The Impending Demise of the Euro. The Impact of Monetary Policy on the Sustainability of the Euro

Zaman, Tahmeed

The Impending Demise of the Euro. The Impact of Monetary Policy on the Sustainability of the Euro

Summary

The aim of this thesis is to study the impact of expansionary monetary policy on the European economies through the conceptual framework of the Austrian Business Cycle Theory. The European Central Bank has continually reduced interest rates as a policy measure to counter the sovereign debt crisis and this thesis examines the implications of this venture. From Germany’s perspective, the viability of reverting to the Deutschmark in times of monetary instability is also explored. The results, based on the deductive reasoning principle of the Austrian School, are also discussed.

Excerpt

Chapter 5: The Deutschmark ... 62

5.1 Agenda 2010 ... 63

5.2 German Stability Culture and Possible Exit from EMU ... 64

5.3 Reverting to the Deutschmark ... 66

5.3.1 Claim: Euro is stronger than the Deutschmark ... 66

5.3.2 Claim: Germany's export industry will collapse with DM ... 67

5.3.3 Claim: Europe will collapse if euro fails ... 70

5.3.4 Claim: Reverting to DM could be costly ... 70

5.4 Benefits of the Euro to Germany ... 72

5.5 Gold-backed DM and Countering Capital Inflows... 78

Chapter 6: Discussion ... 81

Chapter 7: Conclusion... 105

Reference List ... 110

List of Abbreviations

ABCT

Austrian Business Cycle Theory

Deutschmark

ECB

European Central Bank

EMU

European Monetary Union

EONIA

Euro Overnight Index Average

ESCB

European System of Central Banks

European Union

Fed

Federal Reserve of the United States

GDP

Gross Domestic Product

OCA

Optimum Currency Area

PIIGS

Portugal, Ireland, Italy, Greece, and Spain

Quantitative Easing

Repo

Repurchase Agreement

List of Tables

Table 1 | German Money Supply and Inflation Performance

Table 2 | Government Deficit/Surplus in Germany, France and PIIGS

Table 3 | Government Debt in Germany, France and PIIGS

Table 4 | Current Account Balances of Germany, France and PIIGS

List of Figures

Figure 1 | Deductive Reasoning

Figure 2 | Current Account Balance of Germany

Figure 3 | Bank Exposure

Figure 4 | EONIA

Figure 5 | Interest Rate Comparison between Euro Area and USA

Figure 6 | Key Target Central Bank Interest Rates

Figure 7 | Average Inflation in Germany and PIIGS

Figure 8 | Approximate Gains from EMU

Figure 9 | DAX

Figure 10 | Official Gold Reserves

Figure 11 | EU Money Supply: M3

Figure 12 | NASDAQ

Figure 13 | Dow Jones

Figure 14 | Unemployment Rates in EU

Figure 15 | Country-Specific Youth Unemployment

Figure 16 | Average Youth Unemployment in Eurozone

Figure 17 | EU Favorability in Selected Nations

100

Figure 18 | Three-month Interest Rates in Germany & PIIGS

101

Figure 19 | Approval Rating: Economic Issues

102

Chapter 1: Introduction

The sad reality is that the European countries that currently find themselves submerged in

the sovereign debt quagmire are not in a position to get out of it any time soon. It all started

when interest rates fell down drastically, encouraging investments and spending that were not

backed by an increase in savings. Bastasin (2012) observed that the eurozone had been on the

verge of sinking at least three times within the space of a few years; in September 2008, in May

2010, and in November 2011. In all three instances, the political motives behind the existence of

the eurozone have proven stronger than the weaknesses of the vessel and the ineptness of its

command. However, if this process continues for a while longer, it might not make much sense

to have a common currency in Europe.

In today's world where artificially lowered interest rates are undermining the value of

currencies, and policymakers are running out of ideas to kick-start weak economies, this report

presents the Austrian Business Cycle Theory (ABCT) as an alternative to the mainstream

economic line of thinking. The Austrian approach puts strong emphasis on innovation and

entrepreneurship for the sustainability of a healthy economy, and promotes sound money

policies. The hypothesis of our report is that if monetary expansion continues, then the euro will

be unsustainable, and Germany should revert to the Deutschmark.

