at the outset this is not certain – he wants to be able to call on consumption goods at a moment’s notice when the time arises. The borrower, however, wants goods that he can invest for a yearlong production process, tying up those goods for that duration until the project comes to fruition. He cannot accept goods that someone else will want back in a shorter time. It is clear that both individuals cannot have their way and that one or the other must ultimately triumph because the same resources cannot be simultaneously consumed and invested. During the boom phase when credit expansion rises, it is the borrower who wins as his increased purchasing power allows him to purchase the resources and invest them in capital goods – hence there is, during the boom phase, a marked price inflation of capital goods as these borrowers take advantage of their newly found purchasing power and a relatively weaker price inflation of consumer goods as the latter become more scarce relative to the demands of consumers. Once the credit expansion stops and starves the borrower of fresh purchasing power, however, it is the lender’s preferences that rule the roost. Either the lender must be prepared to start saving and thus provide the resources to complete the borrower’s investment projects; or, if he is not so prepared and maintains a preference for consumption, then the borrower’s investments must be liquidated. Hence, in the bust phase we experience a heavy price deflation of capital goods as they are hastily sold off and a weaker, relative price deflation in consumer goods buoyed up by the fact that these goods are still in demand.


What we can see from all of this is that the destabilising effects of fractional reserve banking on the one hand and its illegal and immoral aspect on the other are two sides of the same coin. The fact that people do not know which units of currency in existence represent real, genuine savings and which have been conjured out of thin air as fiduciary media is the essence of both the fraudulent  and destabilising nature of fractional reserve banking. The government in bed with a monolithic banking system pulls the wool over everyone’s eyes for their own enrichment at the expense of wasteful malinvestments during booms, followed by unemployment, misery and taxpayer funded bailouts during busts. It is high time that the public realised the true nature of their fractional reserve banking system and anyone who cares for liberty is right to emphasise its odious nature.

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1As Ron Paul has suggested, it was this that resulted in a withdrawal of gold coin from circulation and its concentration as deposits in banks that made it easier for governments to confiscate them. It is for this reason that both Paul and, earlier, Mises urge the need for gold coins to be used physically in transactions. See Ron Paul, “The Political Agenda for the Real Gold Standard”, Ch. 7 in Llewellyn H Rockewell, Jr. (ed.), The Gold Standard – Perspectives in the Austrian School; and Ludwig von Mises, The Theory of Money and Credit, Part Four, Chapter III, “The Return to Sound Money”.

2We can also suggest that, as per Ron Paul’s analysis cited in note 1 above, that as electronic transfers and paper notes bear the same legal value, Gresham’s law comes into effect and the paper notes are stashed away in banks while electronic digits are traded.

3Ludwig von Mises, Human Action, The Scholar’s Edition, p. 436.

4See, for example, Nikolay Gertchev, “The Inter-bank Market in the Perspective of Fractional Reserve Banking”, Ch. 10 in Jörg Guido Hülsmann (ed.), Theory of Money and Fiduciary Media – Essays in Celebration of the Centennial.

5This expansion of credit is not likely to last for very long in a competitive banking environment that lacks deposit accounts. Not only, of course, could overexpansion call for redemption of the overissued notes in specie, but soon the economy would clearly be awash with paper tickets which reveal that something is amiss. Central banking, abolishing competition, would be needed to sustain the expansion of note issue and electronic transfers between deposit accounts would be needed to hide the expansion from plain sight. Ironically, therefore, monetary expansion or “printing money” these days involves a contraction and not an increase of circulating paper notes. As a note of historical interest, Peel’s famous Bank Charter Act of 1844 failed to control economic instability because, following the otherwise insightful Currency School of thought that was prevalent at the time, it concentrated only on banknotes and overlooked the role of deposit accounts in expanding the money supply.