There Is a Huge Amount of Mean Reversion in Nate Silver's Model Right Now...
Academic Misconduct

Paul Krugman Asks a Question: On the "Austrian" Hatred of Fractional Reserve Banking, Paper Money, etc. Weblogging

Paul Krugman asks a question:

Ron Paul on Money Market Funds: [T]he Ron Paul link, in which [Ron Paul] condemned fractional reserve banking, prodded me to ask a question I’ve been meaning to ask: How do the Austrians propose dealing with money market funds?

I mean, it has always been a peculiarity of that school of thought that it praises markets and opposes government intervention — but that at the same time it demands that the government step in to prevent the free market from providing a certain kind of financial service. As I understand it, the intellectual trick here is to convince oneself that fractional reserve banking, in which banks don’t keep 100 percent of deposits in a vault, is somehow an artificial creation of the government. This is historically wrong…. But consider a more recent innovation: money market funds. Such funds are just a particular type of mutual fund — and surely the Austrians don’t want to ban financial intermediation (or do they?). Yet shares in a MMF are very clearly a form of money — you can even write checks on them — created out of thin air by financial institutions, with very few pieces of green paper behind them.

So are such funds illegitimate? What about repo, which has many of the same features?

One of the key lessons of the 2008 crisis was precisely that banks are defined by what they do, not by what they look like, and there are a whole range of financial arrangements that in economic terms act a lot like fractional reserve banking. So would a Ron Paul regulatory regime have teams of “honest money” inquisitors fanning across the landscape, chasing and closing down anyone illegitimately creating claims that might compete with gold and silver? How is this supposed to work?

OK, I don’t expect a serious answer. But it’s scary that this has become the more or less official doctrine of the GOP.

Well, in its origins it springs out of Medieval Christian (and earlier) condemnations of usury as unjust enrichment:

And by the 1920s it's part of a general fear of Jews, intellectuals, homosexuals, financiers, and people who weren't born rich but might be smarter and become richer than you. For example, Churchill's Secretary P.J. Grigg on Keynes:

I distrust utterly those economists who have with great but deplorable ingenuity taught that it is not only possible but praiseworthy for a whole country to live beyond its mens on its wits and who in Mr. Shaw's description tech that it is possible to make a community rich by calling a penny two pence, in short who have sought to make economics a vade mecum for political spivs...

But on the doctrinal level? I tried to untangle it. I am not sure whether I was successful. In any event, here it is all in one place:


Noah Smith ventures deep into the weeds where people talk about good German engineers and bad Jewish financiers:

Noahpinion: Inflation for the People: For the past few weeks I've been getting acquainted with the popular wing of the "Austrian economics" movement. First I discovered the Bizarro Economics World of online forums, then I got re-acquainted with Zero Hedge, which seems to have taken a more and more inflationista/goldbuggy/Austrian tone in recent years. Then a bunch of Texan friends started posting "End the Fed!" memes to my Facebook feed. So I went on Facebook and I asked: "Why do people want to end the Fed?"

In response, a friend sent me this video… a guy loses his house, and his American Dream is crushed. He is then taken back in time by a guy with a horribly fake African-American accent, to witness the source of his problems. As it turns out, everything is the fault of bankers, who steal people's money through fractional reserve banking. Eventually, banking power is concentrated in the hands of a shadowy cabal headed by the Rothschilds, to whom even J.P. Morgan must kowtow. Thomas Jefferson and Andrew Jackson temporarily hold off the evil bankers here in America, ushering in a huge boom "with real money, backed with real gold." But eventually the bankers get in, and end up forming the Fed, which proceeds to steal people's hard-earned money even more via inflation and collaboration with the IRS.

