Austrian Economics, Money and Finance

Thomas Mayer

• Publisher: Routledge
• Year: 2017
• ISBN:
  9781351685528
• Edition: 1
• Topic: Business
• Subtopic: Finanza
• Index: Business

The financial crisis has exposed severe shortcomings in mainstream monetary economics and modern finance. It is surprising that these shortcomings have not led to a wider debate about the need to overhaul these theories. Instead, mainstream economists have closed ranks to defend existing theories and public authorities have expanded their interference in markets.

This book investigates the problems associated with mainstream monetary economics and finance, and proposes alternatives based on the Austrian school of economics. This school emanated from the work of the nineteenth-century Austrian economist Carl Menger and was developed further by Eugen von Böhm-Bawerk, Ludwig von Mises, and Friedrich August von Hayek. In monetary economics, the Austrian school regards the creation of money by banks through credit extension as a key source of economic instability. From this follows the need for a comprehensive reform of our present monetary system. In a new monetary order, money could be issued by both public and private institutions, and there would be no need for fractional reserve banking. Instead of creating money, banks would intermediate it.

In finance, the Austrian school rejects the notion of rational expectations and measurable risk. Individuals use their subjective knowledge to gather and evaluate information, and they act in a world of radical uncertainty. Hence, markets are not "efficient" nor can portfolios be built on the basis of known probability distributions of asset prices as described in the modern finance literature.

This book explores the need for a new theoretical foundation for asset pricing and investment management that will give practitioners more useful orientation.

1  Introduction

As I write these lines I have an eye on the Dome of Cologne. The foundation block of this monumental cathedral was laid in 1248. The choir was inaugurated in 1322 and building work continued until 1590, when it was stopped, probably for financial reasons. In 1842 construction was resumed and the cathedral was finished in 1880. In 1943, the Dome withstood bombs of British war planes and was repaired after the war. Since 1996 it has been a UNESCO World Heritage Site.

Most of the time, those building the Dome were not construction engineers but master builders. Master builders used common sense and their experience, gained through trial and error, to create astonishing works, which have not only been beautiful, but have also stood the test of time. With the rise of the science of physics, the master builders were replaced by architects and construction engineers. The latter applied the law of physics to construction. Some of the beauty created by the master builders may have been lost, but the construction engineers were able to build bigger and taller buildings. Thanks to construction engineering, we can today build skyscrapers 830 meters high (the Burj Khalifa in Dubai), which are even resilient to earthquakes (the 300 meter high Abeno Harukas in Osaka). No one in his right mind would advocate abandoning construction engineering and going back to construction in the way the master builders did it.

As long as people have built buildings they have also saved and invested (which in fact are requirements for being able to build). Most of the time, savers and investors have relied on common sense and experience, gained through trial and error, like the master builders. With the rise of economics as a science, however, the investing of savings has also turned into an engineering science. This science, known as Modern Finance, emerged in the 1950s and rapidly gained influence on decision makers in the financial area. Like the construction engineer in the building trade, the financial engineer became the dominant figure in the financial sector. And like the construction engineers in the real world, the financial engineers built skyscrapers in the financial world, because they were convinced that they had equally reliable formulas at hand.

However, during the Great Financial Crisis of 2007–08, the financial skyscrapers fell down. The general public blamed the greed and irresponsibility of bankers for the catastrophe. Politicians and academics in economics and finance joined in on the banker bashing as it distracted attention from their own contribution to the mess. I do not want to whitewash the bankers. But in this book I shall make the case that mainstream macroeconomics and Modern Finance deserve a fair share of the blame. They produced theories which may have been internally consistent, but not applicable to the real world. Nothing would have happened, had they remained a pastime for the residents of the ivory towers. But they broke out and guided decision making in economic policy and financial activities.

What is to be done now? In this book, I argue that practitioners in economic policy and the financial sector need to go back to practical knowledge, based on common sense and experience gained from trial and error. Physical science can be successfully applied in construction, but mainstream macroeconomics and modern finance do not work in the fields of economic policy and finance. What is then left for economics and finance as sciences? Economics and finance are social sciences and follow rules that are different from those of natural sciences. They are unable to derive reliable quantitative impulse response functions for individuals, groups or societies as a whole in the way natural sciences do for objects. But they can analyze and describe the patterns of behavior of individuals, groups and societies. Based on the recognition of such patterns, they can make qualitative predictions. In this book, I shall argue that the Austrian school of economics provides a highly useful base for rethinking macroeconomics and finance from a sociological perspective.

