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The Austrian School of Economics- Pro et Contra

The Business Cycle and the Case of Free Banking

Ludwig von Mises and Karl Hayek

The representatives of the Austrian Economic School are the last knights of capitalism. They have a wonderful logic that we can only admire. They have a religious belief in the market forces, and they are uncompromising supporters of private banking.

The Austrians Ludwig von Mises and Friedrich Hayek are the most famous representatives of the Austrian economic school.

Ludwig von Mises 1881-1973 Ludwig von Mises was born in Lemberg, which is now part of Ukraine, to Jewish parents in 1881. His father was a railway engineer. One of Mises ancestors was knighted by the Emperor Frans Josef of Austria-Hungary in 1881; hence, the term "von" in his name. Ludwig grew up in Vienna.

Mises was economic advisor for the Austrian Dolfuss government 1932-1934.

Austrian Nazis murdered Dolfuss, and von Mises fled to Switzerland and from there to USA, where he lived the rest of his life.

His principal work is the "Theory of Money and Credit," published for the first time in 1912. It became a textbook in banking.

In this book he argues that the recurring economic crises, "The Business Cycle" are caused by an uncontrolled expansion of bank credit.

In 1922 he published the book "Socialism". That was five years after, the Soviet Union has been founded.

Socialism would inevitably fail, he wrote.

Since there is no market, which can define a price, it would not be possible to perform economic calculations. It would therefore not be possible to calculate, whether one or another economic alternative would be the most advantageous to implement. Therefore, a socialist economy cannot become optimised, and for this reason socialism would fail.

Ludwig von Mises never really got a foothold in the academic world in the United States. His ideas were too controversial for the economic professors, who in the post war era were more inspired by the Englishman John Maynard Keynes' ideas.

He died in New York in 1973 as a man of relatively small means.

Today, the Austrian Economic School is very popular, especially in the U.S. Numerous financial web sites profess to Mises and Hayek theories.

karl Hayek 1899-1992 - Nobelprize winner in economy 1974 Karl Hayek was born in Vienna in an aristocratic Austrian family in 1899. He was distantly related to the philosopher Ludwig Wittgenstein. Hayek was a student of Mises. When the First World War broke out in 1914, he lied about his age and joined the army. He survived the war and was decorated for bravery.

He lived a great part of his life in England.

Hayek received the Nobel Prize in Economics in 1974 for his work on "The Business Cycle". He believed, that the governments and the central banks' faulty monetary policy could explain the economic situation of society with its regularly recurring crises and unemployment. This means that their attempts to stimulate the economy with money creation and low interest rates in fact laid the foundations for new continually evolving crises.

His principal work is the "Road to Serfdom" from 1944. He warned his English countrymen, that the central planning, that was practiced during the Second World War, should cease, as soon as the war ended. Otherwise, it would lead to socialism. Under socialism, he wrote, the economic planning inevitably would fall back in the hands of a small group of key persons. They would be unable to process the overwhelming amount of information, and the succeeding chaos would pave the way for a dictatorship.

The Business Cycle

The Case of Free Banking - The credit Multiplier

The Business Cycle

Unemployed in the inter-war period Money note from the German inflation 1922-1923 The liberal capitalist economies seem to be organically linked to cyclical recurring crises characterized by business closures, unemployment and poverty.

These repeated, apparently unavoidable crises played a major role in the Marxist arguments against capitalism.

The inflation and unemployment in the inter-war period seemed to confirm this weakness of the liberal economic system. Then Mises published the second edition of "Theory of Money and Credit," which contained his theory of "The Business Cycle" in the form, we know today. The capitalist economics could be improved by an appropriate economic policy, he wrote, so that the recurrent crises could be avoided.
PRO The Austrian Economic School - The Business Cycle

The recurrent economic crises are simply a result of a misguided monetary policy. If only the governments and the central banks would leave the money to the market forces, they would not occur.

Mises explained that two types of credit are offered in the financial market. We can call them "transfer credit" and "created credit". Borrowers cannot see any difference. For them it is just credit. The difference comes from the way, they are created.

Local bank from about 1930 Banks receive deposits from many savers. Much of the capital, which in this way is created, they will lend to creditworthy customers, project makers, who will invest in raw materials, production machinery, labour force and similar.

