This is the next part in a series on the Austrian school of economics. The previous part was here.

The previous discussion comes more from a philosophical orientation. I do believe that philosophy does not follow theoria but precedes it as a necessary and determining factor. However, a philosophical argument of this type should not stand on its own but should be obligated to demonstrate how the enactment participates in the philosophical paradigm. To this end, I will begin a series of discussions that will deal with specific Austrian economic literature and issues. This is the first of that series…

On ‘savings’ and loans Jonathan Catalan, and Austrian economist states:

Production is derived from consumer preference. The explanation of the price mechanism above, however, simply assumes that the entrepreneur commands the necessary capital to invest and meet consumer desires. It is important to bear in mind that this capital, and the capital goods (producers’ goods) that it represents, does not simply appear ex nihilo; rather, it is the product of prior accumulation (savings). Savings can only be described as consumption deferred to an unknown future point in time, allowing temporary use of said capital for investment.

…

What triggers the revelation of this incomplete investment, oftentimes described as “malinvestment,”[40] is a consequent rise in the price of consumer goods relative to capital goods. That capital deepening did not come at the expense of consumer demand but instead was made possible by an artificial increase in loanable funds, suggesting that the initial fall in the price of consumer goods that should have otherwise taken place did not actually occur. Consumer-goods prices will also rise as a factor of an increase in the price of labor, a product of an increase in the demand for labor as a factor of production, and as a result of a possible diminishing in the stock of capital goods, as some nonspecific goods are used in earlier stages of production. The rise in the price of consumer goods catalyzes the abrupt shortening of the structure of production, revealing a mass of malinvestment.

“The Foremost Austrian Contribution to Economic Science”, Mises Daily: Thursday, January 06, 2011 by Jonathan M. Finegold Catalan, http://mises.org/daily/4924

It is perfectly understandable how loans could introduce artificial price supports on the capital side. However, the juxtaposition of ‘savings’ and ‘loans’ seems a bit archaic. Most businesses today would never get off the ground with ‘savings’. If ‘savings’ are defined as “consumption deferred to an unknown future point in time, allowing temporary use of said capital for investment” then, an implied capital base for investment is assumed. However, if most capital is always in flux, not sitting around waiting to be invested, but leveraged, then debt, as loan obligation, must be thought together with the notion of capital not in opposition to ‘capital at rest’. Capital as leveraged not ‘saved’ is the functional notion of business origination. I suspect that without loans, modern business, as we know it, would not exist. Capital works for the investor by balancing the service debt of leverage with anticipated profit. If pure ‘savings’ were used for investment then the notion that loss would get more effectively communicated to consumer pricing would have merit.

However, since capital as ‘savings’ is almost always leveraged with debt obligation, there will be some compression/expansion effect on consumer pricing. If economic fundamentalism does not take this compression/expansion effect into consideration as valid modifiers of market dynamics it will get forced into a fictional regression of ‘capital at rest’. Loans and leverage are not simply correlated to central bank liquidity. The compression/expansion effect would happen apart from a central bank influence. It may be true that central banks can influence this compression/expansion effect with monetary liquidity but a simple cause and effect relationship would have to be proven empirically. While the logical case that Catalan espouses could be true, it could also be that the private market could quite handily demonstrate the same lag between capital goods and consumer pricing with the leverage effect as well. So private sector loans, capital at work, would produce the same shielding effect of capital goods and consumer pricing. This, in itself, does not indict central banking.

If the Catalan’s argument wants to establish an exaggerated and aggravated relationship to the shielding from monetary policy, a purely logical argument will not prove whether this happens in the real word. In my opinion, economics should deal with the situation at hand and not a logical, hypothetical situation that could be. If Catalan wants to make a further point that private investors would more directly suffer the effects of private malinvestment than central banks and therefore be governed more by market risk than the central bank I think this is cogent. However, central banking in the U.S. came into existence not to protect the institutional investor from risk but to protect smaller deposits in banks. Consumers make up the lion’s share of the U.S. economy. Banks leverage consumer deposits to fund institutional investors. Banks also make it possible for institutional investors to push risk down to the consumer. Therefore, when institutional investors lose from malinvestment the effects of the risk are felt primarily by the consumer not the entrepreneurial investor.

Additionally, institutional investors do not invest equally and randomly over the entire breadth of the market. Institutional investors invest more heavily in businesses and market segments with proven track records. This has a congealing effect on capital investments in less risky, more certain returns on investment. To the degree that this occurs larger businesses with larger capital resources become the instrument of new business start ups and venture capital gets diverted from unaffiliated [with larger corporations] start ups to market conglomeration dynamics. This natural pocketing of capital resists the notion that a randomized investment pattern offsets risks/loses in the market and therefore exercises the least possible negative effects on individual parts of the market making booms and busts not likely [or less likely] to occur. It is quite possible that because of market conglomeration and even more, market monopolizing, apart from central banking concerns, booms and busts would still occur and their impact might not be mediated by the idealized, random effects of the pure free market, the fundamentalist’s dream.

