The flaw of the monetary system and proposals for reform An Austrian Perspective.

Extended Abstract Submitted to RIBM Doctoral Symposium 2011 30th 31st March

Richard Whittle Research Institute for Business and Management Manchester Metropolitan University Business School Aytoun Street Aytoun Building Manchester M1 3GH Tel: +44 (0) 7960007233 Skype: Richard.Whittle4 Fax: +44 (0) 161 247 6854 E-Mail: Richard.Whittle@stu.mmu.ac.uk
Richard Whittle Page 1

Abstract There is a clear ideological clash between the Austrian and Neoclassical schools of economic thought. The neoclassical school approaches economic study from a mathematical positivist ideology as used within the natural sciences, the Austrian school, criticising the reliance on constants and fixed laws for the study of human action, take an approach based upon verbal formalism and explication (de Soto 1998). Austrian philosophy acknowledges the subjectivism of human decision making which they argue cannot be encapsulated within mathematical formalism (Mises 1977). Austrian theories of economic cycles and the monetary process have clear relevance to the study of financial crisis and recession (Miller 2009), the view of these events as a readjustment of the market against malinvestment and the false temporal subjectivism created by the inevitable expansion of fiduciary media is worthy of further study in light of current events. A mixed method approach to the Austrian perspective will make a definite contribution to current knowledge. Mixed method in this context is not simply a qualitative and quantitative research method, but a combination of both Austrian and neoclassical approaches.

Key words: financial crisis, Austrian economics, monetary policy, financial system reform. Background Recent economic events have once again caused for a reassessment of neoclassical analysis and the Keynesian approach to monetary policy. Fundamentally critics of the neoclassical system query whether the application of a positivist empirically based economic approach can be used for the study of human action, Hayek (1979) terms this approach as Scientism, used to describe his view of the inappropriate use of a formalist natural science and mathematical approach to the study of economics, Chick (1998) argues that a formalist approach is unsuitable to the study of a subject so complex and interwoven as economics. Carl Menger, the acknowledged father of the Austrian school took the position that a mathematical language cannot describe the fundamentals of a dynamic economic position and thus only a verbal approach is justified. Menger (Walras 1884) questions the mathematical approach to the study of land, labour and value. In the natural world there are absolute constants, for instance a Hydrogen atom is identical to every other Hydrogen atom and the gravitational pull of a body is calculable and fixed, these predictable functions allow for testing to replicate the same observation time and again. We can say with absolute certainty that there is an inversely proportional relationship between absolute pressure and volume of a gas at constant temperature within a closed system, or that acceleration is produced when a force acts on a mass, the greater the mass of the object being accelerated the greater the amount of force needed to accelerate it. These physical laws, Boyles and Newtons Second law of motion, respectively, allow for this; however the Austrian view of economics is one where such functional relationships can not be measured, and therefore the prescriptive functions, for example supply and demand or cost and utility can be disregarded. Mathematically a function is defined as a one to one process from an element of the initial set to the final set, A (initial set) to C (final set)
Richard Whittle Page 2

via B (function or process), The Austrian school argue that with regard to human activity none of the components of a function (A, B or C) can be measured, making the mathematical study of them impossible. The very nature of the human animal is one of constant progress through life and experience, thus making every decision different from the next therefore the elements of the initial set (A) cannot be considered constant, the elements of the final set (C) likewise cannot be considered constant, and crucially with the process of transference (B) from A to C, different for every element, and thus impossible to measure or predict, the mathematical analysis of human action is flawed from the Austrian perspective. Given an increasing acceptance of the flaws of the neo-classical approach, and the prescience (though Austrians do not see the goal of economics as prediction) of Austrian theory, there are calls for its adoption to the global stage, Evans & Baxendale (2008) question if there is now room at the highest level for Austrian ideas. Frum goes further declaring the triumph of Austrian Economics (Murphy 2010). Literature Review The objective of the literature review is to explore the theoretical basis and political economy of Austrian criticism of the existing financial system and the Schools proposals for reform. This is done via the consideration of two key review questions, namely a study of the literature of the systemic limitations of the current system from the Austrian perspective and the proposals for reform developed from an acceptance of these limitations. The viewpoints of adherents of the Austrian School of economic thought have been examined, with regard to the limitations of the existing fractional reserve banking system (FRB)1, and in their association of distinct ideas for monetary reform within this philosophy2. Without exception the literature surveyed provided the same perspective on the end goal of monetary reform, that of a backed means of exchange and a severely reduced or nil role for the state, that is to return to the highest stage of money market development as explained by Mises and Menger (Herbener 2002). The literature displays a variety of proposals for monetary reform from the Austrian authors surveyed, as discussed the end is the same, but the means can vary, dependant on the authors adherence to branches of thought within the school, for instance Sennholz and Hayek see a competitive role with the state in money production, Mises envisaged a state role in monetary conversion and Rothbard saught for total removal of the state from the entirety of the money process. The authors views on deflation of the monetary supply against fixing its current level3, the