The remainder of this book is organized as follows. Part I is about money. In Chapter 2 we discuss the functions and the creation of money. Money is an insufficiently understood social instrument, created by human societies more complex than families or tribes, to facilitate economic transactions. In the course of history, money has acquired several functions. It has been used as a means of exchange, store of value, and unit of account on the one hand, and as a measure of debt on the other. Where money is used as a means of exchange, store of value and unit of account, it can exist without a state. Even when anarchy rules and people do not trust each other, money will emerge spontaneously (i.e., without being planned) to allow people to transact. Since money in this function was generally derived from a suitable commodity, it has been called commodity money. Reflecting its nature of an asset, I call it “active money”.

Things are different when economic transactions are based on credit and debt. In this case, every more complex society needs an authority to enforce creditor-debtor relationships when needed. Hence, the function of money as a measure of debt tends to emerge in societies that organize themselves as states. States tend to take advantage of their role as enforcers of creditor-debtor relationships expressed in monetary terms by monopolizing the issuance of money. This allows them to issue new money to appropriate goods, services and assets of their citizens to themselves. Money becomes “legal tender”, which is another word for state money. Reflecting its nature of a liability I call it “passive money”.

Chapter 3 reviews different perspectives on the nature of inflation. Mainstream economists all agree that inflation refers to an increase in the general level of consumer prices, whereby changes in relative prices do not play a major role. Seen over the long-term, inflation is the result of an excess supply of money. According to the Keynesian view, money may influence the real economy in the short-term but is neutral in the long-term there as well. The mainstream theories are fairly vague about how new money reaches people. This is exactly the point where the Austrian school of economics comes in. It explains the creation of money as a result of the extension of credit by the banks. This has consequences considerably different from the mainstream view. Money creation leads to a change in relative prices and influences the real economy in a decisive way over both the long and short term. Inflation can manifest itself in a rise in consumer prices, asset prices or both. Credit extension and money creation have a significant influence on the distribution of income and wealth.

Chapter 4 discusses the concept of interest. There are an astonishingly large number of ideas in the economic literature about the nature of interest and how it arises. It is even more astonishing that there is no consensus among economists, which one of the various ideas and explanations is the most appropriate one. In accordance with the Austrian school of economics, I end up with the definition of interest as time preference. Since time is a scarce resource for humans, waiting must be compensated by interest.

Should we be content with our existing monetary order or does it pose problems? If so, are there better alternatives? These are the questions pursued in Chapter 5. Answers to these questions are closely associated with the question of whether the state should play a constructivist role in the economy or better show more restraint, because it throws spanners in the works of the economy. In my view, history has answered this question clearly: Less state influence confined to the upholding of a market liberal economic order is better than more meddling. Consequently, this chapter ends with a plea for the move from our existing money order, which leads to more and more government interference, to another one more distant from the state, in which money is legally defined as an asset.

In our existing system, credit money is produced in a public-private partnership (PPP). Banks create book money through credit extension, while the public sector guides the money creation process and acts as a backstop in the case of problems. Chapter 6 discusses the alternatives to this system, which follow from the dissolution of the PPP of money production: the nationalization or the privatization of money production. The chapter concludes with the support of private issuance of active money in a competitive setting. Government plays a minor role in an active money order as this order is based on social convention instead of government design. The role of government is to enforce general and abstract legal principles in the financial sector, and not to organize it according to its own design.

Part II of the book is about finance. To set the stage, the role of ownership and debt in investing is discussed in Chapter 7. Ownership is central to economic growth and development. By investing in shares, one can participate in the return of productive capital. Yet, when investing in shares, one must always evaluate how the company is positioned and whether the interests of shareholders are appropriately considered. Investing in bonds requires less intimate knowledge of the issuer’s economic circumstances and provides the bondholder more protection against losses than a shareholder gets. This is why the return for bonds is lower than that for equities. Government bonds are particularly popular among investors. However, it is precisely with this type of borrower that the risks are high, as a government may choose to repay its debt with money that is worthless.

Chapter 8 presents the building blocks of Modern Finance Theory (MFT), which extends from the “Mean Variance Optimization” (MVO) introduced by Harry Markowitz in 1952 to the option pricing theory (OPT) of Fisher Black and Myron Scholes published in 1973. Between these two building blocks are important others, such as the “Efficient Markets Hypothesis” (EMH) established by Eugene Fama in the 1960s, and the “Capital Asset Pricing Model” (CAPM) developed by William Sharpe, John Lintner and Jan Mossin and extended by Robert C. Merton in 1973. The sketch given here should not be seen as a short-cut to a more intensive study of MFT and its elaborations, although it intends to give more than just a superficial introduction. Its purpose is to enable the reader to appreciate the achievements of MFT, and to better understand the criticism of it presented in the following chapter.

In Chapter 9 we look at assumptions needed for the theory of Modern Finance to work. We examine in particular the assumptions of the rationality of investors, and of the Normal Distribution of financial prices. For both cases, we arrive at the conclusion that the assumptions do not hold in real life. The consequence is that markets are not “efficient” in the sense of Modern Finance, and risk cannot be measured as described there.

