An Introduction to Austrian Economics, Part 9


(light jingle) – Welcome back to our final segment of our introduction to Austrian economics. This one will be focusing on, if you will, Monetary
Mischief, Booms and Busts, inflations, recessions, and
how money affects the economy. The Austrians have long emphasized, indeed from the time of
the founder Carl Menger, that money is like one of
those special institutions, that to use the phrase of the 17th century Scottish philosopher, Adam Ferguson, is the result of human action
but not of human design. In fact, Carl Menger expressed
it in the following way. “How can it be that institutions “which serve the common welfare “and are extremely significant
for its development “can come into being without a common will “directed towards establishing them? “Law, language, the state, money, markets, “all these social structure
are to no small extent “the unintended result
of social development.” Money is one of them. Money is not the result of
a benevolent king or prince or tyrant saying that his
people needed something to facilitate their transactions. Money is one of those unintended
institutional evolutions that have emerged not from the top-down but from the bottom-up through the interactive
needs and necessities and discovered opportunities of the market participants themselves. Individuals soon found in ages long past that barter transactions were limited in ability and efficiency. If I have one product or
good and you have another, and if you have what I want but I don’t have what you want, then there is not what economists call a double coincidence of wants. You have what I want, but
I don’t have what you want. A trade cannot occur. Or it could be a case
where we each have a good that the other wants, but we cannot agree upon terms of trade that would involve the
dividing up of the goods without them perhaps losing their goods qualities and characteristics that make them desirable
to either you or me. So individuals soon found that
they could find indirect ways to satisfy their needs and wants for acquiring goods through exchange. Imagine that a Bob is not interested in the commodity that I have for sale even though he has that which I desire. I might very well scratch my head and say, what if I first traded my good for some quantity of what Sam has? Not because I personally may
need or want Sam’s commodity, but it may be the case that I’m confident that if I have some of Sam’s
commodity, whatever it is, I could then easily turn
around and resell it to Bob in exchange for what he has that I desire. In this case, whatever commodity
it is that Sam has for sale has served for me as a medium of exchange. Now, we could imagine a
circumstance where most goods had similar qualities,
features, and characteristics, and therefore, to
differentiate them in some way was not really possible in terms of their serviceableness
or their frequency of use as such a medium of exchange. But the fact is, goods are different. They have different qualities,
features, and characteristics that makes some of them in
higher and wider demand, more easily transportable, more durable, easier to divide up to represent agreed upon terms of trade. That has been the case historically with such commodities as
gold and silver for instance. Now, I may be that frustrated person who first trades my commodity for Sam’s and uses Sam’s commodity to
buy something I want from Bob. But then perhaps, others
come into the market, and they too see that
whatever this product is that Sam has for sale,
a lot of people want it. And if you first trade what you have for some of Sam’s commodity, you then easily turn around and buy goods from William and Edward and Bill and a whole numerous of other people. And they in turn find that if they accept
that commodity from you, they too can turn around and use it to facilitate desired transactions to acquire the goods they actually want for some, perhaps, consumption
or production purpose. Slowly but surely this
commodity evolves and emerges and is then, by routine,
custom, and habit, accepted as the most widely used and generally accepted medium of exchange. And that in fact is the definition that both Austrians and most
other economists give to money. The most widely used
and generally accepted medium of exchange is, by
definition, the money good. Money also serves an
invaluable other purpose. Now in an earlier segment of this series, we talked about what enables
economic calculation to occur. We saw that there was a
need for private property so people could own things
that they could buy and sell, markets in which the exchanges could occur and prices could emerge reflecting people’s subject evaluations about what they value to
buy or to sell or produce objectified in the agreed upon prices at which these goods and
services are transacted. But the other one was the use of a money to facilitate those transactions to serve as a common denominator
for economic calculation. Now this happens again unplanned, almost unintendedly in the market itself. How so? Well, when everybody
turned to Sam’s product, to first buy some quantity of it before they then reentered the market to buy other things they wanted. They, in fact, increasingly
were generating a situation in which as more and
more people did the same, and let us suppose for simplicity that Sam’s product is gold. First trading what they
have for sums of gold to then turn around and use gold in the, to buy the things they want, gold as a money is increasingly on one side of every exchange. Increasingly, the price of every good is reflected, represented,
and stated in sums of gold for a unit of this, two
units of that, and so on. Once this emerges in this way, because of the emerging
integration of money in virtually all transactions and money being on one
side of every exchange, it now is a common denominator. You’re now able to express
and estimate and calculate the value expressed in
prices of all other goods. This amount of money for this product, this amount of money for that product, and therefore, all these goods are reduced to a common money value for
easy estimate, comparison, and calculation of profit, no profit, more expensive, less expensive. This combination of resources
would make the product at a lower total sum of money expenses than some other combination. And therefore, money serves
this essential element of a common denominator
for economic calculation, which itself was not
planned or intentioned or even thought about until