The structure of this thesis is as follows: we begin with a brief history of the Austrian

School of economics, which discusses the emergence of the Austrian methodology, Austrian

view regarding `mainstream' thought, and identify predominant contributors to the Austrian

School. This is followed by a detailed analysis of the Austrian Business Cycle Theory. The next

chapter provides us with a theoretical look at the role that central banks play in the creation of a

financial crisis. Having discussed this in great detail, we then highlight the fragility of the euro

and how it may prove to be unsustainable in the future. The thesis also comprises of a chapter for

evaluating the possibility of Germany reverting to the Deutschmark in response to current

monetary instabilities. In addition, an elaborate discussion will be undertaken with particular

emphasis on savings, money supply, interest rates, government debt and deficits, unemployment,

inflation as well as deflation. Finally, a way forward is presented as recommendation in chapter

6, before the conclusion is drawn.

politics,

models.

insuffici

that it is

statistica

followin

Figure

overcom

both beg

there wa

the Euro

and Spa

analysis

invest h

risks in

core cou

domesti

These c

beyond

culmina

aversion

Unfortunate

, human beh

So, analysi

ient and in

s important

al models. T

ng method t

1 | Deductiv

Now, unde

me it. Bastas

gin with the

as a signific

opean Mone

ain (the acr

s, German a

hundreds of

the euro are

untries to th

ic demand (

ountries qui

their mean

ated in a gl

n, and the ex

ely, the story

havior and

is based on

certain cas

for us to se

Taking Aus

to identify a

ve Reasoni

erstanding t

sin (2012) i

e observatio

cant reductio

etary Union

ronym PIIG

and French

billions of e

ea. Within a

he peripher

(both privat

ickly becam

ns, particula

lobal crisis,

xternal defic

y of the Eur

an ever-exp

huge amoun

es led to en

elect deduct

strian Busin

and observe

ing

the causes

identified tw

on that once

on in real in

n (EMU). T

GS is often

h banks, am

euros in the

a short span

ry and this

te and publ

me reliant on

arly in Gree

the money

cit in the pe

ropean sove

panding mo

nts of data c

ntirely misle

tive reasoni

ness Cycle T

the problem

of the sov

wo main inte

e the euro c

nterest rates

These countr

used to de

mong many

e peripheral

n of time, th

massive inf

lic consump

n such forei

ece. Howev

y started to

ripheral cou

ereign debt

oney supply

crunching an

eading pred

ing as the r

Theory as th

ms before de

vereign deb

erpretations

came into e

s in the so-c

ries include

enote these

other finan

countries d

here was rap

flow of cap

ption), in c

gn capital in

ver, once th

dry up con

untries thus

crisis had m

y than with

nd risk mod

dictions. Th

esearch met

he starting p

eriving the r

t crisis is

s of how the

xistence as

called periph

Portugal, I

nations). A

ncial investo

due to the ab

pid moveme

pital led to

ountries lik

nflows, and

he financial

nsiderably d

became uns

much more t

predictable

dels have pro

hat is why w

thodology,

point, we w

right conclu

vital if we

e crisis evol

a common

heral countr

Ireland, Italy

According to

ors, were te

bsence of de

ent of capita

a sudden in

ke Greece a

d people star

l disruption

due to incre

sustainable.

to do with

statistical

oven to be

we believe

instead of

will use the

sion:

e want to

ved. They

currency,

ries within

y, Greece,

o the first

empted to

evaluation

al from the

ncrease in

and Spain.

rted living

s of 2008

eased risk

The second analysis states that as a result of lower interest rates, the pressure on

government debt service declined in the periphery, and government spending increased. Real

estate bubbles started to develop in Ireland and Spain, and until 2007, revenue generated from

these bubbles largely offset the significant increases in public spending. However, when

financial conditions worsened and the bubbles burst, the precariousness of fiscal positions in the

periphery came to the surface. So overall, low interest rates, reckless investments by German and

French banks, fiscal profligacy, government indebtedness and low efficiency in the peripheral

countries, all played a part in causing the sovereign debt crisis.

At the heart of this problem lies government intervention in the market. By buying

government securities and artificially lowering interest rates, a central bank can trigger an

increase in money supply and in the available funds for banks. The idea that governments could

smooth out the volatility of free markets by expanding the supply of money and running large

budget deficits in times of crisis is the main viewpoint of what is known as Keynesian

economics. The theories forming the core of Keynesian economics were first presented by the

British economist, John Maynard Keynes during the Great Depression of the 1930s.

Keynesianism allows governments to pretend that they have the power to raise living standards

with the assistance of a money printing press. The advocates of Keynes, called Keynesians, came

into conflict with the "Austrian School" of economic thought which followed the views of

economists like Ludwig von Mises and Frederick Hayek.

The Austrian economists have the opinion that recessions are necessary to compensate

for unwise decisions made during the boom phase that always precede the bust in a business

cycle. Austrians also believe that the booms are created by the false signals given to businessmen

when governments artificially lower interest rates in the hope of stimulating economies. So,

whereas the Keynesians look to mitigate the adverse impact of the busts, Austrians look to

prevent artificial booms from happening in the first place.