This alone would be sufficient to reject the application of Modern Finance as a guide for practical action in the financial area. But other important assumptions, such as permanently liquid markets or unrestricted access to loans at a risk free rate, are also not fulfilled. Nevertheless, many actors in financial markets and economic policy have relied on the wisdom of Modern Finance. The consequence of this is the subject of the following chapter.

Chapter 10 uses three historical events to show how Modern Finance contributed to financial crises, and how it arrived at the end of its wisdom in the zero-rate era after the Great Financial Crisis of 2007–08. First, in the stock market crash of 1987 “portfolio insurance”, which had promised to limit drawdowns in portfolio values by computer-driven quick sales of equity holdings in difficult market conditions, was demystified. Second, towards the end of the 1990s the hedge fund Long-term Capital Management (LTCM), staffed with Nobel Prize winning economists, failed because of the incomputability of risks. Third, in the course of the 2000s the engineering science of Modern Finance seduced market participants to the construction of products and management of risks, with which any level of indebtedness allegedly could be carried without any problems. After the Great Financial Crisis, the recipes of Modern Finance have been used to repair the damage created by their use. It is high time to heed Albert Einstein’s warning that we cannot solve our problems with the same thinking we used when we created them.

Chapter 11 presents the main building blocks to an alternative theory to Modern Finance, which I call Austrian Finance. As explained above, economics and finance are social sciences. They need to analyze and describe the patterns of behavior of individuals, groups and societies, in order to make qualitative predictions. The key insights of this analysis are: (1) people base their action on subjective knowledge; (2) they minimize the time it takes to reach their objectives and hence have positive time preferences and positive “natural” interest rates; (3) markets are in a continuous dynamic disequilibrium; (4) uncertainty is radical and cannot be measured; (5) the diversification of portfolios serves the purpose of reducing the consequences of errors and follows the rule of diminishing benefits from diversification.

Chapter 12 gives a few examples of the application of the insights of Austrian Finance. First, we discuss the rationale for “passive investment” in index- or exchange-traded funds, and “active investment” in discretionary funds. Next, we have a look at hedge fund strategies and so-called “factor investment”. Finally, we discuss the problem of an investor who intends to distribute his consumption over his lifetime more equally through saving and dissaving.

Chapter 13 concludes with a few thoughts on the relationship between the order of our society and of our monetary and financial order. Our existing monetary order reflects the mixture of private and public elements in the order of our society. Since the Great Financial Crisis, the public elements have increased. In the monetary domain, this has been reflected in the rising influence of central banks and the growth of government regulation. The next step would be the nationalization of money or, as the advocates put it, the change-over from our mixed order to a sovereign money order. This seems more likely than the opposite, the reestablishment of money as a social technique developed in a spontaneously ordered society. The demise of liberal principles in the order of our society seems inevitable. It is also regrettable as it undermines the progress mankind has made applying these principles.

Part I

Money

2 The functions of money and money creation

Whether we like it or not: Money plays a crucial role in our lives. Soon after we as children learn how to do simple math, we start using this skill with money. Then there are those who spend their last days of clarity mulling over who will inherit the money they have earned over a lifetime. Due to its importance to our lives, many of the social sciences deal with the question of money.

Monetary theory and policy also figure prominently in the economic sciences. One would therefore assume that we know full well what money constitutes. But as surprising as it may sound, that is not the case. Money is a complex and insufficiently understood social instrument. As we will see later in this chapter, there are two very different views of what money represents. For some money is a special commodity which, as a result of social consensus, has developed into a means for the exchange of goods. For others it is only a measure of debt that we owe others who provide us with an economic good.

Give and take versus trade

In literature, there are two schools of thought on the nature of money: an anthropological one and an economic one. The best-known representative of the economic one is the Scottish philosopher Adam Smith who, in the eighteenth century, laid the foundation for the doctrines behind what constitutes economics today. But, one of Smith’s challengers from our current time is the anthropologist and activist David Graeber, who is a professor at the London School of Economics and Political Science. In this unfair competition, we have on the one side a social philosopher from the eighteenth century and an anthropologist, financial system critic and self-declared anarchist on the other. Let us look at both more closely.

According to Smith, production can be increased by the division of labor. From this follows the need to trade.

This division of labour, from which so many advantages are derived, is not originally the effect of any human wisdom, which foresees and intends that general opulence to which it gives occasion. It is the necessary, though very slow and gradual, consequence of a certain propensity in human nature which has in view no such extensive utility...

Table of contents

• Cover
• Title
• Copyright
• Dedication
• Contents
• List of figures
• List of tables
• 1 Introduction
• Part I Money
• Part II Finance
• Index