reflectively long after, as itself, the result of
some commodity emerging as the widely used medium of exchange through the spontaneous
process of use and evolution. Now economists, particularly the Austrians have come to distinguish
between several types of money. One, using the terminology
somewhat that Mises was using, is what we call commodity money. Commodity money is actual
the commodity money, a sum of gold either in a bullion, the bars, or coined money, that represent the object
which is directly traded for other goods. But it need not always be the case that you need to use this
direct commodity money, this gold money for instance, to undertake transactions. In the market, there had developed what is called money substitutes. Because of the desire for
safety and convenience, people began to leave their
sums of gold, bars and coins, for safekeeping with those who had the facilities of vaults. It could be a goldsmith or a silversmith, and they would pay a fee and they would leave their gold and silver with these people for safekeeping rather than run the risk of carrying such large sums
of money on their person and possibly waylaid by
a band that highwaymen who would proceed to rob them or kill them or the difficulty and uncertainties of housing it on your own home property and the greater likelihood if it’s known to attract burglars and thieves. Now, when you turned in
your gold and silver, you would be given a receipt by the goldsmith or silversmith
in those early days, and these receipts were
claims to that specific sum deposited with them for safekeeping. And at any time during
normal business times, days, you could turn in that
certificate, that claim and get back your coined or barred money. Now over time, it may be the case that because of convenience and efficiency and the growing reputation and confidence about those storing these sums of the gold and silver
money for safekeeping regenerated a situation in which the titles to these
sums of gold and silver, these receipts, these claims themselves came to be facilitating transactions. Rather than run to the depository, turn in the claim, get a
sum of gold and silver, run out to make the purchases, if the depository, the
gold and silversmith, the emerging bankers were
known in the community or had a degree of confidence
and trustworthiness in their brand name reputation, those from whom you wanted to buy would readily accept these
claims to the commodity money in lieu of the commodity money itself, knowing that they could at
any time during normal hours turn them in for the
actual commodity money that the exchange represented. These came to be called money substitutes, money substitutes. Money substitutes in the sense that they were claims to the actual money and were circulating in place of them but with sufficient confident
of those repositories where the gold and
silver were being housed, they were viewed as good as gold. Now the other form of money
that one could think of is fiat money. This is just paper money. How did this historically come about? There have been historical instances where there was a paper money substitute used in lieu of the actual gold and silver being housed in a repository. And then in one way or another, a government acted in a way to break the link between
the money substitute and the gold which it was to represent. And then if people found
it useful and convenient even though you could no longer
claim it for a sum of gold, that became the money itself. There was also another
distinction that Mises made and that was between commodity money and what he called created money. And by this, he meant commodity money or by the idea that this
was money or claims to money that represented people’s real savings. Someone earns a $100. They decide to save $25 of it. They put $25 into the bank. The bank gives them a claim to that. That $25 is, let’s say,
left to the bank for a year. During that year’s time,
that $25 worth of savings and the real resources that $25 represents could then be lent out by the bank to some desiring borrower perhaps
for an investment project. So through the partial savings of income and the money income’s representing a certain sum of real
resource in the economy, savings of some could be
transferred to investors of others who wanted to undertake
capital formation projects. And therefore, these
intermediary institutions, emerging banks, served as the facilitator between savers and investors. The intertemporal exchange of some people’s deferred spending so that the resource and the
money of that deferred spending could be used by others in the present to undertake in investments that would bring forth
goods in the future. And of course, a rate of
interest would be paid for having you, the depositor, foregone the use of that sum of money for the period of the loan. And therefore, the rate of interest was meant to be the market price to bring about a harmonious
balance or coordination between that part of the
people’s income saved and therefore transferred to
those who wished to use it for investment purposes. Now to make a long story short, over time, governments found it useful to approach banks to give them loans, loans to undertake spending in excess of the amount of
taxes that they took in, what today we call deficit spending. The problem was that banks often offered to lend money but only
at rates of interest that the king or the
prince or the government did not want to pay. And some governments made
deals with these banks, and that is, we’ll give you a monopoly over the issuance of all money substitutes if you’ll give us interest-free
loans or low-interest loans. And all other banks have to come to you to get these money substitutes as claims against any
gold and silver deposited with those other banking institutions, to basically have a monopoly in the issuance of the money substitutes. Governments would pressure these banks to give more and more loans, and the banks can only do so by issuing more and more money substitutes that the governments
would then use to spend. And as the substitutes
passed into the economy and people were spending it, and people became concerned about whether these money substitutes
would ever be redeemable with so many in circulation relative to gold deposited
at such a bank or banks and the greater amount of
paper money entering the market and competing for goods
and pushing up prices and people’s concern
about the diminished value of these money substitutes expressed in the prices at
