“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.


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.

Money – the Root of all (Government) Evil?

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In addressing the evil and parasitic nature of the state, libertarians focus on many of the state’s specific characteristics in order to demonstrate its destructive effects upon civilisation – whether it is nationalised industries, market interference, the minimum wage, anti-discrimination and egalitarian pursuits, the business cycle, or whatever, there is a treasure trove of libertarian literature available that explains and elaborates the deleterious effects of these particular state endeavours. However, a less addressed question is which of these areas, if any, are the most important? Which of them amount to mere nuisances that can be circumvented or otherwise put up with and which, if any, of them amount to a significant transfer of wealth and power to the state with seemingly permanent effects? Furthermore, is there any one issue that libertarians should stress above all others if we are to deliver a real and significant puncture to the state’s ever-inflating balloon?

One prime candidate for this title is war and international conflict. With war comes every glittering prize that the state could ever dream of – mass mobilisation of labour and industry towards a common purpose dictated by the state; control of all markets; mass propaganda; control of communications; suspension of free speech and possibly of habeas corpus; and not to mention the bogeyman of the supposed enemy to which to channel the attention and hatred of the average citizen. Indeed Murray Rothbard, relatively in his career, recognised that while libertarians had some very profound things to say about the state’s mismanagement of, for example, the post office, focussing on war was the real key to unravelling the state’s power and oppression of the population.

Nevertheless, while a permanent and lasting degree of state power and control is enabled by war there is another contender for the top spot. That is the government’s control of money and, specifically, the ability to create an endless supply of paper money distributed to itself and its favoured outlets, as opposed to the rigour and discipline imposed by a “hard money” standard such as gold. Ultimately it is the state’s ability to fund itself that is at the root of all of its other absorption of power and control – even war.

In order to demonstrate this let us look at what the situation would be if government was constrained by a denationalised, “hard” money such as gold. In the first place, government would be wholly reliant upon the tax receipts of its individual citizens for funding and would be unable to resort to extensive deficit spending or inflation. The plainness and visibility of that confiscation places a much lower limit upon the state’s coffers. Put simply, when too much money is taken out of your hands physically you are likely to revolt much sooner. Indeed, in the past, war itself was an expensive operation and battling kings often struggled to raise funds to maintain campaigns. Strategic brilliance was often not accomplished by an all-out destruction of the enemy but, rather, by out-manoeuvring your opponent and preserving for as long as possible expensively-trained soldiers and equipment. In many cases funding had to come from external sources. The genesis of the aristocracy was in those who were rewarded with titles to the conquered land in return for funding the war – in other words the ruler had to parcel out parts of the new territory to those who had helped him grab it. Indeed even the English parliament itself and the Magna Carta­ – famed as the genesis for two cardinal principles of liberty, no taxation without consent and no trial without due process – resulted in part from the reliance of the king upon his relationship with the barons for support and funding. Hard money therefore not only physically restricts the amount the state can spend but has been the indirect cause of the enshrinement of restrictions upon the state’s despotic power.

In more recent times, however, the ability to provide funding from a non-stop printing press has permitted the state to expand its activities without having to account for them through tax receipts. People do not see the money disappearing from their pay packets or from their bank accounts; all they see is the prices they have to pay for goods and services rising and squeezing their purchasing power, a fact that can be easily blamed on greedy businessmen and shareholders. It is possible for a libertarian to be sympathetic with the view that as long as you know how much the government is taking from you then it has a reasonable degree of tolerability. But when government resorts to the smoke and mirrors trick of robbing not the money in your hand but, rather, its purchasing power then it must be opposed emphatically. In comparison to earlier conflicts, the wars of the twentieth century were so prolonged and destructive precisely because government could resort to the printing press. Had they relied solely upon tax receipts “war-weariness” would have set in much sooner among the population and they would have demanded a swift end to hostilities. Hence all of the overreaching effects of the state’s engagement in war flows directly from its ability to control the supply of money. If we wish to end the consequences of war upon the state’s metastasised growth then we need to attack the root of its ability to fund it.

It is true, of course, that there may be something of a chicken and egg story when it comes to war and paper money. Does paper money cause government to engage in war or does war cause government to print paper money? Either way, however, even if government was previously respectful of a hard money standard which it does not abandon until the outbreak of a war, it is this power of printing paper money in and of itself that fuels the extent of its belligerence. And in any case, the ease with which government can suddenly suspend a hard money standard only comes about because they have arrogated to themselves monopolistic control of the operation of money issuance. It would be much harder for government to print un-backed notes and force their acceptance when others are issuing notes fully redeemable in gold. Whatever comes first, however, either the paper money or the war and the growth of the state power, if you wish to prevent the flood then you must turn off the taps.

In more peaceful times hard money also disciplines the citizenry into realising that government is not the fountain of all wealth. The state has grown so much under democracy because, apart from the veneer of legitimacy that popular elections lend to the state, politicians are able to bribe the electorate with endless goodies that they do not believe that they have to pay for. The resulting borrowing and inflation – now reaching an eye-watering level in the West – which does not touch the citizen directly gives the impression of government as an endless stock of resources, the only difficult task being to elect someone who will give them to you rather than worrying about the more trifling matters of production and enterprise. Indeed, public discourse rarely seems to acknowledge the fact of scarcity, usually focussing on single issues and concluding with an explosion of outrage about how government isn’t “doing more” to combat the alleged societal ill. The more difficult question of the expense that we would endure, what should be given up as a result and which goods cannot be brought into being because of the new expenditure diverted to cure the problem complained of is overlooked. To the citizen there is always more money, more resources and more of everything that government can acquire from somewhere other than himself. However, in exactly the same way as a hard money standard would induce “war-weariness” in belligerent times so too would it induce “state-weariness” in peaceful times. People would soon tire of having their pay packets robbed to fund goods for other people; and people would soon realise that many of the things they would otherwise want from government for free simply cannot be afforded and must be worked for by themselves.

Let us turn next to the whole problem of the business cycle. Although panics existed before the advent of modern central banking many of these occurred precisely because hard money rules were casually abandoned, with issuing institutions expanding the volume of credit beyond the stock of monetary gold and government happily stepping in and relieving them of the obligation to redeem their notes in specie. But whatever the characteristics of pre-central banking business cycles it is undeniable that they reached a depth, severity and prolongation in the twentieth century that was not seen before. There are two reasons for this. First, government’s enhanced control over the supply of money induces a more serious degree of malinvestment than would otherwise be the case where the supply of money is checked by the stock of redeemable gold. In both of the biggest collapses of the last one hundred years – 1929 and 2008 – credit expansion ran for the best part of a decade or more. The longer the false signals towards entrepreneurs are continued the more they will borrow and invest in unsustainable capital projects and the further those projects go the more difficult they will be to unwind. When the bust finally comes, therefore, the situation is far more serious than it otherwise would have been. This brings about the second factor – that it lends credibility to the argument that the government should step in and “do something” to combat the malaise. The reason why the Great Depression endured for years (and why we are still enduring the current one) is not because of the initial collapse – it is because government did everything it could to maintain the existing structure of production, wages and prices. Fittingly enough President Hoover often invoked the language of war in describing the threat of the downturn and the culmination of this in the New Deal – the complete cartelisation of industry and agriculture into a fascistic economy – was achieved by the resurrection of World War One era departments and programmes. It is supremely ironic that government-caused depressions give rise to ever more invasive government intrusions, an irony that turns truly into tragedy when we consider that what followed the Great Depression was the carnage and destruction of World War II. With the current belligerence of the US in provoking tension with Russia and China another war is something that cannot be ruled out as a result of the present crisis; and we all know how destructive war is to freedom.