Itisofcrucialimportancetonotethatsimilartootherschoolsofthought,Austriansdifferamongst themselvesonfundamentalaswellastechnicalviewpoints,SelginandWhite(1996)voicesomesupportfor fiduciarymediaandfractionalreservebankingwithinagoldbasedsystemdesignedonAustriantheory.Barnett &Block(2005)defendthisAustrianFRBapproachagainstcriticismwithintheschool. 2 Selgin(2009)challengesa100%reservebankingsystem,thisiscounteredbyThornton(2010)using argumentsfromCantillion(1730) 3 Forinstance,Senhholzinhisearlyworks(1955)condemnsdeflationasanextremelyharmfulpolicy,andisa supporterofMisesantideflationaryreformproposal,inhislaterstudy(1987)hecallsforthepeopletobe liberatedfrominflationandproducesaplanformonetaryreformthatwhichisseentobeseverelydeflationary (Bagus2003). Richard Whittle Page 3
1

rights and functions of private property law and the nature or existence of a money substitute differentiate the literature. A crucial aspect for the Austrian School for monetary stability is the elimination or reduction of the role of the state in the monetary process, some thought is given to the likely efforts of the state to restore its involvement and associated benefits. It is acknowledged that the long term success of any reform is dependent on preventing this resurgence (Herbener 2002, de Soto 2009). A criticism levied within the school against the majority of the reform proposals surveyed is the scope they provide for this to occur, Hayek notes that any crisis can be used by the state to justify increasing the money supply, Rothbard (2001) proposes the most complete elimination of the state. The work of de Soto (2009, 2010), developed in the light of the recent financial crisis and recession, provides a contemporary interpretation of this issue, de Soto considers that new cycles of artificial credit expansion and thus recession will inevitably occur unless the existing financial system is fundamentally redesigned according to principles of private property law that require a 100% reserve for any demand deposit contract. Mises theory of the economic impossibility of socialism is applicable to state intervention in capitalist banking, the theory states how the state does not have the required information to succeed over the market, using this de Soto argues that the state via central banks indulges in Hayeks fatal conceit in believing itself able to deliver the appropriate monetary policy in a dynamic circumstance for the benefit of the economy, and that central banks are directly responsible for the recent crisis. De Sotos proposed monetary reform includes the complete removal of central banks4, this would provide two functions in restoring the monetary primacy of the market, it will remove state interference and ensure that a 100% reserve requirement on demand deposits is maintained through the removal of the lender of last resort from the monetary process. Austrian theory is still far from the orthodox and not accepted by many of the economists in practice and academia. It is justifiably criticised in many areas, this review is not the medium for a detailed technical critique of the proposed reforms though Whites (2007) consideration of whether Austrian philosophy worsened the Great Depression provides significant general as well as technical criticism. It is also worth stating the standpoint of Zimmerman (2003) who argues in the Journal of Austrian Economics that Austrian monetary policy is not ignored or the subject of a neo-classical dismissal conspiracy, but is simply often monocausal or too routed in Austrian ideology5 at the expense of relevant input from other perspectives6. Thornton however argues for the Austrian perspective concluding that in terms of prediction (the goal of neoclassical economics7), standard analysis fails and the Austrian succeeds, citing examples of standard claims of ending boom and bust and paving for perpetual growth against