If there were no increase in the money supply, i.e. the total available credit, then each saved monetary unit would represent a refrain of consumption here and now for consumption in the future.

Reduced demand for groceries would be balanced by a corresponding increased demand for investment goods. The number of job losses in the production of groceries due to the saving zeal, would largely be restored by the increase of jobs in the production of investment goods, machines and such like. The economy would be in a state of near perfect balance.

This basic form of credit, we call "transfer credit", because it represents a real transfer of demand from the grocery market to the market for capital goods.

Money note press on work in the printing shop of a Central Bank But however, the politicians and the central banks possess the right and the means to increase the money supply by making additional credit available for the banks, which in turn will offer it to their customers.

A "Monetary Expansion" is a recognized national economic tool to boost the economy and make the wheels of society go round. It has been used again and again all over the world.

Such additional credit we can call "created credit" because it does not represent a refrain of consumption here and now. No matter how much "created credit", which is offered the project makers, the consumers will in the short run demand roughly the same amount of groceries.

Since the additional "created credit" increases the total amount of credit, it will obviously cause the price of credit, namely the interest rates, to be lower.

The low interest rates will make marginal projects viable. Contractors and project makers will be tempted by the cheap money and launch new projects. They want to develop new products. They will plan new production lines and design of new buildings.

It takes a long time to prepare new products and new production facilities They need time to the technical development of the projects. The right technicians and specialists must be assigned. The right locations must be found. Buildings must be constructed, materials must be ordered, marketing must be planned and much more.

But the individual project maker is not alone on the track. Because of the new "created credit", many projects need engineers, specialists and skilled workers. Their salaries will go up. Increasing demand for raw materials and production machines will make their prices to rise. After some time the higher general salary level will make also the prices of groceries to rise.

In short, there will be inflation.

The new situation will again make the politicians and central banks to enter the field. They will be concerned that the economy is "overheating". The central banks will battle against inflation and raise the interest rates, and the politicians will brandish the saving knife and cut government costs.

The business cycle has again shown its ugly face The now increased interest rates and the increased costs will in turn make many of the new marginal projects unprofitable. Because of the inflation, the potential customers for the new product will no longer have the same purchasing power as before. Many of the new companies will go bankrupt, and their employees will be out of work.

Society is again in crisis. "The Business Cycle" has again shown its ugly face.

After further a few more years, the politicians and the central banks will plan a new monetary expansion to boost the economy, make the wheels go round and pull up their distressed society from the swamp.

The Austrian's point is, that the politicians and the central banks themselves create the periodic crises. They have exactly brought the economy out of balance by the excessive money creation, the "created credit".

If only governments and their central banks would allow the market to take care of itself, it would find a perfect balance, and the economy would not have to face the ever-recurring crises.

CONTRA The Austrian Economic School - The Business Cycle

It is a mistake to think that all economic crises have the same nature and similar causes, and that it basically is the same pattern that repeats itself again and again. The economy of the real world is not so simple.

Unemployed from the crisis in thirties The American crisis in the thirties was undoubtedly caused by an imbalance between supply and demand. There had been created some money, as the Austrians rightly point out. But this money was only passed to those, who had enough already, the businessmen and contractors. For this reason there was a boom in shares and other finance products ahead of the crises.

The American industry of the thirties was the most effective in the world. It produced all sorts of products. But the potential customers, the ordinary people had no money to buy for.

The oil crisis of 1973 was caused by the Arab oil suppliers closure of the oil supply as a protest against Western support for Israel's warfare.

The economic crisis in Southeast Asia in 1997-98 was causes by the manipulations of the international financial speculators.

Modern American unemployed The world's next economic crisis will fundamentally be caused by the globalization. We have carelessly engaged us in open competition with countries like China and India, where labor costs are about one twentieth of the level in Europe and America. It is becoming increasingly clear, that the West cannot take the competition.

But one has to agree with the Austrians that the ongoing crisis in Zambia and many crises in South America are due to excessive money creation.

The net present value model discounts all payments to present The investment theory has various mathematical models, which can determine whether a project is beneficial or not, for example, the Net Present Value Model and the Internal Interest Model. The result can be calculated with the accuracy of several decimal places.

The Austrians seem to believe, that contractors respond quite automatically on the indications of economic models, such as a positive result of the Present Value Model.