If the consumer could absorb loss by pushing it further down, the hypothetical lesson learned from the brute market might salvage the market fundamentalism of Catalan. However, the dynamics change when the largest investor, the consumer, is also the bedrock of the market. The Great Depression and now the Great Recession are examples of what happens when the consumer loses on the free market. When consumers recoil en masse, the market suffers a catastrophic distortion that effects the normative operation of the market to recover. True, given enough time, even if the market and government totally collapse, the market will re-spawn perhaps with different rules from a different government but the question that should come to the fore is how much human suffering and regime change are we willing to endure before a recovery takes place? This decision is not an economic decision. It is a political decision. A devout faith in market fundamentals cannot break the tendency for capital to be leveraged, institutions as the instrument of leverage to push risk down and fund itself from the consumer, market busts to occur from natural market conglomeration, and the largest investor [in terms of sourcing capital] and least able to absorb loss, the consumer, take hits that produce social suffering, upheaval and regime change. All this can happen quite independently from the central banks issue [and I think could be historically demonstrated]. The question then becomes, can central banks worsen this situation? I am not going to address the whole issue of central banks now but I will bring up a few points for consideration.

I certainly think that central banks could worsen the situation. It is also possible that as I have already discussed that even if they did not exist the situation could get worse of its own free market accord. However, I also think that central banks can soften to impact of catastrophic market failure. The central banking system is not and should not be used as an instrument of market fine tuning. However, economies do not turn on a dime. Large economies are much like large cruise ships. You cannot head full steam into a slip and expect to throw a cruise ship into reverse for a soft impact. The central bank has to look far ahead and make changes in the economy with rather crude tools to try to forestall foreboding bubbles and busts in the normative operation of the market. When the economy stalls monetary liquidity can make more money available for loans, business start up and spur consumer spending. However, when central banks follow the philosophy that if some is good more is better, inflation and deflation is the inevitable outcome. I agree, historically speaking, inflation is more likely. The market fundamentalists appear to think that central banks can only either create or grossly aggravate booms and busts in the economy. They do not seem to believe that central banks can exercise an effective governor type effect on the economy. Consider this interview with Alan Greenspan, a Republican, a professed market fundamentalist, and Brian Naylor:

BRIAN NAYLOR: The man once known as the maestro for his direction of the nation’s economy as Fed chairman sat for four long hours yesterday, watching lawmakers who once cheered his performances turn into harsh critics. Testifying before the House Oversight Committee, Greenspan didn’t down play the severity of the crisis in the nation’s markets.

Mr. ALAN GREENSPAN (Former Chairman, Federal Reserve): We are in the midst of a once-in-a-century credit tsunami. Central banks and governments are being required to take unprecedented measures.

NAYLOR: Under questioning from Democrats on the panel, Greenspan conceded he might have been, as he put it, partially wrong in not moving to regulate trading of some derivatives that are among the root causes of the credit crisis. He also admitted his free market ideology may be flawed. This exchange with committee chairman, Democrat Henry Waxman of California, verged on the metaphysical.

Representative HENRY WAXMAN (Committee Chairman, Democrat, 30th District of California): You found a flaw in the reality…

Mr. GREENSPAN: Flaw in the model that I perceived is a critical functioning structure that defines how the world works, so to speak.

Rep. WAXMAN: In other words, you found that your view of the world, your ideology was not right. It was not working.

Mr. GREENSPAN: How it – precisely. That’s precisely the reason I was shocked, because I’ve been going for 40 years or more with very considerable evidence that it was working exceptionally well.

Additionally, there are practical considerations that the purist, market fundamentalists are not adept at addressing. In particular, I will repeat some points I previously made in another post on international realities and the U.S. Federal Reserve. Whether we like it or not, believe in a ‘free-market’ or not, the reality is that almost all other countries (and the Euro political conglomerate) manipulate their currencies. They subsidize businesses and whole market segments to their advantage. If we cannot or will not play that game we will lose. We live in a world economy where such historical and simpler models such as the gold standard would put us at a huge disadvantage relative to the rest of the world. If you are playing with dirty poker players you better be up on your dirty game or you will lose the majority of the time. For this reason we need a Federal Reserve that can devalue our currency relative to other large economic powers such as the Euro and Chinese Renminbi. This makes our exports more attractive and stimulates growth in our country. The Fed has multiple functions historically but some of these like overnight deposits for local banks are not as important as they used to be and others like the ‘elasticity’ of money, the money supply available at a given time in the economy, is much more important than it used to be. The Fed has to strike a balance between putting too much money into circulation and increasing inflation or not putting enough in and driving the cost of money up with higher interest rates thereby making credit harder to come by and growth slower. The flip side of putting more money in circulation is that our currency gets devalued relative to the rest of the world and our exports are stimulated. The Fed achieves the elasticity of money through buying and selling U.S. securities from the Treasury department (which is the agency actually responsible for ‘printing’ money). If we got rid of the Fed our currency would be at the mercy of the rest of the world economic powers. Therefore, we can control our monetary destiny or hand it to over to other powerful economies. This is where the real debate over the Fed needs to be centered. For this reason, I believe we need the Fed and our central banking system. Those that would get rid of the Fed in favor of the unfettered ‘free market’ would be sacrificing the elasticity of our money supply relative to other country’s un-free market like behavior.