What we can see therefore is that government control of money is a prime contender for the top spot of issues that libertarians should consider as the most serious when combatting threats to liberty. If this should be doubted then one has to question why the mystery of central banking and its ability to pull the monetary strings from a shady, secretive outlet has been a political non-issue for decades. Politicians only bring into debate the relatively “easy” problems that do not upset the apple cart. While they are keen to oust their immediate, political opponents they never provide the public with any serious choice that would restrict the power and growth of government as a whole. At least democracy – another cause of government growth and legitimacy – gets praised and lauded from time to time, if only ever to justify the government’s military crusades against foreign tyrants. But before the last few years central banking and monopoly issuance of money was hardly even mentioned – not even to give it a blessing. It seems as though government is fine with brainwashing its citizens into embracing the justice of elections by voting but it is far too scared to even make them aware of its power over money. Although this is now beginning to change and there is a greater enquiry into and scrutiny of the US Federal Reserve (not least because of ex-Congressman Ron Paul’s emphasis of the issue) the acceptance of and absence of discussion of these evil institutions has pervaded for too long. This is where government would be truly and irredeemably hurt. It could enact as many reams of invasive and destructive legislation as it liked, yet they would be of zero threat if government was starved of funding to enforce them.

It is appropriate to end with the words of Ludwig von Mises who recognised everything we have been saying here in his first major treatise on the subject of money:

Defense of the individual’s liberty against the encroachment of tyrannical governments is the essential theme of the history of Western civilization. The characteristic feature of the Occident is its peoples’ pursuit of liberty, a concern unknown to Orientals. All the marvellous achievements of Western civilization are fruits grown on the tree of liberty.

It is impossible to grasp the meaning of the idea of sound money if one does not realize that it was devised as an instrument for the protection of civil liberties against despotic inroads on the part of governments. Ideologically it belongs in the same class with political constitutions and bills of rights. The demand for constitutional guarantees and for bills of rights was a reaction against arbitrary rule and the non-observance of old customs by kings. The postulate of sound money was first brought up as a response to the princely practice of debasing the coinage. It was later carefully elaborated and perfected in the age which—through the experience of the American continental currency, the paper money of the French Revolution and the British restriction period—had learned what a government can do to a nation’s currency system.


Thus the sound-money principle has two aspects. It is affirmative in approving the market’s choice of a commonly used medium of exchange. It is negative in obstructing the government’s propensity to meddle with the currency system.

The sound-money principle was derived not so much from the Classical economists’ analysis of the market phenomena as from their interpretation of historical experience. It was an experience that could be perceived by a much larger public than the narrow circles of those conversant with economic theory. Hence the sound-money idea became one of the most popular points of the liberal program. Friends and foes of liberalism considered it one of the essential postulates of a liberal policy1.

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1 Ludwig von Mises, The Theory of Money and Credit, p 414.


Economic Myths #2 – Consumption Boosts Growth

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The belief that economic growth is boosted by consumption is based upon such a simple misunderstanding that a realisation of the truth will cause one to question why such a simple fact evaded you in the first place.

The confusion is based on a conflation of the desire to consume on the one hand with the act of consumption on the other. It is true that all economic growth, and all economic activity, is motivated by the desire to achieve consumption – in other words, to devote scarce resources in order to satisfy our most highly valued ends. Without any desire to consume or to satisfy any ends there would never be any economic activity whatsoever. The act of consumption, however, does not in and of itself fuel any economic growth. For consumption is the result of growth – i.e. of increased production – and not the initiator. Consumption is what we reward ourselves with once we have achieved growth and not that which we do in order to begin it. Stated in its simplest way you cannot consume a good unless it has first been produced.

At any one moment in time there is an array of produced goods available to us. Each of us faces a basic choice as to what to do with these goods – consume them now, or turn them into productive capital goods that will yield a greater output of consumption goods in the future. If we choose the first path – consumption – all we do is reduce the number of goods available to us and we are left with less. We may have achieved immediate satisfaction but we now have fewer resources left with which to produce more in the future. If I burn a log of wood to keep warm I cannot then use it as building material later. Rather it is gone forever and I will now have to labour in order to search for fresh building materials if I am to make good this loss. A farmer who decides to eat the seeds for crops in the spring will then have nothing to sow and come harvest time will have barren and empty fields rather than lush acres full of wheat. Beyond the point of providing nourishment and sustenance to the human body the act of consuming of these goods will not provide any growth. Consumption, for the most part, is the destruction of what we have. Growth is the transformation of what we have into something that will produce more for us in the future. If we choose the second option – that of turning our goods into productive resources – rather than destroying the resources available to us we will invest them in productive enterprises that raises the yield of consumer goods in the future.

The key to promoting growth, therefore, is not to encourage the act of consumption which equates with an act of destruction. Rather it is to encourage production and a direction of a greater proportion of our resources available today towards saving and investment so that we may consume more in the future. This is particularly important following a bust that results from a boom or bubble inflated by credit expansion. With so many malinvestments left starved of resources the best thing we can do to minimise the pain is to increase the proportion of saving and investing so that at least some of the doomed projects may realise a degree of viability. Instead our economic lords and masters do the precise opposite and encourage us to borrow, spend and consume which only exacerbates the losses experienced by those projects that were started in the boom. Growth must begin with saving, sound investment and production which is then rewarded by greater consumption. Consumption will never lead to growth and it is important for Austro-libertarians to point out this grave fallacy.

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Executive Pay

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Within the firing line of public vitriol, particularly since the 2008 financial crisis, is the issue of executive remuneration, the rewards and incentives paid to executives and directors of large corporations in return for their productivity. Specifically, of course, we mean remuneration that is deemed to be excessively high in relation to the resulting output that these rewarded executives create. Needless to say the level of remuneration in the financial services sector – the proximate cause of the seemingly endless depression we are enduring currently – has been singled out for its apparent injustice. Why should executives, motivated by their greed and lust for riches, get to walk off with pots of gold when they are responsible for so much entrepreneurial failure while the rest of us are left to suffer job losses, redundancies and unemployment? Indeed there is even the accusation that executive remuneration is the primary cause of the financial crisis, fuelling the fire of so-called “irrational exuberance”.

There are many typical free-market responses to this sort of criticism – that high levels of remuneration are simply a function of supply and demand; that talented bosses would just go elsewhere if a firm did not offer competitive remuneration, and so on. Indeed, many of the same responses are made to criticisms of egregiously low pay in developing countries and the call is always to leave things alone and let “the market” determine the figures. While this is all true, it is only so in a genuine free market and not in the heavily managed and distorted economy with which we are cursed today. It is only by analysing and understanding the influences on wage rates in the economy as it actually exists that we can propose any solution, should one be needed. To simply dismiss the problem leaves it vulnerable to alternative (and false) explanations that lead to the danger of equally false solutions. Indeed, one of these current incorrect analyses is that there is a natural (rather than a deliberately engineered) tendency for the rich to get richer while the poor get poorer, with all economic development fundamentally being a struggle of rich against poor. As libertarians and “Austrian” economists we must examine the root causes of social phenomena and not assume that everything is alright simply because the proximate social relations appear to be voluntary. Let us, therefore, proceed with this task.