Anyway, for now I'll ignore the oddity of anti-semitic video makers latching onto an economic philosophy (Austrianism) invented by a Jewish guy and a movement (the Ron Paul movement) inspired by another Jewish guy. Anti-semitism has always been a bit weird like that. I'll also put aside the thing about fractional reserve banking (a subject for another post)…

We may never see Noah again…

So let me throw him a lifeline, in the form of an explanation of where this Austrian fear not just of central banking but of any kind of banking comes from:

Hoisted from the Archives: November 2011: Brad DeLong: "Fictitious" Wealth and Ludwig von Mises: In comments, rootless_e warns:

Attempts to make sense out of right wing Austrian economics can never amount to anything.

Nevertheless, like a moth to a flame--or like a dog to its vomit, or like a dog to something worse--whenever I see something like:

Ludwig von Mises: Attempts to carry out economic reforms from the monetary side can never amount to anything but an artificial stimulation of economic activity by an expansion of the circulation, and this, as must constantly be emphasized, must necessarily lead to crisis and depression. Recurring economic crises are nothing but the consequence of attempts, despite all the teachings of experience and all the warnings of the economists, to stimulate economic activity by means of additional credit...

I find myself under a mysterious but inexorable and irresistible compulsion to waste what would otherwise be productive work time trying to make some kind of sense of it--to at least understand wherein lies the error, and how somebody trying very hard to understand the economy (never mind that he is a big fan of the political leadership of Benito Mussolini) can go so pathetically wrong.

It is, of course, not the case that every expansion of the circulation is an "artificial" (and unnatural) "stimulation of economic activity" that must "necessarily lead to crisis an depression". So why does Ludwig von Mises think that it must?

Here is my current guess as to where von Mises is coming from:

Let us start out with a world of publicly-known technology and constant returns to scale in everything. People happily make things and trade them. And everything sells at its resource cost.

One of the things people make is little disks of gold, usually decorated with pictures of bearded men on one side and allegorical female figures on the other, with lettering saying things like: "Fecund Augustae" or "Concordia Militum" or "Fides Exercituum" on them. These little gold disks trade--like everything else--at their cost of production: the cost of digging the ore out of the ground, extracting the metal from the ore, and stamping the disk into the right shape.

Then somebody has a bright idea: Because these little metal disks are valuable and easy to carry, they are subject to theft. I will offer to perform a service: I will keep everybody's little metal disks in my stronghouse, and let's write out signed, notarized declarations that people have little metal disks in my stronghouse and they can trade those rather than the disks directly. And--as long as 100% of the circulating medium is backed by gold--everything goes on as before, with everything selling for its cost of production.

Then somebody else has a bright idea: They write out a whole bunch of signed declarations that they have little metal disks in the stronghouse, even though they actually do not have any such. They then buy things with these pieces of the circulating medium that they have written out.

These people, Ludwig von Mises says, are thieves: thieves pure and simple:

They have bought useful things.

They have claimed that they have done so by trading (claims to) valuable little metal disks (in the warehouse) for useful commodities.

But they have lied.

They did not have any valuable little metal disks for trade.

And, Ludwig von Mises would say, these lying thieves come in three forms:

  • governments that print dollar bills without having 100% gold bullion backing for them in Fort Knox.

  • banks that issue bank notes.

  • banks that allow depositors to write checks in amounts that exceed the specie reserves they the banks have in their vaults.

The problem, I think Ludwig von Mises would say, is that the wealth of society is the amount of work has gone into creating the commodities in the economy: the food, the clothing, the houses, the little gold disks. The sum of past work crystalized in commodities is society's wealth. The food is wealth, the housing is wealth, the clothing is wealth, and the little gold disks are wealth. Then add unbacked fiat money and bank credit--either public or private, it doesn't matter--to the mix. The fiat money and the bank credit are counted as wealth, as if they were claims to little gold disks that took sweat and tears to create, but they are not wealth at all. They are fictions: false promises that there is somewhere some valuable gold that you have title to.

And, Ludwig von Mises would say, the larger the unbacked circulating medium the bigger the lie and the theft. It is all guaranteed to end in tears. Whenever society thinks that it is richer than it is, plans will be inconsistent and unattainable. When that unattainability becomes manifest, that will trigger the crash and the depression.