AcriticismofdeSotoandthegeneralviewoftheAustrianschoolontheremovalofthestateisthatitis simplyunrealistic,Zimmerman(2003)statesthatintherealworldthereisahighprobabilitythatcentralbanks willcontinuetoexistdespiteAustrianwishes,withthegeneralpublicperceptioninlightoftherecentfinancial crisisthatbankingneedsinfactclosersupervisionandstatecontrol,thisseemsextremelylikely. 5 Costabile(2005)arguesthatintheTheoryofMoneyandCredit,Mises(1980:LibertyClassics)cameclosetoa demonstrationthatartificialmonetaryinflationcouldinfactresultincapitalaccumulationratherthan malinvestmentbutrefusestoexplorethispossibilityinlightofhisideologicalviews. 6 Laidler(2003)continueswiththisthought,butconcludesthatwhenalltheovergeneralizationsarestripped awayfromAustriantheory,therestillremainsahardcoreinsightperhapslackinginotherapproaches. 7 ThemottooftheEconometricsSocietyisinfactScienceisPrediction. Richard Whittle Page 4
4

Austrian predictions of a collapse and readjustment, he states (Thornton 2008) that in economics Austrian realism8 triumphs over mainstream positivism.

Scope for further research

An excellent consideration of the technical differences between the Austrian and neoclassical approach can be found in de Soto (1998); an assessment of the limitations of the FRB system from the Austrian perspective revealed a progression of microeconomic effects which support a system based on sound money or bring a system based on unsound money to collapse. An assessment of these micro effects from a neoclassical perspective coupled with an assessment within the Austrian framework of these effects in the contemporary setting of the recent financial crisis are presented by the literature review as areas which would benefit from further research.

Methodology

Within the literature there is a consensus of differing aspects between Austrian and mainstream economic analysis; the first being extreme subjectivism, that is the acknowledgement that choice is affected by circumstance, this goes beyond the consideration of opportunity cost found in most orthodox economic approaches. Secondly, Austrian analysis is based in methodological individualism, where the most apt way to examine economics is from the perspective of the individual9. Austrians consider human action to be purposeful, standard analysis judges choice based on abstract utility whereas the Austrian school will judge choice based on utility toward a certain goal, crucially the Austrian school of thought attempts to be non-scientistic (Ekelund & Herbert 1990). This approach will be used to continue the analysis and proposed reforms of de Soto (2010) within the specific setting of the United Kingdom. Error-correction modelling as an econometric analysis tool has been suggested as being an appropriate methodology for the consideration of Austrian theory from a mathematically formalist perspective (Mulligan 2006) and will be used to aid understanding, not simply provide an empirical analysis. This methodology will provide an estimate of a structural or equilibrium process and the error-correction or dis-equilibrium process which provides adjustment toward the hypothesised equilibrium. An Austrian rejection of the existence of any equilibrium due to human action, does not discount an interest in the disequilibrium process, indeed Austrian philosophy seeks an understanding of the process and not necessarily of its conclusions (Mises 1912). The proposed model consists of two aspects, firstly a structural equation analysis of the long term equilibrium process and the residual of this demonstrating the disequilibrium in a set time period. In the initial case data will be gained from standard sources for econometric estimation in the UK, for instance published Treasury and Bank of England datasets.

8 9

ForanextendedexaminationofAustriandifferenceswithintherealistapproachseeLong(2006). Economics is the science of choice and therefore the chooser should be studied (Ekelund & Herbert 1990). Page 5