In this report, we encapsulate under the name of Keynesianism, not only John Maynard

Keynes's economic theories, but also the ideas of all schools of economic thought that seek to

allow excessive government interventions. In our view, any government influence that extends

far beyond the essential sovereign tasks of ensuring security and property rights should be

considered excessive. So, just like Vogt & Leuschel (2011), we draw no distinction among

multiple schools of economic thought, all of which demand a vigorous role for the government in

the society and economy.

Woods (2009) notes the fact that the Austrians warned of the formation of bubbles and

predicted the financial crash before anyone else did. Austrian economists consider the central

bank to be the main culprit of financial crises. The Austrian approach to understanding what has

happened to the economies of the world holds far greater explanatory power than does any

competing school of thought. According to Hammond (2012), the most important contribution of

the Austrian school to the field of economics is its theory of the business cycle (ABCT), which

offers a unique, comprehensive and coherent description of the process of booms and busts that

takes place frequently in a cyclical pattern. It highlights monetary intervention by the

government in cooperation with the banking system as the origin of these booms and busts. So,

let us now move on to the next chapter to discuss the Austrian school and its business cycle

theory in greater detail.

Chapter 2: The Austrian School of Economic Thought

The Austrian School of economics is one of the oldest schools of economic thought.

Birner & van Zijp (1994) highlights the fact that the Austrian School has contributed several

major ideas to what can be termed `mainstream' economics, most notably, the concepts of

opportunity cost and subjective value. The Austrian School was founded by Carl Menger with

the publication of Grundsätze der Volkswirtschaftslehre or Principles of Economics in 1871. The

Austrian method is largely based on theoretical deductive reasoning based upon axioms of

human action. By studying human action and reasoning logically, such seemingly complex

economic phenomena as interest, prices, profits and inflation could be explained and understood

as being grounded in the actions of individuals. They also

strive to solve complex economic

issues by means of outside-the-box thinking.

Austrian economists believe that human behavior is

too distinctive to be accurately modeled in mathematical terms and that it is best to have minimal

government intervention in an economy.

The Austrian School places special emphasis on interest rates and according to them, it is

determined by the time preference of borrowers and lenders. In other words, subjective decision

of individuals to spend money now or in future determines the rate of interest. F

rom an Austrian

economist's point of view, business cycles are caused by distortion in interest rates due to the

government's attempt to control money. When a government indulges in artificial manipulation

of interest rates, it results in the misallocation of capital and resources.

Moreover, the Austrian School insists that innovation and entrepreneurial profit seeking

are the two most important attributes that drives growth (Kirzner, 1997). According to them,

entrepreneurship is central to creating the growth and prosperity that most Keynesian economists

believe can be regulated by government intervention. Entrepreneurs are risk-takers, who

combine labor and natural resources with the purpose of creating profit. The personal gain from

the profit seeking activity helps not only the entrepreneur himself, but also raises the living

standards of everyone else. Furthermore, entrepreneurs help to enhance productivity by utilizing

resources efficiently, which makes it possible for people to consume more. So the economy does

not actually prosper due to a rise in consumption first, but rather the increase in consumption is

brought about as a result of the growth of an economy (Schiff & Schiff, 2010).

Austrian economists suggest that government intervention kills the entrepreneurial spirit

by setting up regulatory obstacles to enter the markets, and high taxation also decreases the

incentive to strive for success. However, if entrepreneurs do fail, the Austrian School is adamant

about allowing them to be eliminated. Companies that are not able to survive are considered to

be a misallocation of capital. Regardless of the size of these companies, those who have made

wrong decisions must be discarded from the market and the capital which is left behind would

then be reallocated and put to productive use. When such companies are bailed out by

government money, the unprofitable companies are kept in business, which prevents the tied up

capital from being better utilized elsewhere. Bailouts promote an environment of bad decision

making, and the issue of moral hazard arises. Woods (2009) defines moral hazard as the

increased likelihood of risky behavior arising whenever the acting party believes that any costs

of his behavior will be borne not by himself alone but by a large group of people.

2.1 Money

Almost everybody wants more money, and we generally use money without thinking too

much about its function. Few people are concerned about who controls the supply of money,

where it comes from, or why it has value. Since money is an integral part of our daily lives, it is

high time we take an interest in the aforementioned aspects to make sure that money remains

sound and does not become something that keeps on losing value.

Due to the inconvenience of bartering (where goods are directly exchanged for other

goods), money was invented out of necessity, and it has some major functions. Firstly, it is a

medium of exchange, which has eliminated the inefficiencies of the barter system, by being

generally accepted as payment for goods and services. Secondly, it is a unit of account which

facilitates the calculation of valuation, and most importantly, price comparison. In addition,

money is portable, implying convenience of usage, and last but not least, it is also supposed to

act as a store of value.