But the project makers of the real world are not such unconscious lemmings, that they immediately take action, just because the net present value of a project has been found to be positive at the last calculation.

Robert Storm Petersen's self-portrait "Fortune telling is difficult, especially about the future," wrote the Danish author Storm P.

Experienced project makers know, that estimates for expected revenues and costs several years into the future are associated with great uncertainty. Plus minus 50% does not sound unrealistic. Not to mention the uncertainty of the funding rate. Managers of the real world know that interest rates in the future will go up and down as they always have done. They will dispose in accordance with this knowledge.

In the real world, contractors and project makers are not so easy to tempt into action, as the Austrians' "Business Cycle" theory prescribes.

Typical retail shop from around 1930 The Austrian economists have an exaggerated faith in the market forces. "The market is always right" is a typical "Austrian" statement. As long as governments and the central banks will leave the market on its own, it will by itself find a perfectly stable equilibrium.

They believe that Adam Smith's "invisible hand" will guide everything to the best interests of the society. Perfect competition is characterized by many suppliers But Mises and Hayek disciples are living in the past.

"The Invisible Hand" works only efficiently under a near perfect competition. Which means that there are so many suppliers that they separately cannot affect the price.

Today's markets are almost all dominated by a few large international companies which share the market among themselves in friendly competition. For example, Carlsberg, Heineken, Budweiser and a few others dominate the beer markets.

This modern market form is called oligopoly. A few suppliers, who know each other, dominate the markets, and individually they are able to influence the price.

Modern shopping mall When Mises first described his "Business Cycle" theory in the years before and after the First World War, he was by no doubt quite right. The "invisible hand" of the market was a very effective mechanism, because the markets were of the type near "Perfect Competition". In Austria as well as in Denmark numerous suppliers characterized all business areas. There were small farms, independent fishermen, local furniture factories, small family stores, wholesale dealers and local contractors all over.

But one by one all the small family shops and the local contractor companies have given up. Today only very few own their farm, shop or company.

In the modern markets we can no longer assume, that the market forces automatically will manage everything for the best of society.

The Case of Free Banking

Ludwig von Mises Mises and the modern "Austrian" economists believe that a completely free banking, combined with a return to the gold base would be the ultimate solution of the "Business Cycling" problem. Such a system would be able to create the conditions necessary for preventing recurrent, devastating crises.

All legal restrictions on banking activities should be abolished. Central banks' monopoly on currency issuance to be abolished, and it should be free for any bank to introduce their own currency.

It would no longer be necessary to maintain legal restrictions on private banks money creation, as minimum reserve requirements and the like. Thanks to the requirement that all currencies should be redeemable with gold, the market forces will keep the individual currency-issuing banks in check, so they do not exaggerate their money creation.

PRO The Austrian Economic School - The Case of Free Banking

Ludwig von Mises introduced the concept of free banking in his article "Monetary Stabilization and Cyclical Policy" in 1928. He argued that the inflation and depression, which the industrialized countries had experienced the late nineteenth and in the early twentieth century, could have been avoided "if there had been no deviation from the principle of completely free banking, and if the case of "fiduciary media" in no way had been excepted from the laws of economic activity." "Fiduciary media" were bank notes, which were not covered by the bank's corresponding deposits, in other words the banks' money creation.

He had in mind the central bank's monopoly on currency issuing and certain rules which limited the money creation of private banks.

Only in connection with a completely free banking market the booms and crises of the business cycle can be finally reduced or eliminated, said Mises.

Citi Group The world's second largest Bank Ludwig von Mises modern American disciples have taken the case of "Free Banking" very much at their hearts.

The Central Banks with their monopoly on currency issuance owe their position to the politicians. For this reason they are in constant risk of being compromised by the executive power. National Banks works often as the prolonged arm of the government.

Central banks will always be vulnerable to political abuse. In election years, the politicians will motivate the central banks to stimulate the economy with increased money and low interest rates to improve their chances for re-election. Political pressures for increased employment can make ministers to motivate the banks to a loose monetary policy.

Neither politicians nor central bank directors have any perfect knowledge of the society. Therefore, they are not able to manipulate the economy with such scientific precision, as they like to make us believe.

Their political intervention in the market will simply bring it out of balance and provide basis for future crises.