Richard Whittle

Contribution to Knowledge

The contribution to knowledge provided by this research will be considerable; Hayek (2007) states that systemic monetary reform rather than being a mere technicality of finance, affects the entirety of free civilization. On September 15th 2010 two Conservative Members of Parliament began discussion under the ten minute rule, of a proposed reform to extend the restrictions of Peels 1844 Bank Act to cover demand deposits; this would have the intention of completely altering the existing financial system to address the limitations perceived by the Austrian school of economic thought. Research here will have an impact at the highest level of British government. Existing knowledge is limited by the conflicting ideology of the Austrian and neoclassical approaches, although work has been done analysing Austrian ideas through the neoclassical lens and vice versa, e.g. Garrison (2001), Sechrest (2006) and Mulligan (2006). Addressing this ideological conflict through a new empirical analysis of Austrian micro theory within monetary action will contribute to knowledge by providing an assessment of the Austrian interpretation in a manner agreeable to the formalist neoclassical school and thus widening the appeal and acceptance of this theory. A neoclassical assessment of Austrian theory will also provide evidence to further the preliminary discussion of systemic monetary reform within national government. An assessment within the Austrian methodology of the relevance of the schools monetary theories and reform proposals specifically within the unique setting of the UK will make a further twofold contribution to knowledge. Firstly academic research in this area using the Austrian approach is lacking due to the recent nature of the financial crisis and the dominance of neoclassicism in the UK and secondly the political and public opinion concerning the financial sector have resulted in an overwhelming body of research addressing specific limitations within the existing system and not limitations of the system itself.

Richard Whittle

Page 6

Work-Plan Table 1: Work Plan Month

13 47

Objective

Methodology

710

1113 1418

1921

2227

2831

3234 3536

LibraryStudyoftheAustrian Extensiveliteraturereview. andneoclassicalmethod. LibraryStudyofthe Extensiveliteraturereview. microeconomicprocessof marketcorrection. Datacollectionforeconometric Secondarydatafromstandard analysis. sources,thisdatawillbetested forreliabilityusingstandard quantitativetechniques. EconometricAnalysisofthe ErrorCorrectionModelling. collecteddata. Writeupofthisanalysis. Itisintendedthisstandalone aspectwillgeneratesignificant publishablematerial,a secondarywriteupwiththisin mindwillbeperformedusing highlyratedjournalexamples asaguide. Librarystudyoftherecent Extensiveliteraturereview. financialcrisiswithinthe Austrianmethodology. Originalstudyofthefinancial AdaptationofAustrianverbal crisiswithintheUKviaan explicationandmodelling Austrianmethodology. constructions. Writeupofthisanalysis. Similartotheeconometric analysis,theAustriananalysisis intendedtoproducesignificant publishablematerial.Likewise therewillbeasecondarywrite upofadditionalscopeto producepublishablearticles. Relevantjournalarticleswill againbeusedasaguide. Conclusiontothethesis. Format,binding,submission.

Key: Objective underlined Introduction or Conclusion to thesis. Objective in italics Administration of the thesis. Darker shaded text Neoclassical empirical aspect of the mixed method approach. Lighter shaded text Austrian aspect of the mixed method approach.

Richard Whittle

Page 7

References Adams, C. (2010) The Role of the State in Managing and Forestalling Systemic Financial Crisis: Some issues and perspectives. Asian Development Bank Institute (ADBI) Working Paper Series No. 242. Bagus, P. (2003) Deflation: When Austrians become interventionists. Quarterly Journal of Austrian Economics. Vol.6. No.4. Barnett II, W & Block, W. (2005) In defence of fiduciary media A comment; or Whats wrong with clown or play money. Quarterly Journal of Austrian Economics. Vol.8. No.2. Barnett II, W & Block, W. (2007) On Laidler regarding Austrian Business Cycle Theory. Review of Austrian Economics. Carilli et al. (2004) Monetary Reform from a Comparative-Theoretical Perspective. Quarterly Journal of Austrian Economics. Vol.7. No.3. Carilli, M & Dempster, G. (2008) Is the Austrian business cycle theory still relevant? Review of Austrian Economics. Chick, V. (1998) On Knowing Ones Place: The role of Formalism in Economics. The Economic Journal, Vol.108. No.451. Costabile, L. (2005) Money, cycles and capital formation: von Mises the Austrian vs. Robertson the Dynamist. Cambridge Journal of Economics. De Soto, Jesus. (1995) A critical analysis of central banks and fractional reserve free banking from the Austrian School Perspective. The Review of Austrian Economics Vol.8, No.2. De Soto, Jesus. (1998) The ongoing methodenstreit of the Austrian School. Journal des Economistes et des Etudes Humaines. Vol.8, No.1. De Soto, Jesus (2006) Money, Bank Credit and Economic Cycles. First English Translation (Melinda A. Stroup). Ludwig von Mises Institute. De Soto, Jesus. (2010) Economic Recessions, Banking Reform and the future of Capitalism, LSE Hayek Memorial Lecture Transcript provided by the Mises Institute, originally published by the Cobden Centre. Ekelund, R.B & Herbert, R.F. (1990) A History of Economic Theory and Method.Third. McGraw-Hill International Editions. Evans, A & Baxendale, T. (2008) Testing Times for Central Banks Is there room for Austrian Ideas at the top table? Institute of Economic Affairs Journal Compilation. Oxford: Blackwell Publishing. Fillieule, R. (2005) The Values-Riches Model: An alternative to Garrisons Model in Austrian Macroeconomics of Growth and Cycle. Quarterly Journal of Austrian Economics. Vol.8. No.2.
Richard Whittle Page 8