For money to be valuable, it must have limited supply. Ever since 1971, when U.S.

president Richard Nixon formally ended the convertibility of US dollars ($) to gold, all

currencies have become fiat currencies (money not backed by anything). Fiat currency is

considered as money solely because a sovereign government says it is money. It has no intrinsic

metallic or redemption value, and its nominal value is what the government engraves on the face

of the respective paper note or coin. However, the real value of fiat money is what it is worth in

exchange for the currency of another country (Schiff & Downes, 2009). Bonner & Wiggin

(2003) identifies clearly the main problem with all fiat currencies. It is that the fiat money

managers may create more of it, as per their convenience, without giving due importance to the

fact that they should never create so much that the illusion of scarcity is destroyed.

2.2 Business Cycles

A business cycle can be defined as fluctuations of aggregate economic activity. The most

widely used measure of this is the gross domestic product (GDP) variable. Other measures that

are included for a broader perspective on aggregate economic activity are unemployment figures

and financial market figures, such as the short term interest rate. The Austrian School and

Keynesians view business cycles in a contrasting manner. An Austrian business cycle goes from

a period of expansion to a period of contraction and is measured from trough to trough, while in

the eyes of Keynesians, an entire business cycle is a period of contraction followed by a period

of expansion and is measured from peak to peak. The period of time where aggregate economic

activity is growing is called the expansion or the boom phase. This phase goes from trough to

peak. In contrast, a contraction or recession goes from peak to trough, and represents the period

of time where aggregate economic activity is falling. If a recession is severe enough, it is referred

to as a depression.

Austrians explain business cycles with particular focus placed on the money supply. They

consider money supply, controlled largely by the central bank, to be explanatory of fluctuations

in aggregate economic activity. Austrians are convinced that they know what causes the bubbles

preceding a recession, while Keynesians believe that they have the necessary tools for avoiding a

recession when it emerges. Therefore, it comes as no surprise that these two schools of economic

thought always clash with each other due to the difference in viewpoints.

2.3 The Austrian Business Cycle Theory

The Austrian business cycle theory (abbreviated as ABCT) was first introduced by

Ludwig von Mises in 1912 in the book "The Theory of Money and Credit" and has since been

developed further. Two other predominant contributors to this development are Nobel Prize

winner, Friedrich Hayek, and Murray Rothbard (Ebeling, 1978). ABCT focuses primarily on

credit expansion, un-backed by savings, as being the cause of an unsustainable boom. Un-backed

credit expansion results from interest rates prevailing in the economy at a rate much lower than

that which clears the market. As interest rates coordinate present and future consumption, this

un-backed credit expansion initiates a boom by distorting the productive structure of an economy

with both unsound investments, mainly in interest sensitive producer goods, and

overconsumption. This unsustainable boom is inevitably followed by a bust.

When the mistakes are exposed, the malinvestments, as Mises called them, are liquidated,

creating the bust. Expansions that are financed by actual savings do not need such economic

busts. It is only the un-backed credit expansion that sows the seeds of their ultimate demise. As

Mises saw it, investors were not carelessly overinvesting; rather they were duped into responding

to false economic signals sent to them courtesy of the easy money policy (excessive monetary

expansion). According to Schiff & Downes (2009), this is the reason why Mises called such

mistakes, malinvestments, instead of over-investments. In any case, these malinvestments must

be liquidated, as prolonging their existence prevents the economy from shifting production and

consumption patterns to those that would otherwise contribute to long-term growth. (Bagus &

Howden, 2011)

Now, let us discuss in further detail, how credit expansion misdirects spending and

investment in an economy. First of all, credit expansion implies an increase in the money supply

but not an increase in real savings. Printing more money, or increasing the supply of credit, does

not make more resources available. Such a monetary expansion causes interest rates to fall down

even though there is no increase in real savings. At these artificially low rates, investment

projects become profitable that would be unprofitable if the rates were higher. As we know,

investment projects can be of varying lengths, so the entrepreneurs must decide which projects to

start. A high interest rate would naturally make entrepreneurs more cautious and prevent them

from tying up resources in long-term projects, unless they are sure that they can generate large

gains from such investments. In contrast, a low interest rate reduces the risk associated with

longer investments, and thus acts as a signal to tie capital up in lengthy projects (Murphy, 2016).

As a result, investment projects are undertaken that cannot be successfully completed with the

available real savings in the economy.