Only a completely free banking, only regulated by market forces, can regulate the monetary system with success. Such market-based monetary system will be free of abuses and political agendas and thus be able to provide a stable national economy.

The Market forces would be a much better guarantee for a sound monetary policy, than politically appointed central bank directors can be.

UBS- one of the world's largest banks Free banks should be introduced simultaneously with a return to the gold standard. This will allow the market forces to be able to regulate and restrict the private banks money creation in the same way as the gold standard before in the years before the World Wars created a basis for stable international exchange rates.

Under the international gold standard, before the World Wars, the nations central banks were obligated to redeem their currency with gold to other nations. A nation, which solved their economic problems by running the money note press excessively, would then be punished with a corresponding increase in claims on their gold reserves. The years before the World Wars were for this reason characterized by very stable international exchange rates.

Let us imagine a currency issuing private bank, which have been tempted to let its money note press run. The large quantity of banknotes, which they in this way send out, will sooner or later end up in other banks' stocks. These other banks will go to the issuing bank and require having the notes redeemed in gold.

The bank, which has issued too much currency, will see its gold reserves shrink, and thereby be motivated to stop excessive printing of money notes.

It will work somewhat in the same way, as when de Gaulle in the years up to 1972 often required the Federal Reserve to get the French holdings of U.S. dollars redeemed in gold.

With such a free banking sector, the monetary system will wrench itself free of political abuse and form the basis for a liberal capitalist economy free from the cyclical recurring crises.

Perhaps the new stable monetary units will be named "Citi Group Credits", "UBS notes" or such like.

CONTRA The Austrian Economic School - The Case of Free Banking

The Austrians are raging against the governments and the central banks. They place all responsibility for the money creation in these organizations.

They want to put the entire monetary system in the hands of "the market", i.e. the private banks.

But yet it is the private banks, which accounts for the major part of the money creation. For several hundred years, it has been known that private banks create money.

Big banks are able to create money, completely independently of the central banks. To leave everything to them, seems to be like assigning the fox with the job to guard the chickens.

The famous Danish practical economist  C.F. Tietgen In December 1857, the Danish state owned "Loan Fund" addressed the newly founded Private Bank's twenty-nine-year director, C.F. Tietgen, and asked for a loan of several million "Rigsdaler". They intended to use the money to lend to savings banks, manufacturers and other companies, which had problems because of the difficult times. As a guarantee they offered a large amount of sterling cheques, which the government had received in connection with the abolition of the "Sound Duties".

The new "Privat Banken" had not nearly enough money to cope with such a large payout.

But on 21 of December Tietgen gave the following commitment: "Tomorrow, 1 million "Rigsdaler", the day after tomorrow 0.5 million and the rest after the holidays." Tietgen knew that loans create deposits. The recipients of the money would not like to keep such large amounts of cash in their private homes, particularly not during the Christmas holydays.

They would as fast as possible place the money in the bank. And as the newly founded "Privat Banken" was the only private bank in Copenhagen, a very large part of the money would quickly return to the bank, and then they could be paid out a second time.

Even though nowadays there are many banks in Copenhagen, they need not be afraid that lending money will not come back as deposits.

All money belonging to the citizens and the companies are namely in the banks all the time.

All our money are in the bank all the time When we make a payment with our payment card, we just move money from one account to another, possibly from one bank to another. When we buy something in the shopping mall, we pay with our payment card, and as we pull the card through the slit, the money will be moved from our account in the bank to the Shopping Mall's account in the bank.

Only in the few milliseconds it takes for some electrons to race from one account to another, one can say, that the money is not in a bank.

At C.F. Tietgen's time there was only one private bank. Now there are several. But however, they have a good cooperation.

As all banks offer credit on very much the same terms, then they can maintain roughly the same market share. Thus they will get roughly the same amount back in as deposits as they pay out as loans to their customers. When their customers use the loans, they have got, the money is just transferred from their account to some others persons accounts, in the same bank or in other banks. The monetary base of the bank will remain fairly stable.

Payment card for parking fees and purchase of gasolin A temporary imbalance in the cash flow between banks is easily offset by short-term interbank loans.

Only small independent banks seem to have trouble getting the money back. Perhaps too few of their traditional customers are left, the self-employed small contractors, farmers, family shops and such like.