Theoretically, executive remuneration is no different from the remuneration of every other type of employee – all workers, from bosses to bin men, earn their marginal revenue product. Bonus payments, an aspect of executive remuneration that seems to particularly grate in the public mind, can even save a firm money in a given year. A firm might agree to pay an executive a £1m bonus if and only if he achieves £1m or more worth of productivity; if he delivers £0-£999K worth then he gets nothing; if he delivers £2m worth then the firm is paying only £1m for double that amount in net income. In both cases the firm receives a level of productivity without having to make a corresponding pay out. However, this idyllic description is not the situation in the economy where the government distorts price signals, causing the delivery of false income during the boom years only to have it all come crashing down at the bust. The basic problem with executive pay lies in understanding the influence of government credit expansion on the economy, and particularly on the financial services sector.

The starting point of the business cycle, as understood by “Austrians”, is the expansion of credit and the lowering of the rate of interest. Not only does this falsely incentivise all firms to enter longer term investment projects but, crucially, this new money enters through the financial system. It is, therefore, the firms most closely connected to the source of new money – large banking and investment operations – that will experience the largest distortionary gains first. Hence, remuneration in these firms will rise fastest and strongest, in line with the false profits made from all of the doomed loans and investments that they happily make in blissful ignorance. Everything at this point looks fine, executive remuneration for apparently successful operations going without mainstream criticism. Yet, once the taps are turned off and the flow of new money dries up, the bust sets in and it is exactly those same firms that benefitted the most in the boom – those closest to the source of new money and ploughed it into unsustainable assets – that have the most to lose. Indeed it is no exaggeration to say that the entire financial system would have collapsed in 2008 had central banks not intervened to prop up asset prices and hence keep financial firms nominally solvent. Executive pay, therefore, is not a cause but merely a symptom of a deeper, underlying problem that is caused by governments and central banks. Anticipation of higher profits does not appear because executives are paid more; rather, it is the false anticipation of future profits caused by the distortions of credit expansion that leads to rising executive pay.

This is not the end of the matter however. For the very same problem – credit expansion – produces an endemic and seemingly endless price inflation, price inflation we are told is the natural consequence of growing economies. Indeed central banks even maintain price inflation targets (the Bank of England’s being 2%) as a result of the false (or perhaps dishonest) impression that price inflation is required for economic growth. The result of this is that anyone who holds cash for an extended period of time can watch the real value of their wealth diminish. This has several important impacts upon the financial services sector. First, companies opt to switch from equity financing to debt financing as it is cheaper, in real terms, to fuel growth through servicing a loan rather than from revenue reserves. Secondly, the need to hold appreciating assets rather than depreciating cash has meant that the average saver – i.e. someone who wishes to put money away for retirement – now has to invest in stocks or bonds rather than simply save cash. Indeed it was once possible to fund one’s retirement simply by hoarding gold coins, the coins appreciating in real value through a gradual price deflation caused by increased productivity. Now, however, everyone has to entrust their hard earned savings to money managers and speculators who, having taken a fat percentage cut, will probably be barely able to keep up with price inflation anyway. Both of these aspects cause a vast swelling of the demand for financial services and, consequently, an increase in executive pay in that sector.

The latter aspect, however – that of investing in order to fund one’s retirement – also has another important consequence. Executives serve their shareholders and are employed to meet the needs of those shareholders by “executing” the purpose for which the shareholders formed the enterprise. They are the delegates, the servants of the shareholders and their scope of activity and their remuneration for the same is bound by that which the shareholders desire. Taking a part ownership of an enterprise as a shareholder, therefore, is an important and active responsibility, one that requires the focus of one’s attention and is not a mere hobby or pastime. It was once the case that most companies and corporations were privately owned by a handful of active investors rather than publically traded on stock exchanges like they are today. Yet, because of the necessity to invest one’s money to keep a pace with inflation, we are now in the position where the majority of beneficial owners of businesses are passive investors, merely entrusting their money to a fund manager who will spread it across a vast array of businesses – probably following an index of shares such as the Dow or S&P 500. The result of this is that there is no one keeping an active eye on executives, or at the very least the capacity for doing so is greatly diminshed. Indeed, the most popular base index for tracker funds in the UK – the FTSE All-Share Index – is comprised of around one thousandcompanies. No single beneficial owner of the companies in that fund can hope to maintain a keen interest in even a significant minority of those organisations. With executives left alone to run the shop entirely, their ends begin to take precedence over the ends of shareholders. The primary preoccupation of the latter is to grow, sustainably, the capital value of the business, investing assets in productive services that meet the needs of consumers. Executives, however, are mere “caretakers” of those assets who can derive a gain from the enterprise only so long as they are in charge. Not only, therefore, will they have the incentive to increase present income as fast as possible at the expense of long term capital growth, but they will attempt to milk the business as much as possible for all they can get during their tenure – the primary method of doing this being through their remuneration packages. This incentive is always present in any business of course, but the lack of shareholder oversight presents an enhanced opportunity for it to be fulfilled. Indeed, most boards – who, nominally regulate the activities of the executive on behalf of the shareholders – are usually made up of other executives in the same or related industries and will, therefore, largely defer to and be empathetic towards the management rather than the shareholders. This is not to imply that executives are only looting businesses for all they can get. There are, of course, many brilliant and competent managers who richly deserve their rewards for growing, sustainably, complex and important operations that serve the needs of consumers. However where all other outcomes are equal and it comes to a basic choice between maximising long term growth on the one hand and increasing present income on the other we can see quite clearly that executives will plump for the latter. Some attempt has been made to rectify the situation by paying bonuses in shares or options and creating longer-term incentive plans – in other words, turning bosses into part-owners – but it does not remove the fundamental problem which is the lack of keen oversight from the beneficial owners.

What we have learned therefore is that excessive executive remuneration, especially in the swollen financial services sector, is not a cause of financial collapse but merely another unhappy consequence of underlying problems – that of government and central bank interference in the economy through meddling with the rate of interest and expanding the volume of credit. If we want to return to executive pay that accurately reflects the creation of long term growth in sustainable businesses then we need to do away entirely with government interference and establish a genuine free market economy.

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Time Preference and Human Action

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The role of time preference in human action can be a difficult subject to grasp correctly. This essay will seek to resolve some common misunderstandings that are essential before one can consider the full implications of the concept in economics. First of all we shall attempt to correct a few particular errors or myths before explaining the true, praxeological foundations of time preference.

Classes of Goods

The first misunderstanding we must address is that the concept of time preference is nearly always expressed with the statement “present goods are more valuable than future goods”. However such a formulation is only shorthand at the very best as it violates some well accepted and understood truths with which “Austrians” are well acquainted and have no difficulty in applying to other concepts. Humans do not have any relation at all to whole categories of goods in their physical embodiment – all of the gold, all of the iron, all of the bread in the world and so on. Rather, humans only act in relation to specific quantities, or units, of goods in order to meet their ends and it is these specific quantities to which value is imputed. Hence the so-called paradox of value – i.e. why a diamond, a seemingly trivial ornate luxury, is more expensive than a bottle of water, which is essential for life – was solved after having confounded the classical economists. The categories “present goods” and “future goods” are precisely this kind of holistic, indiscrete and meaningless concept that has no relevance to action. No human ever acts in relation to all of the present goods in the world, nor to all of the future goods. Rather, we have to examine the precise circumstances in action from which this shorthand derives.