The second point to note regarding credit expansion is that it leads to an increased level

of consumption, beyond what it would have been if interest rates had been at their natural

(higher) rate. Just like in the case of any other good, the supply and demand of loanable funds

goes up and down, and they determine the price (interest rate). In a free market economy, interest

rates naturally go down if families are saving more or more banks are lending. By contrast, if

there is a shortage of loanable funds, interest rates go up, making it costlier for investors to

borrow money (Woods, 2009). In the absence of free market forces and

enticed by the artificially

reduced interest rate, people increase their current consumption, which naturally means that

savings decline.

Third, there is a shift to the financial sector where credit expansion creates the greatest

profits. Banks make use of this fresh liquidity prior to its use by others, thereby generating

profits before Cantillon effects set in (see page 24-25 for details). Prices will rise only after other

firms utilize the money. Moreover, Bagus & Howden (2011) explains that by extending loans

against its deposit base, the financial sector creates new money endogenously, and attracts

resources (and gains the associated profits) from all over the economy. Provided this process

continues long enough, the banks ultimately find themselves in a situation where they are being

surpassed (in relative profit terms) by firms engaging solely in financial speculation. It no longer

remains beneficial for these institutions to earn money exclusively by relying on extending loans,

instead speculation becomes the real profit driver, with profits relying on the continual influx of

money and credit.

According to the Austrian School, monetary expansion to finance government spending

sows the seed for a business cycle to take place. This credit expansion not only causes significant

increases in the money supply, but also large gains in asset prices (particularly in the housing and

stock markets). As observed by the ABCT, artificially inflated prices during the boom period

result in the eventual sharp decline in the value of stocks and housing. As the bust phase of the

business cycle is a period where resources are reallocated to their highest value use, any policy

which prevents this spontaneous market process from occurring, such as propping up of bankrupt

firms, must be avoided. An important observation garnered from the Austrian Business Cycle

Theory is that the economy will reallocate resources quicker in the absence of monetary

intervention, resulting in a shorter recessionary period.

2.4 Credit Creation and Liquidation

In an ideal world, credit creation should be the result of savings by depositors in banks. In

such a scenario, banks act as financial intermediaries and provide a link between savings and

investment. People deposit money with the banks in return for interest and these savings are then

loaned out to borrowers who also pay interest. The difference between the two rates of interest

generates the profit for banks. However, what we witness nowadays is that most credit comes

about through money printing which allows banks to issue loans that are not backed by adequate

amount of savings. This type of credit expansion is a clear violation of the monetary irregular

deposit contract. In this case, a bank's main purpose is to provide safety over the customer's

assets. The bank is obliged to pay the full amount of the deposit if and when it is demanded by

the customer. When this rule is not adhered to and money is printed out of thin air, the false

signal entrepreneurs receive from this increased supply of credit is that there has been a rise in

savings that will inevitably result in an increase in future consumption. This illusion brings about

Philipp Bagus ("Asset Prices--An Austrian Perspective," Procesos de Mercado: Revista Europea de Economía

Política 4, no. 2 [2007]: pp. 5793, "Monetary Policy as Bad Medicine") discusses the herd behavior that results

from this process.

an increase in the level of investments, which would not have taken place otherwise. (De Soto,

2009).

When the interest rate is set by genuine market forces, it gives the correct guidance to

entrepreneurs and hence only the most profitable projects would be undertaken, without any

malinvestments. If consumers are willing to defer immediate gratification, they save large

amounts of their income, which frees up real resources from current consumption. Naturally, this

pushes down interest rates and thus provides the right incentives for entrepreneurs to invest. In

stark contrast, artificially lowering rates result in unnecessary investments and encourages the

formation of unsustainable economic booms. F.A.Hayek was awarded the Nobel Prize in

economics for explaining this phenomenon by showing how central bank manipulation of

interest rates and money, create distortions throughout the economy and sets up the stage for an

inevitable bust.

It must be said that in the beginning, the unsustainable expansion appears prosperous.

Growth is visible in most industries, unemployment declines, while wages and commodity prices

go up. However, sooner rather than later, it all comes crashing down. Woods (2009) points out

that soon the realization strikes a large number of entrepreneurs that the pool of real savings is

actually smaller than what they had initially anticipated. Thus the complementary factors of

production turn out to be scarcer. The prices for labor and other resources will therefore be

higher than expected, and business costs will rise. Firms will then need to borrow more to

finance these unanticipated increases in input prices. This increased demand for loanable funds

will raise the interest rate, thereby bringing into question the feasibility of some of these projects.

To add to the woes, the banking sector starts to get nervous at this point. As banks become more

reluctant to lend, interest rates start to rise even further. The tightening in the credit markets

gradually becomes a source of pain for more and more businesses, especially the most leveraged

ones. Entrepreneurs finally figure out that they were too ambitious, as it becomes impossible for

them to complete the long-term projects they had begun. Workers get laid off as investment

projects are abandoned, paving the way for the painful bust to set in.