Let us consider the traditional formula for credit multiplication:

A sudden saving zeal has given a bank a deposit of the size A.

The bank decides to set reserve ratios to "r" and lends out the rest


Very fast the lent money come back as deposits. Again, the bank applies its reserve ratio and lend out the rest

A×(1-r)×(1-r) which is A×(1-r)2

Very fast the lent money come back as deposits. Again, the bank applies its reserve ratio and lend out the rest

A×(1-r)2×(1-r) which is A×(1-r)3

Very fast the lent money come back as deposits. The bank can then do it again and again an indefinite number of times.

This means that the original deposit "A", the banks original monetary base, now have been multiplied to:

Summa = A + A×(1-r) + A×(1-r)2 + A×(1-r) 3+ - - A×(1-r)Infinite

It can be seen easily, as it is said, that this is a geometric series. The formula for the sum of an infinite geometric series from 0 to infinity is:

Summa = A/(1-a).

Where "a" is the ratio, here (1-r)

Then the formula for the "credit multiplier" will be:

Summa = A/(1-(1-r)) which is

Summa = A/r

Where "A" is the initial monetary base and "r" is the applied reserve ratio. We can see that with a reserve ratio of 0.05, the initial deposit, A, will be geared with a factor 20. Some say, that many big banks of our time in effect have used a ratio of 0.025 which represent a gearing factor 40. They have been too greedy and lent to a lot of marginal costumers, people who cannot pay back.

In the lifetime of Luwig von Mises and also in the time of bank director Varnęs the reserve ratio was called for "the cash fraction". Banks have all times strived to utilize their assets as best as possible. Only the invention of payments- and credit cards has made the whole scale of money creation much grander.

Today only very old people, criminals and tax-evaders still use paper money. Thus the overwhelming part the costumers of the bank use payment cards, which means that the money comes back into a banks in a flash of a second, as soon as they are used.

We can see on the formula that when the reserve ratio goes towards zero, the sum of created money goes towards infinity.

We see on our personal accounts in the bank that they are filled up with our salary in the beginning of the month, and as the days of the month pass by, the amount becomes smaller and smaller, as we spend money during the month.

But seen from the bank's perspective the money do not disappear during the month. The shops and companies, to whom we pay the money, have also accounts in the banks. So when we pay out for our cost, the money will in a split of a second be back in a bank, on another account of course and, possibly, in another bank. But in average the banks keep their market shares and they get pretty much the amounts as paid in as they paid out.

So no matter what we do, close to all the citizens' money will be in the banks all the time.

The Bank manager will have a walk around in his shop and find that actually he has a lot of money in the bank, almost the same amount all the time, even though they constantly flicker around from account to account.

Why not lend them out and earn some interest? He will think.

He will fix the reserve ratios to perhaps 0.03 and lend out the rest against an appropriate rate.

They lent money comes back quickly, because no one is holding cash nowadays.

The headquarter of Deutche Bank in Frankfurt Once again the bank manager will have a walk around in his shop, and he will find, that he has very much just as much money in the bank as before. Available unused funds are missed opportunities and missed profit. Again he applies the reserve ratio and lend out the rest. And so it goes.

Big banks are money factories. They can in any practical sense create all the money they want. Their real limitation is to find customers, who want to borrow all this money for an appropriate rate.

Some will object that modern banking is not like this. Savers do not just put the money in a bank account. Modern savers buy parts in, for example, a bond pool, administered by the bank.

But when this pools buy a bond, the price will be transferred to the Real Estate Credit Association, which will transfer the proceeds to the borrower, which in turn will transfer the amount to a seller or some building contractor companies, which in turn will transfer the money to their suppliers and their employees' salary accounts - who, like all other agents in this sequence, all have their money in accounts in the banks. So no matter what you do, the money will end up in a bank.

Modern banks have difficulties to find borrowers to all that money, they can create. They may choose to buy shares and bonds directly as investment banks. But in this way the money will also be back in the banks in a split of a second.

The investment banker buys a share from a private investor, the money will be credited the banks cash account and debited the private investors account - in a bank. Even if the private investor decides to escape from the share business and instead buy a summer-house, there will be no escape for the money, they will all, in a few seconds, come back in the banks through the sellers or the contractors accounts .