Present Ends and Future Ends

Secondly we must realise that an understanding of time preference cannot come about from any comparison of present ends with future ends, that is, ends that must be met now compared to ends that must be met at some point in the future. Economic laws are only true when they conform to the ceteris paribus rule – that all else is equal. In understanding an economic phenomenon, it is necessary to hold all independent variables constant and to alter only the dependent variable under examination. With time preference, the variable under examination is goods, the means used to extinguish an end, and more specifically the time at which they become available. In testing this variable and making alterations to whether a good takes effect in the present or the future, the end itself, another variable, must remain constant. To talk of present ends and future ends in trying to understand time preference, however, is to make an alteration to a variable other than the one that is under examination. It is to change both the nature of the good and the nature of the end simultaneously, the equivalent of trying to understand the effects of an increase in the quantity demanded while also varying the quantity of supply. If demand was to rise beyond the valuation of the marginal buyer yet supply was to rise beyond the valuation of the marginal seller at an equal rate then price would, all else being equal, remain constant. One would derive from this the conclusion that an increase in demand has no effect upon price, which is clearly incorrect. With time preference, therefore, the examination is to determine the difference between the ability of a present good and a future good to satisfy the same end.

To elaborate on this point, a human has needs that arise at different times, some in the present and some in the future, depending on the length of his period of provision. He may, for example, realise that he needs to satisfy his hunger not only today but also tomorrow, the next day, next week and so on. However, humans themselves exist only in the present and all decisions, choices and actions must be made in the present – not tomorrow, not next week and not next year – and the ends to which they strive must all be ends that exist now. Simply because a need takes effect in the future and may be described as a “future need” does not mean, praxeologically, that it is a future end – end being a category of action that can exist only in the present. Therefore all ends that are sought after must take a place in a human’s rank of values now, and the urgency of their satisfaction will be determined by that rank. For example, I may know that I need to satisfy my hunger today and also that I will have to satisfy my hunger tomorrow. I have two loaves of bread now, one of which I devote to satisfying my hunger now so I eat it now; the other I direct towards the end of satisfying my hunger tomorrow so I store it in a bread bin. Or, in place of the latter, I may arrange to acquire a second loaf of bread tomorrow rather than having one available immediately. However one of these ends is not a present end of satisfying my hunger now and the other a future end of satisfying my hunger tomorrow. I can only make choices and decisions that lead to actions now, in the present, as I do not exist in the future. Therefore all ends must be expressed as present ends. The two ends are, therefore, correctly described as follows: the end of satisfying my hunger now; and the end of providing for the satisfaction of my hunger tomorrow. For the first end, the relevant action is eating the first loaf of bread today. For the second, it is directing the second loaf into the bread bin for storage (or arranging for the acquisition of the second loaf tomorrow). Both ends are therefore present ends met through present actions and if the second end is sufficiently high in my value rankings then it will need to be fulfilled now also and the stored loaf bread, or the expected acquisition of a second loaf of bread, is fulfilling this end now. Crucially, however, the importance that each end may have could be higher or lower than the other. There is no necessity for the second loaf of bread, simply because it will feed me tomorrow, to be less valuable than the first. If I am desperately hungry today then the first end, satisfying my hunger today, may be very high on my rank of values and the second end may be low. Alternatively, if I believe that tomorrow will bring excruciating hardship then the end of providing for tomorrow might be the highest end and the one with which I will be preoccupied. Solely because one end concerns the present and the other the future does not automatically mean that the end concerning the future is a less valuable and provides any explanation of time preference. And there is, consequently, no necessity for the second loaf of bread to be ranked lower in value than the first. Indeed, if providing for tomorrow was the more important end then if one loaf of bread was to vanish this loss would be shifted to the least valuable end – hence I would go hungry today and use the remaining loaf to eat tomorrow.

This analysis explains why, at any present moment in time, a set of fireworks for July 4th may be more valuable than the same set for May 4th; or why ice cream in winter is less valuable than ice cream the following summer; or why someone may engage in plain saving without any expectation of interest. Indeed it is quite conceivable that someone on May 4th would exchange a set of fireworks in return for acquiring the very same set (or even a set with a lower quantity or quality) back on July 4th. The understanding of time preference does not come from situations where the goods are available either now or in the future and where the ends also take effect at varying points of time also. Rather, it comes from those situations where the ends must be met now but where the goods are available at different points in time. In short, we are comparing the ability of a good available today with a good available at a point in the future to satisfy the same end.

Psychology and Physiology

Related to the previous discussion is the fact that psychological and physiological explanations of time preference are not sufficient to establish the necessary truth of the phenomenon. The notion that people may underestimate their future needs, that they may care less about the future than the present, or that their aging bodies will simply be less capable of enjoying satisfaction in the future may all be true but they needn’t necessarily be so. Further, much of this would again be varying the end rather than the type of good. Moreover as we shall see further below, the fact of uncertainty is not sufficient to explain time preference either. Rather, our investigation will concern why time preference arises praxeologically. In other words, what is it about action that causes the law of time preference to arise as a necessary result?

Goods and Serviceability

A step forward towards understanding the difference between a present unit of a good and a future unit of the same good is the difference between their serviceability. All goods derive their value from the ends that they service. Ends are ranked in order of urgency, that is a human will devote goods to fulfilling his most highly valued end first, the second highest next, and so on. As goods to fulfil ends are always scarce, any devotion of a good to one end involves the foregoing of other ends. Where goods can be devoted to either end A or to end B, for example, B will be foregone if the value of attaining A with the goods is ranked higher. Where a particular good is able to accomplish the fulfilment of an end alone (or in combination with very few other goods – there will always, at the very least, be labour) we can derive two things. First, as the good will be sharing its service towards the fulfilment of an end with very few other goods, close to the full value of the end will be imputed to the good. Secondly, because so few other goods have to be used to fulfil the end then there are more goods to be devoted to other ends, hence there are fewer ends that need to be foregone in the pursuit of this, most urgent end. Hence this latter end will be relatively more highly valued. Let’s say, for example, that there are five ends, A, B, C, D, and E, and that there are five goods a’, b’, c’, d’ and e’ to service these ends. If good a’ can service end A without any use of the remaining goods then this leaves all of these goods to service ends B-E. Not only will good a’ be accorded the full value of end A, but the relative value of end A and compared to ends B-E is high. We may say, in this instance, that the good possesses a high degree of serviceability. Where, however, a good requires a higher number of complementary goods to fulfil an end then a lower value will be imputed to that particular good as the full value of the end must now be imputed to a greater number of goods; furthermore, the necessary devotion of more goods towards fulfilling the end will mean that a greater number of other ends will have to be foregone. For example, if good a’ was not able to fulfil end A alone but, rather, needed to act in concert with goods b’-e’, then all of the ends B-E would have to be foregone in the pursuit of end A. While end A may be the highest individually valued end, losing all of these other ends will serve to reduce its relative value and, indeed, the cost may be so great that end A will simply be abandoned.