Central banks often try to delay this painful period of financial reckoning, where the

malinvestments are liquidated for an economy to be restored to its true health. They do this by

cutting interest rates again and again. It is just like kicking a can down the road, hoping against

hope that the inevitable would not happen, and the can will keep on rolling forever.

Unfortunately, what they fail to realize is that the can will ultimately reach a dead-end. They do

this in order to maintain labor employment by keeping unhealthy businesses afloat, but this only

prolongs and enlarges the adverse effects of the credit injection. As a consequence, the

corrections in the market become much larger in magnitude, making the subsequent recession

significantly worse.

Instead of letting the markets function under the pricing mechanism, Keynes believed

that government spending and monetary injection into the economy could instigate a rise in

demand for the goods of companies, and keep people employed. The key point here is that

Keynesians want to prevent the bust, whereas Austrians want to prevent the artificial booms,

created by false signals in the markets (Schiff & Schiff, 2010). Moreover, as mentioned earlier,

Austrians argue that unprofitable companies should be allowed to fail and go out of business.

This would open up the possibility for entrepreneurs with excess capital to purchase the valuable

assets for profit seeking activities. Such a process would assist in creating new sustainable

businesses and related employment.

Writing during the Great Depression of the 1930s, F.A. Hayek highlighted the adverse

effect of an easy money policy:

To combat the depression by a forced credit expansion is to attempt to cure the evil by the very

means which brought it about; because we are suffering from a misdirection of production, we

want to create further misdirection a procedure that can only lead to a much more severe crisis

as soon as the credit expansion comes to an end.

Robbins (1934) reiterates that nobody likes unemployment and bankruptcy, but they

would not have been necessary had the artificial boom not been stimulated in the first place.

Producer-goods industries attract more investment than the consumer-goods industries because

See F. A. Hayek, Prices and Production and Other Works, ed. Joseph T. Salerno (Auburn, Ala.: Ludwig von Mises

Institute)

that sector is the most sensitive to interest-rate changes, and so the impact of the downturn is felt

heavier there.

In a similar vein, Ron Paul (2009) continues by stating that when the need arises,

liquidation is necessary and will eventually prove to be beneficial. The financial world requires

this form of liquidation now.

2.5 Criticisms of ABCT

As with any other theory, over the years, some criticisms regarding ABCT have been

raised by economists belonging to different schools of thought. This discussion will mention the

two main critiques of ABCT, and refute them along the way.

First of all, based on the rational expectations hypothesis (REH), developed by American

economist Muth (1961), several economists have criticized ABCT arguing that the theory

requires economic agents to display a certain degree of economic irrationality. Caplin (1997)

raises an important question: why are entrepreneurs tricked into excessive investing by

government-induced artificial low interest rates, instead of correctly predicting central bank

policy and realizing that interest rates will be higher in the future?

To refute this,

Callahan

(2006) asks a counter-question: considering the fact that central banks throughout the world has

been manipulating interest rates for a protracted period of time, how would an entrepreneur

actually determine the `natural' rate of interest in the first place? For businessmen to figure out

the distortionary

effects of un-backed credit expansion, widespread knowledge of ABCT would

be necessary, which is unfortunately not the case today (Davidson, 2013). Even those

entrepreneurs, who have a clear understanding of the Austrian theory, may still find it hard to

resist the temptation of borrowing money when interest rates are artificially low. They may

consider it to be advantageous to invest while rates are low and attempt to ride the boom. A new

project might be launched in the hope that it will be one of the lucky ones and that the

entrepreneur will be able to get out before the downturn hits. Woods (2009) suggests that if these

businessmen are clever enough not to react to the artificially lowered rates, their competitors

surely will, which might enable them to gain market share at the former's expense. So, it

becomes part of human nature to take the bait.

Tulloch (1988) points out another criticism of ABCT, which is that the theory does not

explain why inflation cannot be continued indefinitely. In response, Rothbard (2009) states that

continued inflationary policies will be met with a decreased demand for cash holdings by the

general public. Cash holdings will decrease as there will be increased investment in goods which

might eventually instigate a period of hyperinflation and a flight from the currency. Let us now

move on to the next segment for a more detailed discussion about the important concept of

inflation.

2.6 Inflation

The Austrian School has the firm opinion that any increase in money supply which is not

accommodated by a rise in the production of goods and services leads to an increase in prices.

However, the prices of all goods do not increase simultaneously. Prices of some goods may

increase comparatively faster, while the first users of the newly printed money benefit at the

expense of others, leading to greater disparities in the economy.