American bank run in April 1933 For large modern banks, the risk of a "bank run" is quite minimal. Everybody have his money in the bank. Where else should they be?

Moreover, all modern banks have arranged their business in such a way, that their costumers, the savers, bear the entire business risk themselves. If the savers want just a decent interest, which can match the inflation rate, they have to buy parts in an investment pools managed by the banks. Then all losses can be passed directly to the savers. "Sorry, this year business was not so good, the amount will be deducted your account." When the savers realize, that a crisis is going on, it can be already too late, his losses had already happened.

In a real emergency, the Government and the National Bank also will step in and keep the private savers out of harms way, they believe.

Therefore, large banks are not particularly interested in reserve holdings. For them reserves are representing just unemployed money, idle capacity and lost business opportunities.

Most likely they feel in very much the same way, as if the management of a machinery factory was asked to keep some of their expensive specialized machinery in reserve, doing nothing, even there were demand for the products.

Periodically many banks carry out "sweep operations" to minimize the amount of idle money, i.e. unnecessary reserves. All deposits above a certain size are reviewed and the risk of unexpected payouts assessed for each account. Reserves will be adjusted accordingly

In the credit multiplier example above the "reserve ratio" reflects a certain caution or lack of same. The money that in this way will be set aside in each round will simply not re-used as many times as the rest.

Using the credit multiplier principle, banks generate a large amount of interest paying loans and other profit making assets all based on a relatively small equity.

However, if and when some of their many debtors cannot repay their loans, it will represent a loss. Net loss has to be offset against equity. And if the bank does not have sufficient capital for this, it has a problem.

In the U.S. the banks are required to keep from 3 to 10% of loans as reserves (2007). All Euro area credit institutions must deposit 2% of selected liabilities, based on its balance sheet, in the European Central Bank.

Requirement for reserves as certain fractions of assets or liabilities are not used in Danish monetary policy.

Reserves are assets that are more liquid and therefore more secure than ordinary bank loan debtors. It may be gold, government bonds, paper money or just money that is not predisposed. The authorities, which requires reserves, must define how it should be understood.

Family shop from the thirties - Mises and Hayeks time Representatives of the Austrian Economic School imagine that the market forces will keep the currency issuing banks in check, so that they do not abuse their power by letting their money note press run freely to their own advantage. The "Invisible Hand" of the market will secure all in the best interest of society, they think.

The "Austrian" economists are living in the past.

"The Invisible Hand" works only efficiently in a near perfect competition market. Which means that there are so many suppliers that they individually cannot affect price.

In our parents and our grandparents' time, which was also Mises and Hayek time, was almost all business areas characterized by many suppliers. Almost half the population was closely related to it to have ones own farm or business. There were small farmers and gardeners, numerous fishing boats, thousands of small retail stores, local furniture factories and small contractors everywhere. All these players were small, they did not know each other, and individually they could not affect prices. The Markets could be described as a near perfectly competition and the prices were set by Adam Smith's "Invisible Hand".

Today's markets are almost all dominated by a few large international companies that share the market among themselves in friendly competition. This modern market form is called oligopoly. They are dominated by a few suppliers who know each other, and individually they are able to influence price.

Local Bank from the thirties Thus is also the case with the banking market. At the time when Mises wrote his book, bank services were in general offered by small independent banks, as we know them from "Korsbęk Bank" and "Omegn Banken" in the "Matador" TV series. But all these small banks, owned by local families, has long time since turned the key for the last time. The Banking market of today is dominated by a handful of large national banks, who know each other, such as Danske Bank, Jyske Bank and so on.

However, they are just petty local shops compared to the really big ones as Citi Group, UBS, Barclay, Morgan and so on. And in a completely free banking market, which the Austrians profess, the large international banks will be allowed to operate fully, also in Denmark.

A completely free banking market will result in that the big ones will be even bigger.

They will send the "Invisible Hand" to its final retirement. They will discreetly meet at an expensive health resort in Switzerland, where they will agree on how to get maximum revenue out of the given market, and how to share it.

Richard M. Ebeling has made a good introduction to the Austrian point of view :

Monetary Central Planning and the State

It contains many references to the history of economic theory. Also he presents the theoretical opponents of the Austrians in a quite fair way.

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