Let us examine this first of all by exploring an analogy to time, which is distance. Let us say that I strive towards the end of quenching my thirst and that this is my most highly valued end so that I want to act to fulfil it immediately. If I have a bottle of water right next to me that will satisfy this end then, ignoring the cost of labour, the value of the bottle of water will equate to that of the end itself1. The bottle of water has served to fulfil this end with a high degree of serviceability as it has not required the use of any other goods in order to accomplish its task. This means that more goods are left over for the fulfilment of other ends. So let us then say that, as I have easily fulfilled that end, I have a second end of going to pick apples for the day. I then, having had my first end fulfilled, can proceed merrily with the fulfilment of my second with the remaining stock of goods available. And having proceeded with this second end I may have more goods left over for the pursuit of a third end of baking bread. However, what if, in a second scenario, I still desire the same end of quenching my thirst but now the bottle is not right next to me but is ten miles away? This bottle is the same, physically homogenous resource as the bottle that was right next to me but if the distance of ten miles makes, in my mind, an appreciable difference what now is the value of the bottle? The distance means that an appreciable cost must be borne in order to utilise the bottle, costs that are not shared by the utilisation of this bottle in scenario one, rendering the bottle in the second scenario with a lesser degree of serviceability. These costs, clearly, are those that must be borne in order to transport the bottle to me or me to the bottle. Because of this necessity of transportation, complementary goods must now be brought in order to service the end. But these goods were goods that could have been devoted to ends other than quenching my thirst – namely, picking apples and baking bread. The lower serviceability of the bottle means that, in order to utilise it, additional ends to which means could have been devoted now have to be foregone. From this we can derive two conclusions. First, the degree of remoteness caused by distance means that the bottle in scenario two must share its fulfilment of the end with a greater number of goods compared to the bottle in scenario one. The lower capability of the distant bottle in scenario two means that the value of the end of quenching my thirst must be imputed to a greater number of goods2. The value of the bottle in scenario two, therefore, must be discounted accordingly. Secondly, the loss of the other ends – picking apples and baking bread – serves to impose a relatively lower value on the end of quenching my thirst. If this loss becomes too great – i.e that I am not prepared to forego the loss of picking apples and baking bread in order to quench my thirst – then the then the latter end will simply be abandoned and the bottle will cease to have value (or it may be earmarked for a lower valued end to which it may be more suited). In either case in scenario two – whether I proceed to bring the distant bottle to me or I abandon the end of quenching my thirst entirely – the value of the distant bottle in scenario two is lower than that of the bottle right next to me in scenario one.

It is this kind of understanding that is the foundation of an explanation for the phenomenon of time preference – a present unit of a good has greater serviceability in satisfying an end than a future unit of the same good. We will now explore this in detail.

Time and Serviceability

Although analogous, the remoteness of time presents a challenge more difficult than that of distance and there are some important differences. Whereas with distance, the lower value of the distant good could be explained by the option of foregoing lesser valued ends in order to overcome it, an acting human does not necessarily have this luxury with time. Nothing can be done to “speed up” time and its passage must be borne at a constant rate. We therefore have to look to the particulars of action that we touched upon earlier to explain why “remoteness” in time causes an otherwise equally serviceable unit of a good to have lower value.

An action is the result of a choice to satisfy ends with means available. But as we noted above human exists only in the present and must live through the present before the future arrives. A person cannot act in the future; he has to do so in the present. All decisions are therefore present decisions to act towards present means towards present ends. In other words, the very fact that a human acts at all means that he wants an end to be extinguished now or soon, not in the future or later – to act always means to meet an end sooner rather than later. The contrary position – to seek satisfaction in the future – is antithetical to action for if a person desires to meet an end later rather than sooner then he would never act. The present could pass without action but as soon as the later period of time came around it would itself then become the present and the person would be faced with the same conundrum – he would, at that moment, either have to act (in which case he would revert to preferring satisfaction sooner rather than later) or delay action again, in which case he would never act. The logic of action therefore requires sooner satisfaction rather than later. Indeed, even where the action concerned may not bring satisfaction for a long period of time, to begin the action is to demonstrate a preference for the satisfaction of the end to be brought closer in time. It follows also that the end to which action is directed first must be the one that is, in the eyes of the acting human, in the most urgent need of fulfilment, i.e. it is the highest valued end.

What does this mean for the value of a present unit versus the value of a future unit of a good? All goods, as we know, derive their value from the ends that they satisfy. If a human acts now in relation to a good – say a bottle of water – in order to achieve the end of extinguishing his thirst it means that, now, at this moment, this end is his most highly valued end and the good must be accorded (in the absence of other appreciable costs) the same value as the end. To act now means that this end must be fulfilled now, or at least brought closer in time to fulfilment. However, if we take the same moment in time – the present – but remove the good from present availability and move it to a future availability then what does this entail for action? It means that the most highly valued end at that moment cannot be fulfilled by that good. It completely lacks any serviceability towards this end compared to the serviceability of the presently available good. One of several things may happen as a result. If the end is to be satisfied now, substitute present goods must be found. These, however, must be drawn from the satisfaction of other ends and the urgency of these ends must be reweighed against the urgency of satisfying the human’s thirst in light of the fact that the present bottle of water is no longer available. It is quite conceivable that the end would be either abandoned entirely or satisfaction of it would be delayed – in either case it necessarily ceases to be the most valuable end. As other ends now become the object of action so they become more valuable and hence, the future good reduces in value accordingly3. Furthermore, if the end is either abandoned or satisfied by substitutes, the future bottle of water may be earmarked for a lesser valued end such as providing for tomorrow’s thirst – the end being necessarily lesser not because it takes effect in the future but because it is not the most valuable end to be met at the moment when quenching my thirst is most pressing, the very moment when the relevant valuation under scrutiny is occurring.  In all of these cases – substitution, abandonment, delay and direction of the good to a lower valued end – the future bottle of water derives a lower value than the present bottle of water. It is these facts, arising from the logic of action, that is the cause of the phenomenon of time preference, the future bottle being imputed with a discount to reflect its lower utility. We can therefore state the law of time preference as being as follows: a unit of a good that is available to satisfy an end immediately (or sooner) will be more valuable than a unit of a good that can only satisfy the same end in the future (or later).

We can also understand from this why there are gradations of serviceability of future goods – for example, a present unit of a good may be more valuable than a unit available one year from now, a unit one year from now more valuable than a unit two years from now, a unit available in two years more than one in three, and so on. For if the logic of action is to bring ends closer to their satisfaction the nearer in time a good is to that satisfaction the lighter will be the discount applied. If, for instance, a person chooses to delay satisfaction, then the lower that satisfaction will slip down the rankings the longer it must remain unfulfilled, as the cause of that delay is, by necessity, a decision to devote action to other, more highly valued ends in the meantime. The very fact of delay implies a lower value as to act is to place a higher valuation on the object of action now and to seek satisfaction now or sooner where as to not act or delay action is the precise opposite. From this we can also understand the capitalised value of durable goods – why, for instance, uses that are delivered in future slices of time incur a heavier discount the further they stretch into the future. For, at the moment of valuation, each separate use of the durable good must seek out its ability to fulfil an ever diminishing pool of ends that a human holds, each end reducing in value until they are dissipated. Hence the reason why land that is, for all intents and purposes, a permanent good that can yield utility for all eternity, trades for a finite price – to the extent that the remotest future uses can fulfil any end the human holds at all they will be of such infinitely small value as to be negligible.

What if a person deliberately and constantly decides not to act? Do we not here have a definitive example of where a person can persistently prefer future satisfaction? Not at all. To not act is itself an action that must have an end to fulfil. If so, whatever end this may be – peaceful meditation, reflection, or the strength gained through the bearing of hardship – it is more important than the end that some other present good could satisfy. To continue delaying, for example, the quenching of my thirst by not opening a bottle of water doesn’t mean that I prefer a future bottle of water to the present bottle of water. It simply means that not drinking is more valuable than drinking. As soon as, however, drinking becomes my most valuable end it would be the case that the present bottle of water would be more valuable than a future bottle of water in satisfying that end. The situation of choosing not to act therefore has no bearing on the phenomenon of time preference.

Finally, what about the situation where, for example, my most highly valued end is to provide for next week’s hunger and I want to ensure that this is met now, either by storing goods now or by arranging, now, for their acquisition next week? I have an apple available now but it will rot before next week comes and will not fulfil this end. An apple that becomes available next week however, will not be rotten and will fulfil the end. Surely, therefore, we now have a clear case of where a future unit of the same good is able to better satisfy the same end more than a present unit and won’t, in this instance, the future unit be accorded a higher value? Unfortunately not, because the fact that the present apple will rot imposes upon it a qualitative difference from the apple that will not. In other words, an apple that is rotten before the end is fulfilled is not the same good as an apple that is not rotten before the end is fulfilled. We are therefore altering a variable other than the one under examination and hence we can conclude nothing about the latter from such a situation.