A central bank is supposed to be independent, but to a large extent, it actually ends up

complying with the policies of the government in the financial markets. This means that it tries

to eliminate business cycles by printing money and financing deficit spending to avoid

recessions. When the central bank injects money into the financial system, the private banks

expand their level of credit. In this way, the Austrian School sees inflation as an increase in the

money supply which causes prices to rise, thereby posing a big danger to society (Schiff &

Downes, 2009). Most politicians and economists insist on defining inflation as a rising price

level, when in fact, rising prices is a harmful consequence of monetary inflation.

While attending

conference on the Economics of Mobilization, held at West Virginia, in April 1951, Ludwig

von Mises elaborated on the definition of inflation by stating that:

People today use the term "inflation" to refer to the phenomenon that is an inevitable

consequence of inflation, that is the tendency of all prices and wage rates to rise. The result of

this deplorable confusion is that there is no term left to signify the cause of this rise in prices and

wages...Those who pretend to fight inflation are in fact only fighting what is the inevitable

consequence of inflation, rising prices. Their ventures are doomed to failure because they do not

attack the root of the evil. They try to keep prices low while firmly committed to a policy of

increasing the quantity of money that must necessarily make them soar.

So in simple words, contrary to the generally accepted view, inflation is not a general rise

in prices, but rather it is a term that denotes an increase in the money stock. Mises claimed that

this confusion over defining inflation was mischievous and a deliberate attempt by governments

to get people to focus only on prices when thinking about inflation. Paul (2008) suggests that if

we understood inflation properly as an increase in money supply, we would instantly know that

the best way to cure it is by placing a demand on the central banks to cease manipulating the

money stock. Moreover, Paul (2009) adds that if it is considered only as a price problem, then

blame can be attached to speculators and profiteers. This deflects attention away from the real

source of the problem which is the central bank and its money printing press. Hence, the central

bank's role in the inflation is largely ignored.

Austrians believe that a rise in the money supply do not always manifest in economy-

wide increases in the consumer price index, which is considered as the standard definition of

inflation. Instead, the excess cash might flow into specific areas of the economy, depending on

real-world factors (Doherty, 2012). According to Paul (2008), it is also wrong to believe that

prices rise in conjunction with wages and salaries, and as a result, inflation causes no real

problems. In order to explain how inflation benefits certain parties at the expense of others, he

highlighted the distribution effects, or Cantillon effects of inflation, (named after economist

Richard Cantillon):

The price increases that take place as a result of inflation do not occur all at once and to the

same degree. Those who receive the new money first receive it before prices have yet risen. They

enjoy a windfall. Meanwhile, as they spend the new money, and the next wave of recipients

spend it, and so on, prices begin to rise throughout the economy well before the new money

has trickled down to most people. The average person is now paying higher prices while still

earning his old income, which has not yet been adjusted to account for the higher money

supply...The enrichment of the politically well connected in other words, those who get the

As quoted in The Commercial and Financial Chronicle, April 26, 1951.

newly created money first: government contractors, big banks, and the like comes at the direct

expense of everyone else.

To sum it up, expansionary monetary policies create inflation. Stabilizing prices is a

priority for both the Austrians and Keynesians, but the tools they use are totally different. In the

mainstream Keynesian line of thinking, the economy needs stimulus to avoid recessions, which

for Austrian economists is equivalent to the creation of widespread inflation.

2.7 Deflation

Deflation is commonly defined as a fall in the price level. The real definition of deflation

would be a decline in the supply of money. So, it the opposite of inflation, and is another form of

saying that money becomes more valuable over time. Deflation can be economically clarifying

as it causes banks to tighten up their lending standards and encourages businesses to run tighter

operations. Deflation also raises the real value of government debt and it can actually act as a

restraint on government spending, as it becomes harder to service the debt.

It is true that deflation can become a major cause for concern when demand disappears

due to a complete collapse of income in an economy. However, that is an extreme case as

generally, there is always demand at some level of prices. In simple terms, deflation means that

supply exceeds demand, causing consumer prices to fall. According to Schiff & Downes (2009),

most economists worry about falling prices for two main reasons. The first concern is that people

will stop spending and postpone purchases, as they anticipate cheaper prices, but there is no

evidence to justify the notion that this actually happens. He dismissed this concern by pointing

out that computers and cell phones are becoming cheaper day by day, but they continue to sell in

large volumes.

The other fear is that corporate profits would take a hit, causing companies to reduce

production, downsize and reduce future investments. However, what most people tend to forget

is that profitability is about margins. When costs and prices fall together, margins remain the

See Ron Paul, 2008 p. 103

same. In fact, constant margins often lead to greater profitability, as sales increase due to falling

prices.

