Pragmatic Capitalism

Practical Views on Money, Finance & Life

Understanding why Austrian Economics is Flawed

Austrian economics has been through quite a rollercoaster ride over the last 10 years as the housing bubble appeared to vindicate many of their views and then the economic recovery proved many of their dire predictions completely wrong.  I think Austrian Economics is deficient and Austrian Business Cycle Theory is inherently flawed and built on misunderstandings about the way the modern monetary system actually works.  Allow me to provide three core reasons why I believe this:

1)  Austrian economics is a political ideology that masquerades as an economic school of thought.  Like most of the economic schools in existence today, Austrian Economics is predicated on a political ideology.  Austrians tend to be vehemently anti-government and pro-market.  So they build a world view that conforms to the world they want and not the world we actually have.

We’ve seen this time and time again in the last 5 years during the recovery as the government picked up spending when the private sector cratered.  There is always an excuse within Austrian Economics that implicitly assumes government cannot spend dollars any better than a household.  This might be true in a general sense, but it is not always true.  For that implies that households and businesses always make rational decisions.  As if choosing to have our government spend money on wars and welfare is all that much different than households spending money on the next release of the tech gadget they probably don’t need or the McMansion they can’t afford.

Austrians aren’t the only offenders of this (see here).  We see it in Keynesian approaches, Market Monetarist approaches, Monetarist approaches and just about all of economics these days.  Economics is built primarily on a bunch of political agendas designed to look like a science.  Austrians (particularly the Rothbardians) are so vehemently against government involvement in the economy that they are among the very worst offenders of trying to pass an ideology off as a school of thought.  It results in a very unbalanced presentation of our reality that will consistently come to the conclusion that government interaction in the economy is bad. While true to some degree, this view is simply not supported by empirical evidence.

2)  Austrian Business Cycle Theory Misunderstands Endogenous Money.  Like many other economic schools of thought, Austrian economics is predicated on a loanable funds model with a world view designed to demonize just about everything the central bank does. One of the core tenets of ABCT is that interest rate intervention by the Central Bank leads to a misallocation of capital and that Central Banks control the money supply via reserve creation.  These are both misleading ideas.  As I’ve explained before, the primary purpose of the central bank is not a conspiratorial attempt to enrich bankers, but to help oversee and regulate the smooth functioning of the payments system.

The act of targeting interest rates and implementing monetary policy are very much secondary to this primary purpose and the powers of such policy, as presently constructed, are vastly overstated by most economists.  Yes, the central bank controls a component of the interest rate that helps determine the spread at which banks can lend, but the central bank does not determine the rate at which banks borrow to customers.  It merely influences the spread.  Overemphasizing the Fed’s “control” over interest rates misunderstands how banks actually create money and influence economic output.

The primary flaw in the Austrian view of the central bank has been most obvious since Quantitative Easing started in 2008.  Austrian economists came out at the time saying that the increase in reserves in the banking system was the equivalent of “money printing” and that this would “devalue the dollar”, crash T-bonds and cause hyperinflation.  It was standard operating procedure to see charts of the monetary base like this one followed by dire predictions of high inflation or hyperinflation.  Of course, none of this actually panned out.  The high inflation never came, the hyperinflation definitely never came, the T-bond collapse was a terrible call and the USD has remained extremely stable.

Further, it’s important to understand that all of this talk about “interest rate manipulation” is flawed. A Central Bank supplies reserves which puts DOWNWARD pressure on overnight rates.  The Central Bank must always manipulate rates UP, not down. So it is illogical to argue that low interest rates are manipulation that leads to misallocation of capital.  This doesn’t even touch on the fact that the Fed controls one interest rate out of thousands….This rate, as  we’ve learned in recent years, is no omnipotent policy tool.

So why was Austrian economics wrong on this point?  Because their model is predicated on the same faulty loanable funds and money multiplier based model that most other economists use.  So they assumed that more reserves would mean more “multiplication” of money and thus hyperinflation.   Of course, as I’ve explained numerous times here before, banks are never reserve constrained and do not make loans when they have more reserves.  Further, QE is a simple asset swap that changes the composition of private sector assets.  Referring to this as “money printing” is highly misleading (see here for more details).  Austrians got this wrong because, in an attempt to attack government, they have devised a government centric view of money creation that misunderstand the way money is created primarily by private competitive banks endogenously.

3)  Austrians misunderstand inflation.  Austrian economists actually change the definition of inflation to serve their own ideological needs.  In Austrian Economics inflation is not the standard economics concept of a rise in the price level.  Inflation in Austrian economics is just a rise in the amount of money.  This leads to all sorts of emotional commentary, the most common of which, is the idea that the USD has declined 95% since the creation of the Fed in 1913 (which is true).   But this misunderstands several concepts and misleads us in understanding how the monetary system works.

First of all, the private sector creates lots of “money like” instruments that are not technically included in the money supply but comprise the vast majority of private sector net worth.  I use a “scale of moneyness” to help better understand this concept so that we don’t place an undue specialness on the idea of “money” when trying to understand inflation.  Instead, I try to explain that spending is a function of income relative to desired saving.  And that saving is comprised not only of “money”, but money-like instruments like stocks, bonds, options, etc.  To completely understand how the economy is impacted by inflation we shouldn’t merely focus on narrow definitions of “money”, but should understand the aggregate economic balance sheet.  For instance, if you sell a stock at no gain and obtain cash you’re not necessarily more likely to spend than you were before because your net worth is the same.  Your income relative to desired saving is precisely the same as it was before.  This is basically what QE is.  It is a swap of one type of asset for another and doesn’t actually alter the net worth of the private sector.  Changing the moneyness of private assets does not necessarily mean there will be higher inflation!

But there is a more egregious and nefarious error in this “decline” of the dollar myth.  It completely misunderstands how living standards can rise even while the money supply rises.  In our credit based monetary system the money supply rises primarily when banks make loans which create deposits.  In a highly productive economic environment these loans are distributed by private competitive banks and provide the borrower with the capability to invest in a manner that actually enhances the living standards of society.  So, you borrow $100,000 from the bank, you invent and distribute the washing machine and suddenly we’re all better off because we no longer have to go to the river to wash clothes.  The technological advancement enhances our lives by giving us more time to consume and produce OTHER goods and services.  In other words, the money supply has technically increased, but we’re not worse off because of it.  We’re better off because of it!  What’s happened since 1913 in the USA is just one gigantic version of the washing machine example where our living standards have exploded through the roof in tandem with a rising level of credit and an innovation boom that human beings have never come close to experiencing in the past.

Austrians, in their fervor to demonize the fiat money system, make several errors here.  First, they assume the government controls the money supply (which they don’t).  It’s actually controlled primarily by private banks in a market system that Austrians should love.  Second, they move the goal posts on the definition of inflation to imply that inflation is always and everywhere a bad thing (which, it can be, but generally isn’t).

That really just scratches the surface on some of the flaws in Austrian Economics.  I think Austrians provide some good insights on the way the economy and money works, but these are glaring flaws in the school of thought that render it highly inadequate in helping us understand the world of money in a balanced and objective way.

See also: 

Understand the Modern Monetary System

Monetary Realism Recommended Reading

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