which goods were sold for them would often want to go
for the gold in the banks, have the real money as opposed to the increasingly devalued paper currencies. Banks found themselves in a tight spot. We can’t extend anymore
loans to the government. To do so will threaten our solvency. More paper currency is
coming back for redemption than gold or silver we have in our vaults. And governments often
had an answer to that, breaking the redeemability
and making the paper currency, at least sometimes temporarily and sometimes implicitly longer than that and eventually permanently, as money itself. Paper money no longer
redeemable for any real money such as gold and silver. Now that basically is the monetary system that we’ve had increasingly in the world in the 20th and now the 21st century. Well, any gold links to paper currency were basically eliminated
during the First World War. It returned slightly after the end, but then during the Great Depression and the Second World War, all remaining such links were broken. So in fact, the world
is on fiat paper money. Now that type of analysis with certain amounts of an Austrian twist are not particularly
original to the Austrians. Many economists would say that governments have turned to banks to give them loans in excess
of the taxes they take in. Banks have issued paper money. The money has come into circulation, and prices rise and
inflation is often running. But the Austrians have given
this a particular twist in the writings of Mises and Hayek, Friedrich, Ludwig von Mises and Friedrich Hayek in particular, and that has to do what they call the non-neutrality of money. Now if there was a situation in which the government or
the banks facilitating them increased the money supply, and all prices in the
economy rose at the some time and to the same degree, it might be an inconvenience
and an irritation, but it really wouldn’t have necessarily much of a real effect on the economy. All prices going up more or less the same, you would have to add a
bunch of zeros to prices, but the relative relationships of how many units of one good for another, the relative prices would not be affected. Everything would rise proportionally. What the Austrians gave an analysis to, particularly Mises, was this idea that money never enters
the economy in this way. Money always enters the economy by the government injecting
it at a particular point. Let us think of the analogy. A pebble is dropped into
the center of a pond. The pebble hits the surface of the water. Now from the epicenter,
ripples are sent out in a sort of rippling sequence until the ripples hit
the shore of the pond, and then in fact, the
ripples would then come back bouncing off the shore towards the center from which it began. That is how changes in
the money supply occur. The government or its facilitating bank increases the money supply, injects it at a particular point. The first people to receive
this money from the banks usually attracted by lower
than market rate of interest that suddenly make it
appear that it’s less costly to borrow money for some
investment-related purpose now is spent, but on what? Not on everything, but the
particular goods and services that those particular investment borrowers want to spend the money on. They spend it on particular goods. The demands for those specific goods rise. The sellers of those goods now
have a greater money income. They now increase their
demand for other goods with this new money in their
pockets as the second round, the second ripple, if
you will, of the process. They don’t demand all goods
but the specific goods that represents their taste
preferences or investment uses. And as another round of prices rise, it passes to another group of people and then another and another and another until in a sort of
rippling temporal sequence, slowly but surely, one set
of prices and more prices and other prices and more
prices and more prices until in principle, every
price in the economy in a particular spending sequence will have been impacted upon. But in the process,
different prices are rising at different times to different degrees. The relative costs of some
things are different than others. The profitability of producing
some things are now changed in comparison to some
other investment project. And that non-neutrality
of money brings about not only a change in the
structure of relative prices in this rippling temporal process, but it also means it
changes the profitability of producing different products, investing in different
lines in the economy, attracting resources in
different parts of the market, bringing about a misallocation
of capital and labor, a malinvestment of scarce resources and producing some things
that are the false signals of this rippling inflationary process that would never have been investured or to the degree or the form if not due to the inflationary
price distortions. For the Austrians, this is the essence of the inflationary process. It is also the key from
the Austrian perspective, for understanding the how and
the why of the business cycle. In our institutional system, money is injected into our economy through the banking system. In the US for instance, the
treasury runs a budget deficit. They want to spend more
than they take in in taxes. They don’t immediately
run to our central bank, the Federal Reserve,
and say, here’s an IOU. Lend us so much paper money or trend now basically
computer ledger book money. No, what they do is they
issue a government security, an IOU, and borrow money from what is called the private sector, an individual, a bank, other commercial and
financial institutions. Now in that, it is merely a real transfer. It’s like if you borrowed a $100 from me. For the period of the loan, I
have a $100 less in my pocket, and you have a $100 more in your pocket. There’s no increase in the
amount of spending power. It’s merely been transferred
between you and me for the period of the loan, and at the end of the period, the $100 plus any interest
we may have agreed upon is returned to me. However, what happens is
that our central bank, the Federal Reserve, goes into what is called
the secondary market. That is, the market
where people are holding these government securities in their private sector portfolios. And the Federal Reserve says,
tell you what I’m gonna do. I will buy one of those
government securities out of your bank or personal portfolio, and I’ll pay you the face value of it plus an additional price that makes it attractive to sell to me now than hold on to it and receive the interest