That is, I think, where von Mises is coming from.

And, of course, this is wrong--so so so so so so so so so unbelievably wrong.

It is simply not the case that we can cheaply and easily buy things with money because it is valuable. It is, instead, the case that money is valuable because we can cheaply and easily buy things with it.

One way into the tangle of understanding why it is wrong is to ask each of us: Why are you happy accepting money in exchange when we sell useful commodities?

Hint: It's not because we are looking forward to going down to the bank, exchanging our bank notes for the little disks of gold usually decorated with pictures of bearded men on one side and allegorical female figures on the other with lettering saying things like "Fecund Augustae" or "Concordia Militum" or "Fides Exercituum" on them, taking our little disks home, and feeling happy looking at them.

That's not why we accept money.

We accept money because if we don't have any money we have to buy commodities with other commodities, and when we do so we are unlikely to receive the cost of production for what we sell. Have you ever tried to buy a latte at Peets with a copy of Ludwig von Mises's Money and Credit? It does not go well.

The fact is that your wealth is only worth its cost of production if you are liquid--if you can wait to sell until somebody willing to pay full cost of production comes along, which is not every minute. The use-value of money is that it allows you to time your other transactions so that you can realize the full exchange value of what you sell, rather than having to sell it at a discount.

Thus there is no paradox: no sense in which the existence of fiat money creates a situation in which society must necessarily think that it is richer than it is, with claims to total wealth valued at more than the value of total wealth itself. You think--correctly--that your fiat money has value, and that value is just equal to the discount from its cost of production that your other wealth incurs because it is illiquid. But what if the government prints more fiat money than the illiquidity gap in your other wealth? Well, then people will say: "I don't need to hold all this extra money. I would be liquid enough with less." Everybody will try to run down their money balances, and so the price level will rise until the real money stock is just what people think covers the illiquidity gap between their other wealth and its cost of production.

What von Mises misses completely is that the size of this illiquidity gap can and does change suddenly and drastically--and it is the business of the central bank and of the government to alter the quantity of money to keep such changes from disrupting the real economy.


I started thinking about Ludwig von Mises's claim:

Attempts to carry out economic reforms from the monetary side can never amount to anything but an artificial stimulation of economic activity by an expansion of the circulation, and this, as must constantly be emphasized, must necessarily lead to crisis and depression. Recurring economic crises are nothing but the consequence of attempts, despite all the teachings of experience and all the warnings of the economists, to stimulate economic activity by means of additional credit...

Note what von Mises is not saying:

  • He is not saying that myopic governments may overuse the inflation tax.
  • He is not saying that using monetary policy to push unemployment below the natural rate will generate accelerating inflation.
  • He is not saying that easy money and easy credit sometimes lead to financial crises that cause depressions.

He is saying something different and stronger. He is arguing against ever attempting to cure any depression by expanding the money supply: "never amount", "must necessarily", "nothing but the consequence", "all the teachings", and "all the warnings" are very strong phrases indeed, in one of the statements that led Milton Friedman to say:

there are Austrian insights that are of great value… but not in the field of monetary theory.

Paul Krugman comments on my willingness to think about von Mises. In summary, he says: better me than him:

Mental Monetary Disorders: Brad DeLong has been blogging about von Mises and his belief — shared by a number of people to this day — that any economic expansion driven by monetary expansion must somehow be unsound and destructive.

I'm glad he’s doing this. There’s a tendency on the part of economists, both liberals and Tory Keynesians like Greg Mankiw and John Taylor (because that’s what they are, except when they’re playing for Team Republican), to understate the depth of incomprehension on much of the right.

The best cure I know for the notion that a money-led expansion can’t be real is still the story of the baby-sitting coop… when the coop was depressed, it was depressed because of inadequate demand, and this inadequacy could be cured by issuing more scrip — money that was created by fiat. If you try to ask where the value of that money came from in terms of its production, you’ve already fallen into an intellectual morass. The point was that the miniature economy of the coop was suffering from inadequate liquidity, and creating more money eased that problem.

