Money and Credit Manipulation? Ask Ludwig von Mises!

Austrian Economics - Boom and Burst - Fractional Reserve - Manipulation of Credit - Bitcoin

Hello, I am Nicolas Bustamante. I’m an entrepreneur and I write about building successful startups.

Check out some of my popular posts:

Intelligent CEO

The Impact of the Highly Improbable

Surviving Capitalism with Competitive Moats

Subscribe to receive actionable advice on company building👇

While in high school, I was lucky enough to discover Frédéric Bastiat on the internet. It was a blast. His books such as The LawEconomic Sophisms, or his essays such as "What is Seen and What is Not Seen" greatly influenced me. It also led me into Austrian Economics. I then read many books written by Hayek, Mises, Hazlitt, Kirzner, de Soto, and others. All these ideas had a profound influence on how I conduct my life and my business. Among all ideas, I find that the Austrian Business Cycle Theory is interesting and relevant to understanding our world.

The Austrian School of economics originated in the 19th century in Vienna. The first wave of economists such as Menger, von Bawerk, von Wieser explained phenomenons such as marginal utility theory, the subjective theory of value, or the marginal utility theory. A century after, Austrian economists such as Mises or Hayek worked, among other things, on the Austrian Business Cycle Theory. They argue that fractional reserve banking artificially extends credit, causing businesses to misallocate productive resources leading to an artificial “boom,” which eventually must end in a "bust." I will try to detail more on their theory.

To learn about the business cycle theory, one must understand the fractional reserve banking system. When people deposit money at the bank, they expect their money always to be available. In this sense, a deposit is different than a loan in which the principal is no longer available because it was lent to someone else. With a deposit, the bank must keep the depositor's good. However, most banks engage in a ludicrous activity by lending the money to other customers while keeping the money available to retrieve. Bankers don't act as financial intermediaries but create new money. As long as the bank's confidence is preserved, the bank will be able to continue this process. Customers will be unaware that the bank lacks the necessary liquidity to meet all of its commitments. With fractional reserve banking, the bank can lend 90% of the deposit while providing normal withdrawals for their customers. Creating money out of thin air is a profitable activity.

Fractional reserve isn't bad per se. Some Austrian Scholars such as de Soto argue that it is legally wrong. A contract to deposit money isn't a loan. The bank has thus no right to lend the money deposited. Ludwig von Mises points out that fractional reserve generates such large profits that bankers succumb and always lend more than reasonable. As you may have understood, when a panic occurs, some banks cannot honor their obligations. They go bankrupt and thus lose customers' money. Back in the day, losing customers’ money after having engaged in unreasonable fractional banking was harshly condemned. In the 14th century Spain, if a banker could not pay his debts, he would be beheaded directly in front of his counter, and his property sold to pay his creditors. Better not mess up with private property back then. If you want more stories like that, you should read Money, Bank Credit, and Economic Cycles by Jesús Huerta de Soto.

Fractional reserve banking is addictive, while it's hard to measure its risk. Most often than not, throughout history, banks blow up, jeopardizing the whole financial system. According to Austrians, this led to the creation of a government central bank that imposes rules such as holding a specific amount of liquidity, enacting requirements to lend money, and of course, acting as the lender of last resort. As Hayek noted in The Denationalization of Money, governments love this system because they can manipulate it to their advantage. The government can print money to fund its expenditures and manipulate the economic machine. Hayek explains that the job of the central bank is impossible. It is impossible for central bank officials to adequately coordinate the supply and demand for money, given the highly changeable, unpredictable, seasonal behavior of the multiple variables they work with. In short, they can't have sufficient information for their economic calculation to work. Central banks also create moral hazards. Special interest groups such as civil servants face the irresistible temptation to buy votes or increase the government's size with funds created from thin air. They take advantage of the central bank's power to accomplish their political goals. Having a last resort lender encourages banks to take on more risk knowing that the profits will be private and the loss will be public. It's a classic asymmetry of risk that can lead to nothing good.

The worse part of this system is the misallocation of productive resources. The new purchasing power available for people creates a wealth effect. It leads to the acceptance of disproportionate risks, and in short, the commission of systematic errors in both production and consumption. Entrepreneurs take on risky loans to start investment projects likely to bankrupt them, and consumers spend instead of saving. People and companies can't refrain from participating in the widespread misallocation of resources because they follow market incentives that are alas distorted. Of course, most think they will be able to pull out from their investment before the inevitable crisis, earning considerable profits that they will reinvest during the burst. The future is unpredictable, so most of them won't. The wrong economic calculation throws society off balance and prevents its harmonious development. The manipulation of the interest rate often sets up a culture of short-sighted speculation that discourages prudent business management necessary to achieve long-term goals.

When the inevitable crisis hit, the government does everything to postpone the unpopular recession. By expanding the money supply and depreciating the currency, healthy and painful readjustments are delayed making the future recession worst. The truth is, as James Buchanan wrote, a politician's goal is the next election, not to create long-term wealth. Austrian, such as Mises, believe that an economic recession can be postponed if additional loans, unbacked by real saving, are granted at an ever-increasing rate. However, while it may postpone the crisis, this strategy is doomed to fail. Keynesians think that the recession reveals the inadequacies of a market economy, proving the necessity of government intervention. Different from that, Austrians believe that the manipulation of the credit cycle causes the majority of recession.

At some point in time, the inevitable recession hit. It reveals that many investment projects financed under new loans created by banks are not profitable. Banks have to mark down their assets' value while their liabilities such as the deposits remain unchanged. Put it; most are insolvent. It generates a crisis of confidence in the entire banking system leading to defaults and bankruptcies. There are plenty of examples from the Ancient Times to the 20th century. For a more recent example, just read the Wikipedia page of the 2008 crisis.

In a nutshell, this is a typical example of an inducement of mass entrepreneurial error in economic calculation due to the manipulation of interest rate, which is artificially lowered through credit expansion un-backed by voluntary saving. This manipulation benefits bankers but also the government with unlimited funding to expand its powers. This leads to the misallocation of resources that throws society off balance with massive unemployment, millions of bankruptcies, and enormous wealth destruction. When the necessary adjustment is made, interest rates rise, and economic recovery is on the path, and a new cycle begins. For Austrians, business cycles result from excessive bank credit growth due to artificially low interest rates set by a central bank and reinforced by the fractional reserve banking system. What are the solutions according to them?

For Austrians, fractional reserve banking coupled with a central bank is doomed to failure. Most argue in favor of a 100-percent reserve requirement, which would dramatically reduce the creation of ex nihilo money. Of course, most want to see the abolition of the non-market institution, the central bank. Finally, Austrians want to privatize the monopolistic state-issued money and its replacement with another standard, mostly gold. Hayek's excellent book, Denationalization of Money, argues in favor of private currencies. As a reminder, there were over 5,000 types of banknotes issued by different banks in America.

In my opinion, the current system might blow up like all the others before when the government is manipulating the credit system. If you read the Ascent of Money by Niall Ferguson, you will realize how unstable these systems are. Like most Austrians, I like gold because it’s impossible to inflate. The worldwide stock of gold has grown at an average of between 1 and 3 percent per year over the last 100 years. It seems unlikely that politicians will accept to go back to a gold standard that will drastically reduce their power. Having sound money is essential to push humanity forward. It’s one of the most urgent problems to tackle today. Most revolutions happen at the margin, so maybe a better financial system will emerge on the internet. Maybe it's Bitcoin and cryptocurrencies?

Anonymous survey: What would have made this article more helpful?

If you found this article valuable, please consider sharing it 🙌