Human Appreciation of Time

It must be emphasised that the difference in the elapse of time between the availability of a present unit of a good and a future unit is determined praxeologically. All actions do, of course, take place through time and all goods are remote in time to different degrees. If I decide to drink a bottle of water I first of all have to pick it up, open it and then bring it to my mouth, all of which has to occur through time. But in order to have any relevance in economics the difference has to be appreciated by the human – there has to be a conscious awareness of its passage. With the opening of the bottle all of the actions may happen so quickly that, in my mind, they are praxeologically simultaneous and I therefore impute no lower value to the unopened bottle sitting on the table to the water that I am swallowing and enjoying. On the other hand, the passage of a week before I can drink the water would probably make a lot of difference, especially if I had no other access to water in that time. Further still we can see that £100 received in five minutes will probably not be valued lower than £100 received in this very instant, whereas £100 received in one year’s time would be valued markedly lower. Moreover it should be obvious that it will never occur with units of free goods – a unit of present air is just as valueless as a unit of future air.

Does this fact mean that our analysis of time preference is circular? That we are explaining the fact that humans appreciate time by the fact that humans appreciate time? Not at all, for what we are trying to explain is why a future unit of a good must necessarily be of lower value than a present unit of a good. In other words, using a human’s appreciation of the factor of time as a given, we are concluding from the logic of action that time preference must always be in favour of a present good ahead of a future good. We are not begging the question by reaching this conclusion.


Time preference has often been explained by the fact that the period of time that elapses between now and the availability of the future unit of the good is fraught with uncertainty – that because the future is always uncertain a person does not know whether the future unit will, in fact, become serviceable and hence this risk possibly serves to discount the utility of the future good. This uncertainty has two sources – a) uncertain future circumstances; b) the uncertainty of the future good actually becoming available. While it is true that uncertainty pervades all human action and that, generally, the longer the period of time that must elapse before an action is complete the greater the uncertainty, it is not in and of itself the cause of time preference. Even if uncertainty was reduced to the point of negligibility, to act now would still mean to prefer satisfaction now rather than later. A good that becomes available in the future must still either be the cause of the delay of satisfaction of the end, or, in the event that the end is satisfied with substitute goods, seek to fulfil a lower valued end or not end at all. In all cases the value of the future good would diminish.

This does not mean that uncertainty is redundant in a complete understanding of time preference; the height of uncertainty could certainly affect the rate of a person’s time preference as it imposes a psychic cost on a human which will affect the valuation of either the delayed end or the new end which a future good could satisfy. In other words, the fact of uncertainty would cause these ends to diminish further in value at the present moment in time, this further reduction being imputed back to the future good. But so too could total certainty serve to increase time preference. If, for example, it was certain that the world would be destroyed tomorrow time preference, far from falling as a result of the certain future, would rise to an astronomical height, with a heavy discount applying to goods that may become available as little as an hour into the future. On the other hand, if there was only a reduced chance of the world being destroyed the discount might be a little lighter. The effects of uncertainty are not therefore uniform upon the phenomenon of time preference and as an explanation of its ultimate cause it is neither necessary nor sufficient.

Exchange between Present and Future Goods

If what we have concluded above is true, that a unit of a future good must be less valuable than a unit of a present good, in which circumstances would a person exchange a present unit for a future unit? After all, we see this every day, mostly clearly in the lending of money at interest and almost certainly engage in the practice ourselves. What is it that could entice us to regard a future good as more valuable?

The key to understanding this is that, compared to our scenarios above, there must be an alteration to the serviceability of the future good that, in the eyes of the acting human, serves to increase its value above that of the present good. It cannot be the case that the same unit of a good available in the future is more valuable than the same unit available right now. What, therefore, is this alteration in serviceability to the future good? The answer should be familiar to us. Nearly always it is an increase the quantity of the future good while the quantity of the present good remains constant. So with the lending of money, for example, the present good may be £100 but the future good for which is exchanged may be £110. £110 has greater serviceability in terms of quantity compared to the £100, however the £100 has greater serviceability in terms of time compared to the £110. A human has to decide which of these two imbalances is of greater value to him. Typically we say that if he prefers a larger unit of a future good to a smaller unit of a present good he possesses “low time preference”. Conversely, if he prefers a smaller unit of a present good to a larger unit of a future good he is said to have “high time preference”. While this is useful shorthand for determining whether a person will have a propensity to save and invest rather than spend and consume (or indeed, when judging the direction of a society’s economic development), it does not tell us the whole picture. For to express a high or low time preference by trading present goods for future goods is an exchange like any other and a high value attached to the good received in exchange must correspond with a low value attached to the good given up in exchange. If, therefore, someone has a low time preference he must, conversely, have what we may term a relatively high “quantity preference” – the increased quantity of the future good being more valuable to him than the end that must be delayed, abandoned or met through substitutes today in order to receive it. On the other hand, if a person has high time preference he has a relatively low quantity preference, preferring to meet an end now with a smaller quantity of a good rather than delay it, abandon it or meet it through substitutes. We might say, therefore, that time preference and quantity preference are negatively correlated.

The concept of time preference is not necessarily limited to a single, homogenous good. It would, for example, be possible to exchange a quantity of present apples for a quantity of future oranges. In this case, while it would not be possible to determine a “rate” between the two quantities exchanged in the way that we can express an interest rate, we can say that a present apple would fetch in exchange a greater number of present oranges than a future apple. Or, conversely, a present orange could be sold for more present apples than a future orange could. There is also the possibility of a qualitative difference as opposed to a quantitative difference. A present apple may, for example, fetch a quantity of the ripest and most luxuriant present oranges whereas a future apple may only fetch the same quantity of lower grade, bog standard present oranges. All of these possibilities are expressions of the law that a present unit of a good is more valuable than a future unit of the same good.


What we have determined, therefore, is that the common expression “present goods are more valuable than future goods” is, at best useful shorthand that can muddy the waters when determining the fundamental truth. Neither also does an understanding of time preference arise from psychological considerations nor from the fact of uncertainty. Rather it is the logic of action itself that means a present unit of a good must always be more valuable than a future unit of a good when comparing their abilities to satisfy the same end. Only an advantageous change in the serviceability of the future good – such as an increase in its quantity – can serve to render the future good more valuable than the present good.

We have not explored the further implications of time preference in economics – particularly its role in interest and the business cycle, which is of great import to “Austrians”. However, a clear understanding of the fundamentals of the phenomenon should serve to enable one to tackle these difficult questions.

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1We are, of course, assuming that the bottle cannot be substituted in the event that it is lost in order to avoid the implications upon value that substitution has.

2Exactly the same would be true if, for example, the bottle was, as in scenario one, right next to me, but is now of an appreciably different quality or quantity (i.e. appreciable to the extent that the end cannot be satisfied to the same degree). Once again its serviceability, its power, as judged by my mind, to extinguish an end is diminished and other goods must be brought in to fully satisfy the end.

3It is of course true that in the case of the possibility of substitution the value of the present bottle of water would equate to that of the substitute goods and not from the end of quenching my thirst but this has no bearing upon our analysis of the relatively lower value of the future good as compared with that of the present good.