Neo-classical Keynesian theory has generated deflation paranoia, and created an almost

universal acceptance that prices must keep on increasing to prevent a fall in prices. It must be

said that falling prices is not always good for an economy, but there is also a good form of

deflation, which Keynesians tend to ignore. Austrians argue that some prices fall naturally over

time due to competition, efficiency, innovation and technological progress. Computers, mobile

phones and televisions can be considered as prime examples of technological goods that have

become both better and cheaper, over the years.

2.8 Summary

Having discussed inflation and deflation at length, let us now recap some of the other

important issues that we have covered in this chapter:

· Economists belonging to the Austrian School believe that human behavior cannot be

accurately modeled in mathematical terms and

puts emphasis on the

distortion in interest

rates brought about by the government's attempt to control money to explain why we

experience frequent booms and busts.

· It is a common fallacy of the Keynesians that increasing consumption can be the solution

to current economic problems. In reality, an economy does not prosper due to a rise in

consumption first, but rather the increase in consumption is brought about by the growth

of the economy.

· The Austrian Business Cycle Theory (ABCT) highlights that interest rates can come

down in two ways: either naturally when the general population saves more; or

artificially when central banks force the rate down.

· If interest rates are lowered, businessmen respond by starting new projects. These

projects are usually undertaken in the most interest-rate sensitive areas, especially in the

so-called higher-order stages of production: construction, raw materials, and capital

equipments to name a few. In other words, these are the production processes that are

farthest removed in time from finished consumer goods.

· When the interest rate is lower because of a natural cause like increased saving, then the

market works efficiently without any hiccups. The decision of the general public to defer

consumption to a later date provides the incentive and necessary resources for the new

investment projects initiated by businesses' to be seen through to completion. However,

if the interest rate is lower because of artificial manipulation by a central bank then the

aforementioned projects cannot all be completed. The essential materials needed to

complete them have not been saved by the public, and hence it is soon discovered that

investors have been duped into production lines that cannot be sustained.

· Once these malinvestments become apparent, ABCT suggests that it is essential to

liquidate them. The sooner the monetary manipulation comes to an end, the faster

malinvestments can be eradicated and misallocated resources are redirected into

sustainable ventures. On the other hand, the longer governments try to prop things up in

the form of bailouts and rescue packages, the worse the inevitable bust will become in the

future.

Chapter 3: Central Banks and Monetary Union

Now, let us discuss in detail, the major roles of a central bank. The mission of a central

bank is to provide the nation with a safe and stable financial system. Its main functions are: (i)

being the bank of the government and commercial banks, (ii) being the lender of last resort, and

(iii) regulating the banking system and managing monetary policies (Parkin et al., 1997).

Being the bank of the government means financing its spending which can be done in

two ways. It can be done either by issuing a direct loan which is equivalent to money printing, or

alternatively, by selling government bonds. The central bank changes the supply of money by

buying or selling bonds in the bonds market in what is called open market operations. If it wants

to decrease the amount of money in circulation it sells existing bonds in the market, thereby

removing money from the existing supply. On the other hand, if the central bank wishes to

increase the amount of money in the economy, it buys bonds by creating money (Blanchard,

2003). The price of these bonds and their interest rates has an inverse relationship. The lower the

bond price, the higher the interest rate and vice versa. Thus, financing debt through open market

operations can be used to control the interest rate in financial markets.

Being the bank of the commercial banks imply keeping their reserves, regulating the

banking sector and acting as their lender of last resort. When central banks extend credit to

commercial banks in times of a credit crunch, it means they are serving the purpose of being a

lender of last resort. Restoring the cash levels of commercial banks helps to avoid a possible

bank run. In theory, the central bank can also regulate the money supply by increasing the

minimum reserve requirement.

A central bank can also directly set the interest rate at which commercial banks borrow

funds. Increasing the interest rate makes it more costly to loan money from the central bank,

encouraging commercial banks to cut down on their lending, while a fall in the interest rate

naturally stimulates lending. The banks are required to keep a specific fraction of their deposits

on reserve, to be made available for customer withdrawal. Banks can find themselves below the

reserve requirement set by the central bank if they have made a lot of loans or if an unusually

Details

Pages
Type of Edition: Erstausgabe
Publication Year: 2017
ISBN (PDF): 9783960676768
ISBN (Softcover): 9783960671763
File size: 3.1 MB
Language: English
Institution / College: University of Applied Sciences Worms
Publication date: 2017 (July)
Grade: 1.7 (German Scale)
Keywords: Austrian Business Cycle Theory Deutsche Mark Expansionary monetary policy European economy European Central Bank Debt crisis Austrian economics

Author

Tahmeed Zaman (Author)

The Impending Demise of the Euro. The Impact of Monetary Policy on the Sustainability of the Euro

Summary

Excerpt

Table Of Contents

Details

Author

Tahmeed Zaman (Author)