I know that a lot of people refuse to accept the possibility of such things, and nothing will convince them that a monetary expansion can ever do real good. But they’re mistaking their own confusion for profound insight.

From my perspective, the interesting thing is that von Mises and his remarkably and strikingly unmannerly present-day acolytes appear to believe all of the following:

  1. Increases in the real money stock produced by decreases in the wage and price level are efficacious at pulling the economy out of a depression.

  2. If labor unions push-up wages and prices so that they are "too high"--not, mind you, that real wages are too high (with nominal wages being high relative to consumer prices), but simply that the nominal wage is too high given the money stock--then a union-busting program that does not change relative prices but simply raises the real money stock is efficacious at curing a depression.

  3. Moreover, an increase in the real money stock that comes about from people spending time energy and resources digging gold from the ground and refining it is equally efficacious in curing a depression.

  4. However, a credit expansion caused by government money printing (or by leverage expansion by private fractional-reserve banks) is always, invariably, and inescapably poison.

Now any real economist looking at (1) through (4) has a very hard time even beginning to think how this striking bifurcation between "healthy" and "poisonous" expansions in the real money stock could have a basis in a coherent monetary theory.

I would like to hear an alternative theory as to where this mammoth #economictheoryfail comes from--other than the theory that it comes from enslavement to a naïve cost-of-production theory of value, according to which gold-backed money's value is in some sense "real" because of the resource cost of mining, while fiat money's value is in some sense "fake" and thus bound to cause trouble.

Anybody? Anybody? Bueller?


Daniel Kuehn:

Facts & other stubborn things: Brad DeLong issues a challenge to Austrians: [M]y interpretation of Mises is somewhat different from [Brad's]. Mises, following Menger, clearly doesn't have a cost of production theory of value. It's really much simpler than that. It's not that gold mining is more genuine because you have to work at it. It's simply that gold represents a fixed measure of value. And for Mises, not only is that acceptable - it's preferable. Otherwise, adjustments of the money supply create the illusion of artificial wealth, which for Mises would distort market signals…

But… but… but… If the cost of mining gold falls and we mine more gold and have more gold coins, the money stock has increased and we have the illusion of artificial (non-gold) wealth, which for von Mises ought indeed to distort market signals. Improved gold mining technology ought, for von Mises, to be as bad a thing as running a printing press.

But it very clearly isn't. I have found nothing anywhere in the Austrian corpus about the baneful effects of improvements in gold mining technology, and how they invariably lead to an Austrian boom-bust cycle--how a gold discovery distorts market signals and creates the illusion of artificial wealth just as any other monetary expansion does.

The point is that gold is not a fixed measure of value. Value is stuff that keeps you fed, warm, dry, and entertained. You can't eat gold. It doesn't keep you warm. (You could hammer it into a tent, I suppose--and it does serve as a source of amusement.) The price of gold in terms of commodities that yield utility varies--just as the price of fiat money in terms of commodities that yield utility varies.


In the words of Michael Corleone: Every time I try to get out they drag me back in...

The extremely thoughtful Daniel Kuehn comments:

OK, gold represented a "relatively" fixed standard of value (basically what Bill Woolsey says). That still seems considerably more plausible than your idea that the guy who drones on and on for hundreds of pages about subjective value theory (Mises) actually has a cost of production theory of value. There's a lot to criticize in Austrian economics - a cost of production theory of value is not on that list.

and follows it up with, in email:

I'm guessing if paper money increased at the rate that the gold supply increases [von Mises] would be a happy camper

And Robert Murphy inquires where Ludwig von Mises wrote my paraphrase:

an increase in the real money stock that comes about from people spending time energy and resources digging gold from the ground and refining it is equally efficacious in curing a depression.