“Austrian” Business Cycle Theory – An Easy Explanation

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Against the simple and straightforward siren song of “underconsumptionist” and “underspending” theories of boom and bust, “Austrian” business cycle theory (ABCT) can seem contrastingly complex and lacking in communicability. The former types of theory, associated with “mainstream” schools of economics, in spite of their falsehood, are at least advantaged by the veneer of plausibility. A huge glut of business confidence and spending will, it seems, naturally lead to an economic boom, a boom that can only come crashing down if these aspects were to disappear. For what could be worse for economic progress if people just don’t have the nerve do anything? Add in all the usual traits of “greed” and “selfishness” with which people take pride in adorning the characters of bankers and businessmen (again, with demonstrable plausibility) and you have a pretty convincing cover story for why we routinely suffer from the business cycle. ABCT, on the other hand, with its long chains of deductive logic, can seem more impenetrable and confusing. Is there a way in which Austro-Libertarians can overcome this problem?

“Austrian” economics is unique in that all its laws are deduced from a handful of self-evident truths, the most important being the action axiom, often peppered with a few additional assumptions or empirical truths (such as the desire for leisure time). The entire corpus of economic law – right from the isolated individual choosing between simple ends all the way up to complex structures of production, trade and finance – therefore forms a unified and logically consistent whole. This is not true, however, of “mainstream” schools of thought which tend, nowadays, to be splintered and scattered into separate, specialised areas of study that are based upon their own, individual foundations. The fissure between so-called “microeconomics” and “macroeconomics” is a prime case in point; while “Austrians” will read much that is agreeable in “microeconomics” (although it still contains many faults and general misunderstandings resulting from the lack of coherence and soundness that is furnished by deduction from the action axiom), “macroeconomics”, on the other hand, seems to be a completely different ball game, considering only “the economy as a whole” without reference to its individual components1. It is this fact that “Austrians” can use to give them the upper hand when explaining the business cycle. For in ABCT, the explanations of “macro” phenomena are little more than an extension of what is found in “micro” price theory.

The market price for a good is the price at which the quantity demanded equals the quantity supplied. Prices therefore serve to ration goods as a response to their scarcity, the goods available being traded from the hands of the most eager sellers to the most eager buyers. Those buyers who are not willing to pay the market price will go away empty handed and those sellers who are unwilling to sell at the market price will not be able to get rid of their goods. What happens, then, if this relationship is disturbed by a forced fixing of prices by the government? First, if the price is raised above the market price to create a price floor, the new price will attract more sellers into the market for that good because the price that they will receive for a sale is now the price at which they are willing to sell. However, at this heightened price there are fewer people wishing to buy the good. Some, who were not previously prepared to pay the lower, market price, are certainly not going to pay the higher price now. And those who would have paid the market price before may now decide that the new price is too high so they also do not buy. What results, therefore, is an increase in sellers and a decrease in buyers which can lead to only one thing – a surplus of unsold goods. The sellers may be very eager to sell at the new price but they will have a hard time finding anyone to sell to. Secondly, the opposite case, where the price is lowered below the market price (a price ceiling) creates, as one would expect, the opposite effect. This new price will attract more buyers into the market for that good because the price that they will pay for a purchase is now the lower price at which they are willing to buy. However, at this lowered price there are fewer people wishing to sell the good. Again, some, who were not, before, prepared to sell at the market price, are certainly not going to sell at the lower price now and those who would have sold at the market price may now decide that the new price is too low so they also do not sell2. What results, therefore, is a decrease in sellers and an increase in buyers which, clearly, leads only to a shortage of goods. Buyers will swarm into the marketplace eager to purchase the articles at the new, attractive price but, to their dismay, the shelves will be empty, cleared out by all of the more hasty buyers who got there before them3.

It is this latter scenario – that of artificially lowered prices – that is relevant for ABCT. For the business cycle is, according to “Austrians”, little more than price fixing on the widest scale, the fixing and the manipulation of what is possibly the most important price in the economy – the interest rate on the loan market. Rather than being the price at which a single good is traded, the interest rate is the price at which saved funds are borrowed and lent (i.e. demanded and supplied) in the economy.

When the stock of money is fixed, if one person wants to borrow (demand) money then another must have saved it in order to lend (supply) it. The resulting rate of interest is the point at which the quantity of money saved/lent equals the quantity of money borrowed. Any borrowers who want to borrow at a cheaper rate and any sellers who want to lend at a higher rate will find themselves priced out of the market for loanable funds, the sub-marginal buyers unable to borrow any money and the sub-marginal lenders unable to lend any. This situation produces a stable amount of saving, lending, borrowing and investment because the interest rate – the price of saved funds – is in harmony with the preferences of consumers, in particular, their preferences for allocating their funds towards either capital or consumer goods. The portion of his funds that the saver retains for consumption will be spent on consumer goods (i.e., present consumption) whereas the portion that he allocates towards saving and lending for investment will be spent on capital goods that will not provide any immediate consumption but will provide a greater amount of it in the future. At the market rate of interest goods and resources in the economy will be allocated in harmony with these desires. If, for example, a borrower wishes to borrow money to build a factory (a capital good) and his calculations reveal that the prevailing rate of interest is low enough for him to make a return on this enterprise, it means that savers are willing to lend a sufficient quantity of funds in order to make it viable. If, however, the prevailing interest is too high it means that savers are not willing to lend enough funds to build the factory – the money that could be spent on building the factory they would prefer to spend on their own, immediate consumption4.

What happens, then, if the rate of interest is set below the prevailing market rate? Exactly the same as what happens when prices are forcibly lowered for any single good. At this rate borrowers who before found the rate of interest too high for their ventures suddenly find that they can afford to borrow. The quantity of funds demanded, therefore, will rise at this new, low price. Savers, however, will be less willing to lend at this price. Certainly if they weren’t prepared to lend at the previous rate of interest they will not be induced to do so by an even lower rate and some savers who were prepared to lend at the market rate will not be prepared to do so at the new, artificially fixed rate. The increase in borrowers and decrease in sellers, therefore, causes a shortage of saved funds, or at least it should do so. Why, then, does this shortage not materialise immediately at the point that the interest rate is fixed? Why aren’t the banks empty of cash and why can they keep on lending and lending and lending? Why can this situation perpetuate for years and end in a calamitous crash that causes almost unrelenting havoc?

This is where a degree of complexity enters the explanation. What is really being borrowed and lent is not money but, rather, the real goods and resources that they can buy. We said above that if someone wishes to borrow money another person has to have saved it. But what this really means is that the saver has to have worked to produce real goods and resources in order to earn that money. He then lends that money to the borrower and the borrower uses that money to buy those goods that the lender produced and diverts them towards his enterprise. If, of course, saving, lending and borrowing took place with real goods, or if the supply of money was fixed, then obviously a forced lowering of the rate at which these goods could be borrowed would result in their shortage very quickly. But the fact that the saving and lending takes place through the mechanism of an easily expanded paper money supply creates a clever smokescreen. For our entire financial system rests not on the principal of every pound borrowed requiring a pound to be saved, but rather that pounds can be “created” out of thin air by the central bank and lent out even though someone has not saved. By printing fresh money (or its digital equivalent) the volume of borrowing can expand without a corresponding expansion of the volume of saving. This easy ability to produce more money to meet the higher demand for borrowing means that the artificially low interest rate never causes a shortage of money as we would normally expect when the price of any other good is fixed below its market price. A second problem, though, is that the real goods that this new money can buy have not increased in line with the increase of the supply of money, but, rather, have remained constant and there is, therefore, still only the same quantity of goods that have to be allocated towards either consumption or investment. Surely the artificially low interest rate will mean that there will be a shortage of real goods to devote towards investment?