payment plus the principle at the end period of the loan. How does the Federal Reserve pay for this? They issue themselves a check. Well, if it’s a private individual who has sold this security
to the Federal Reserve, they take this check and deposit it into their commercial bank. Like if you have a check, a paycheck, you deposit it into your bank and you expect it to be
credited to your account, so you can use it as a cash withdrawal or an ATM card or writing a check. So now that check has been deposited with that commercial bank, and the bank has credited
that depositor by that amount. But where’s the money to back up that so the bank can make
good to its depositor? That bank goes to the
Federal Reserve and says, look, one of our depositors
deposited your check. It says Federal Reserve for X number of thousands of dollars. And the Federal Reserve
says, yeah, that’s our check. And since virtually all commercial banks have their version of a checking account with the Federal Reserve, sort of like the Federal
Reserve is the banker’s bank, they then credit that bank’s
account on the ledger book of that X number of thousands of dollars. So where did the Federal Reserve get the money to credit the bank so the bank would have in the legal sense the money to make good to its depositor? Well, at the Federal Reserve,
someone at a computer screen has been told to just
punch in a dollar value assigned to the ledger
book account of that bank, and the mouse is clicked, and out of thin air,
those thousands, millions, tens of millions of dollars are created. And that’s how money is
created in the US economy. The banks find themselves with more money. You don’t make money sitting
on money in the bank. You make money by lending the bank. If you now have more
money to lend than before, how do you attract more borrowers? You lower the cost of borrowing. The rate of interest is lowered. That makes it seem that some
investments are now profitable that at the higher rate of
interest didn’t seem worth it, and therefore, the money
then passes in the economy most frequently to investment spenders who undertake investment
projects, capital formation, attracting resources, workers into these investment
sectors of the economy. And the rippling process is set in motion. But at the end of the day,
this is all paper money even if it’s not on the ledger book of the Federal Reserve’s computer. And there’s more of
this than real resources that the money is supposed to represent. The inflation is finally
at some point set loose, and at the end of the day, the inflation in either one way or another comes to an end. Runaway inflation in the
currency is destroyed, which has happened occasionally in history like the Great German
inflation practically. Or the banks through the Federal Reserve stop the monetary expansion, and it’s realized that the
investments undertaken, the allocation of the resources
throughout the economy including labor are not sustainable because the
real resources are not there to fully finish some if not
many of the projects begun. And the house of cards
begins to fall apart, and the inflationary boom is then replaced with
the recessionary bust. That’s why the Austrians
say that if you want to stop the roller coaster of booms and busts, the ups and the downs of instability in employment and output and uncertainly and
imbalance in the economy, then you have to stop
interfering with that institution through which money is
bringing about the balance between savings and investment and is easily the disrupted linchpin to bring about distortion and imbalance through the economy as
a whole through time through this distortive rippling effect of money’s non-neutrality. It’s the reason why the
modern day Austrians often call for a return
to a commodity money outside of the control
and immediate regulation and manipulation of the government. Or as has with a new branch of the monetary theorists
of the Austrian school or related to the Austrian school, competitive free banking. The government should be out of the banking business completely. It should be a private enterprise between depositors and
financial institutions and in which the ability to
manipulate the money supply and distort interest rates is if, in an imperfect world,
not completely eliminated, at least radically reduced
and minimized in any effects that is most likely and
historically is only occurring when the government has its hand on the handle of the
monetary printing press and influences the financial circumstances of banks to have money that don’t represent real savings to bring about imbalanced investments that disrupt the economy
time after time after time. That, in essence, is the Austrian argument about money, inflation,
the business cycle, and the advantages of
government having no hand on the monetary printing press institutionally in one form or another. The business cycle theory
is probably often the one best known by many people who get interested in Austrian economics, but it in itself is the sort of cumulative and final step of the entire body of economics in the Austrian tradition that we’ve attempted
to outline and present in at least some summary way
over this series of lectures. Understanding the individual, his choices, real scarcity, trade-offs,
opportunity costs, chances for merging exchanges, how profit guides entrepreneurs, the role of the entrepreneur, the signaling purpose of prices
to balance and coordinate, and at the end of the day,
how money can be manipulated to prevent prices including interest rates from doing their job. It is a body of knowledge as a whole that is interconnected and
built one step upon the other and gives a way of thinking
about economics and markets that, in my view, offers insights and challenging understanding that unfortunately some
other approaches do not. I certainly hope that this
series has been of value and use. Thank you for taking the
time and the interest for joining me and watching. (light jingle)

6 thoughts on “An Introduction to Austrian Economics, Part 9

  1. Congratulations on producing such an important series . very easy to understand what is normally presented as too complex for the average person. Thanks

  2. I have finished seeing all videos about this item. Awesome!! Thank you for sharing your knowledge with us. I have practiced English with them.

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