So I went back to my notes and found it:

If gold production had been considerably greater than it actually was in recent years, then the drop in prices [in the early 1930s] would have been moderated or perhaps even prevented from appearing…

That is: if the increase in the money stock in the 1920s had taken the form of an increase in gold (created by the expenditure of human muscle power) rather than of paper money (created by human mental power), there would have been no big deflation in the early 1930s. No big deflation in the early 1930s, no objective need for a Great Depression, and no Great Depression.

That's the source of my belief that, in von Mises-world, if nominal wages are constant--if nominal wages are sticky--then expanded gold mining is an efficacious way of curing and avoiding depressions without major adverse consequences.

And if nominal wages are not sticky and move freely to clear the labor market? Then, in von Mises-world at least, we don't have a Great Depression to cure at all.

I think the analytical point is clear.

Now you do need to know that von Mises recognizes that he has created a problem for himself. He shifts his ground--but in so doing so he, I think, breaks all hope of analytic consistency. His escape hatch appears to me to demolish his own argument for the superiority of the gold standard. Von Mises writes:

attempts of labor unions to drive wages up higher than they would have been on the unhampered market… have nothing to do… actual money prices are higher or lower. Labor unions no longer contend over the height of money wages, but over the height of real wages…. Thus no reason remains for assuming that an increase in the gold supply must, in a particular case, improve the situation…

If that is correct, then there is also no reason for assuming that any monetary change can help or hurt. Most particularly, if real wages are that sticky, then von Mises's claim that you cure depressions by creating huge amounts of excess unemployment, smashing unions, thus putting downward pressure on wages, and so increasing the real money stock through that channel fails as well: wages simply do not fall, depression drags on, and you lose decades.


Our text remains:

Ludwig von Mises: Attempts to carry out economic reforms from the monetary side can never amount to anything but an artificial stimulation of economic activity by an expansion of the circulation, and this, as must constantly be emphasized, must necessarily lead to crisis and depression. Recurring economic crises are nothing but the consequence of attempts, despite all the teachings of experience and all the warnings of the economists, to stimulate economic activity by means of additional credit...

From my point of view, liquidity creation, duration transformation, and simple diversification are all attempts to make the law of large numbers work for us. They are largely successful attempts not to buy liquidity, immediacy, and Insurance from those who want to sell them, but rather to create them out of whole cloth--via clever applications of the principles of probability. As such, they are the preeminent examples of our largely successful ability to make the economy live beyond its means on its wits. Liquidity, immediacy, and insurance are good and valuable things: the marvel of financial engineering is that it creates them out of thin air.

But to von Mises, Ron Paul, and all their epigones, these forms of financial engineering are all terrifying.

I think that the deep point of view underlying von Mises's--and von Hayek, and Marx, and Ron Paul--complaint against fiat money in general and monetary management of the business cycle in particular is this: that value comes from human sweat and toil, not from being clever. Thus it is fine for money to have value if it is 100% backed by gold dug from the earth by sweat and machines and muscles (even if there is no state of the possible future world in which people actually want to exchange their pieces of paper for the gold that supposedly backs it). But it is not fine for money to have value simply because it is useful for buying things. There is, von Mises--and Marx, and von Hayek, and Ron Paul--think, something profoundly wrong on an economic and on a moral level with procedures that create value that is not backed by, in Marx's case, human labor, and in von Mises's and von Hayek's case human entrepreneurial ingenuity. And in its scarier moments some of the trains of thought emanating from this deep point of view slide over to: "good German engineers (and workers); bad Jewish financiers" (and "good Russian Stakhanovites, bad Jewish Trotskyite intellectuals").

Note that this does not just apply to fiat money produced by a government.

This applies to all financial market asset valuations in excess of capital cost of production (or perhaps the value of the inventions of the gigantic Krell-like brain of John Galt). They are, to von Mises, all cheats. Thus Von Mises loathes fractional reserve bankers and IPO-mongers as much as he loathes modern central bank chairs.