Unfortunately, at the beginning, this is not so. For the newly printed money transfers purchasing power over goods out of the hands of those holding existing money and into the hands of those who have the new money. The result of this is that the borrowers of the new money – those who want to devote the goods purchased to capital investment – now have an advantage over those who wish to devote them to consumption. Let’s say, for example, that I earn £1000 in a given month. This means that I have worked for and created real goods in the economy on which I can spend this £1000. Let’s say that I allocate £750 towards consumption and £250 towards saving and investment. Therefore, what I want to achieve is to consume 75% of the goods on which I can spend the money and save and invest 25%. This £250, the 25% of the goods I wish to devote to saving and lending constitutes supply in the loan market that will help to set the market rate of interest. We can illustrate this allocation accordingly:

Consumption  £750   75%


Saving          £250   25%


TOTAL           £1000  100%

If, however, a commercial bank depresses the interest rate and simply prints an extra £500 to meet the new demand at this lower rate, what has happened now? There has been no change, remember, in the quantity of goods – the new money must be still be spent on these goods. The purchasing power of the existing money that I wished to spend on consumption therefore reduces and that of the new money that is to be spent on lending and investment correspondingly increases. All that happens therefore is that the proportion of goods that can be devoted to lending and, hence, to investment has now been forcibly increased from £250 to £750 – and increase from 25% to 50% of the new total stock of money, thus:

Consumption  £750   50%


Saving          £250   17%

New Money    £500   33%


TOTAL           £1500  100%

Newly printed money that enters the loan market therefore forces the economy onto a different consumption/investment ratio from that which is desired by consumers. The poor consumer will find that the newly created money has caused the prices of goods to rise; he is forced, therefore, to curtail his consumption in real terms. The goods that he can no longer afford to buy and consume will be purchased by the new borrowers who will devote them towards their capital enterprises. It is for this reason that none of the expected effects of price fixing occur and the economy proceeds along what appears to be a sustainable boom in capital investment. The problem, though, is that capital projects usually take several years to complete and rely on a continuous supply of goods throughout this time. But consumers don’t want to save voluntarily the amount necessary to complete these projects. The interest rate must therefore be constantly kept low and the new money reeling off the printers to meet it if the projects are to continue. It is only down the line when price inflation inevitably begins to accelerate and the central bank forces an increase in the interest rate and a corresponding reduction in growth of the money supply that the problems are revealed. For now the consumption/investment ratio once again begins to reflect the preferences of consumers – they want, if we remember, more consumption and less saving which means that lending and investment has to reduce. Hence half-finished capital projects have to be left incomplete. They have been starved of the resources necessary as they can no longer afford to purchase them at the new rate of interest. This precipitates a collapse in the prices  of capital assets, a collapse that causes widespread bankruptcy and liquidation of firms and enterprises that, hitherto, had seemed sustainable and profitable. Ludwig von Mises describes the perfect analogy:

The whole entrepreneurial class is, as it were, in the position of a master-builder whose task it is to erect a building out of a limited supply of building materials. If this man overestimates the quantity of the available supply, he drafts a plan for the execution of which the means at his disposal are not sufficient. He oversizes the groundwork and the foundations and only discovers later in the progress of the construction that he lacks the material needed for the completion of the structure. It is obvious that our master-builder’s fault was not overinvestment, but an inappropriate employment of the means at his disposal5.

Mises’ last sentence is important. As the prices of capital goods were accelerating upwards during the boom and then suddenly come crashing down, there is a temptation to analyse this as “overinvestment”. While this is true and that “too much” has been devoted to long term investment projects it should be clear from our analysis that the real problem is malinvestment – a diversion of resources from desired consumer goods to capital goods.

Observant readers might say that it is actually the return to the market rate of interest and not the fixed rate that has caused the sudden shortage of capital goods. This would not be a correct interpretation. Artificially lower prices always give the illusion of plenty, of abundance and availability for everyone. It is just that with the fixed price of a particular good the illusion becomes obvious more quickly. But with fixing the rate of interest, because it takes effect through the mechanism of money, the illusion of plenty is obscured and, for a time, looks very sound. For this new money has the very real ability to divert resources away from consumption towards capital investment. Nothing more has been created but it looks like there has. Couple that with price inflation with higher nominal wages and people, at least, think that they are better off than they were before the “miracle” of artificially low interest rates. Real abundance and plenty, however, would not merely divert resources from consumption. Rather, resources for capital investment would exist independently of and in addition to those desired for consumption, as dictated by the desires of consumers.


What we have seen, therefore, is that ABCT sits coherently with the examination of individual price action and is little more than an extension of it. The business cycle is simply a case of price fixing writ large, causing widespread waste, chaos and misery when its effects are finally revealed. There are no separate bases or foundations of this “macro” sphere of economic theory. There are, however, certain special features that make this form of price fixing especially insidious and long-lasting – that of the easy ability to print fresh money to meet the new, low rate of interest, permitting purchasing power to be transferred to new borrowers and, hence, the real diversion of resources. As soon as this situation ceases the smokescreens vanish to reveal the waste and futility of these diversions.

Whenever, therefore, one has difficulty in either understanding or explaining ABCT, think back to what you know about simple price fixing. In fixing the rate of interest, the most important price in the economy, “Austrian” economics, with its strict deductive logic from the action axiom, will tell you that the results will be the same.

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1Murray N Rothbard, Man, Economy, and State with Power and Market, p. 269 (n. 19).

2This isn’t just stinginess on the part of sellers; rather, the cause of their unwillingness to sell will be, in the long run, that they simply cannot – the lower price will usually not be sufficient for them to recoup the costs of production so they have to abandon the particular line altogether.

3These results were seen during the high inflation of the 1970s in the US when price controls led to long queues at gasoline station because the demanded quantity of gasoline could not be supplied at the artificially low price.

4An interesting question is whether the interest rate may strictly be considered a “price”. In the exchange of goods, the price of a good is the quantity of another good that is fetched in exchange. For example, if one apple sells for two oranges, then the “orange” price of an apple is two oranges (and the “apple” price of an orange is 0.5 apples). In the complex economy, of course, every good is exchanged for money so we always reckon prices in terms of the quantity of money received in exchange. However, whatever the other good that is received, it makes no sense to compare the two physically heterogeneous goods in terms of magnitude. For how does one calculate the “difference” between two apples and one orange, or between £2.00 and a bag of oranges? In the exchange of a present good for a future good, which is what happens in the loan market, this is not the case, however. If a borrower agrees with a lender to borrow £100 today and to pay back £110 in one year’s time, strictly the price of one unit of present money is 1.1 units of future money (or the price of 1 unit of future money is approximately 91p of present money). But because the two goods are physically homogenous we can compare the two magnitudes – 1.0 and 1.1 – in order to derive a rate or ratio between them of 10%. We would therefore state that the interest rate per annum in this scenario is 10%. This rate is therefore not strictly a price but an expression of two prices – the price of present money in terms of future money and the price of future money in terms of present money. However, it should be clear that a manipulation of the rate of interest would have the effect of fixing the actual prices of present and future money. If, for example, the interest rate is forcibly lowered to 5% then the price of one unit of present money is now 1.05 units of future money rather than 1.1 units of future money. The resulting effects of price fixing will therefore be felt in this scenario. Hence, it makes sense to speak of the rate of interest as a price just like any other and, indeed, this is how it is treated by acting humans in the loan market.

5Ludwig von Mises, Human Action, p. 557.