The "value equals cost of production constant returns to scale" viewpoint is an astonishingly powerful set of blinders to wear.

Anybody have a better theory?


March 2009:

A Note on Friedrich Hayek and Lionel Robbins in the Great Depression...: Larry White continues his war with Milton Friedman over Friedman's condemnation 25 years ago of "the London School (really Austrian) view that I referred to... when I spoke of 'the atrophied and rigid caricature [of the quantity theory] that is so frequently described by the proponents of the new income-expenditure approach and with some justice, to judge by much of the literature on policy that was spawned by the quantity theorists'. This time I appear to be Friedman's proxy:

Lawrence White: DeLong acts as though he is unaware (though elsewhere he has indicating having read my paper) Hayek's and Robbins' monetary policy norm was not that the central bank should let a deflationary monetary contraction procede. Rather, the central bank should stabilize nominal income MV, meaning expand M to offset a drop in V, and expand the monetary base to offset a drop in the money multiplier...

Since Friedman can no longer speak, let me say that I still agree with him. I think that White's painting of Hayek and Robbins as people who wanted to stabilize MV is completely wrong--it is Ben Bernanke and the inflation targeters who want to stabilize MV, not Hayek and Robbins. If you had asked Hayek back at the time, he would have said that increasing the monetary base from 1929-1933 in order to offset the decline in monetary velocity was the very last thing that he wanted to see done. Stabilizing MV at its 1929 level was not on his or Robbins's agenda by any means.

In fact, he did say so.

Let me pull out his 1932 denunciation of monetary policies that stabilize the price level:

Hayek (1932), "The Fate of the Gold Standard": ...the extraordinary influence exercised by two particular representatives of... the concept of a systematic stabilization of the price level... Irving Fisher and Gustav Cassel... succeeded in making the concept of price stabilization as the objective of monetary policy into a virtually unassailable dogma... the influence of which upon actual developments it is impossible to overestimate....


It was not a big step from the desire to be released from the unpleasant necessity of adapting the general standard of living to the lower level of national income by reductions in wages and prices, to a theoretical justification of a monetary policy which rendered inoperative the tendencies of the gold standard in that direction.... The most important error is the distinction drawn between temporary movements of gold... [which] should not be allowed to bring about any changes in the domestic volumes of credit, and 'genuine' movements.... What is left unexplained in this is why movements of gold should under any circumstances represent movements of capital that are not genuine.... [T]he great monetary theorists of the classical period from Ricardo onwards always insisted that a non-metallic circulation of money ought always to be so controlled that the total volume of all money in circulation changes in just the same way as would happen if gold alone were in circulation....

[T]he artificial prevention of the fall in prices... up to 1929... is not meant to depict the fall in prices which has occurred since then as innocuous.... Instead of prices being allowed to fall slowly [from 1918 to 1929]... such volumes of additional credit were pumped into circulation.... Whether such inflation merely serves to keep prices stable, or whether it leads to an increase in prices, makes little difference...

Today I would note that Hayek appears to share the gold fetishism of von Mises and others: the "great monetary theorists" insist that the proper monetary policy has the money supply "controlled [so] that the total volume of all money in circulation changes in just the same way as would happen if gold alone were in circulation".

Thus if improvements in gold mining technology halve the cost of production of gold and so double the price level, that--according to Hayek--does not produce any price system distortions that lead to overinvestment and require a prolonged and painful liquidation to put things right. But if a fiat-money government were to undertake policies that double the price level in the absence of improvements in gold mining technology, that would produce price system distortions that lead to overinvestment and require a prolonged and painful liquidation to put things right.

Needless to say, there is no coherent model of a monetary economy in which this could possibly be correct.

Thus I interpret it as the survival at a prelogical level of a deep attachment to a cost-of-production theory of value, whereby it is the sin of the Mammon of Unrighteousness for anything that can be produced as cheaply as fiat money is to actually have value, and that sin must bring fearful retribution from the Gods of the Market.