Fillieule, R. (2007) A formal model in Hayekian Macroeconomics: The proportional goods-in-process structure of production. Quarterly Journal of Austrian Economics. Garrison, R. (1996) Central Banking, Free Banking and Financial Crisis. The Review of Austrian Economics. Vol.9. No.2. Hayek, F.A. (1936) Economics and Knowledge. Presidential Address to the London Economics Club. November 10th 1936. Reprinted in Economica IV. Hayek, F.A. (1937) Investment that raises demand for capital. Review of Economics and Statistics Vol.19. No.4. Hayek, F.A. (1989) The fatal conceit: The errors of Socialism. Chicago: University of Chicago Press. Hayek, F.A. (2007) Denationalisation of Money. Institute of Economic Affairs [reprint of 1976 issue]. Hayek, F.A. (1992) The Fortunes of Liberalism: Essays on Austrian Economics and the ideal of freedom. Collected works edited by Peter .G. Klein. Indianapolis: Liberty Fund Inc. Herbener, J. (2002) After the Age of Inflation: Austrian Proposals for Monetary Reform. Quarterly Journal of Austrian Economics. Vol.5. No.4. Humphrey, T. (1984) On Nonneutral Relative Price Effects in Monetarist Thought: Some Austrian Misconceptions. Paper presented at the Mises Colloquium on Austrian Economics, Ludwig von Mises Institute of Auburn University, Auburn, Alabama, March 9th 1984. Kaza, G. (2005) Review of Meltzers A History of the Federal Reserve, Volume 1. 2003. Quarterly Journal of Austrian Economics: Book Reviews. Lewis, H. (2009) Where Keynes went wrong: And why world governments keep creating inflation, bubbles and busts. USA: Axios Press Littlechild, S.C. (2009) The fallacy of the mixed economy. Institute of Economic Affairs [reprint of 1978 issue]. McCaffrey, M. (2009) Entrepreneurship, Economic Evaluation and the end of Capitalism: Reconsidering Schumpeters Thesis. The Quarterly Journal of Austrian Economics. Vol. 12. No.4. Miller, R. (2009) The Austrians and the Crisis. Institute of Economic Affairs Journal Compilation. Oxford: Blackwell Publishing. Mises, L. (1966) Human Action, A treatise on economics. Henry Regnery Company by arrangement with Yale University Press. Mises, L. (1977). Comments about the mathematical treatment of economic problems. Journal of Libertarian Studies. Vol.1. No.2 pp 97-100. Mises, L. (1980) Theory of Money and Credit. Indianapolis: Liberty Classics.
Richard Whittle Page 9

Montgomery, M.R. (2006) Austrian persistence? Capital-based business cycle theory and the dynamics of investment spending. Review of Austrian Economics. Mueller, A.P. (2001) Financial Cycles, Business Activity and the Stock Market. Quarterly Journal of Austrian Economics. Vol.4. No.1. Mulligan, R.F. (2002) A Hayekian Analysis of the term structure of Production. Quarterly Journal of Austrian Economics. Vol.5. No.2. Mulligan, R.F. (2006) An empirical examination of Austrian Business Cycle Theory. Quarterly Journal of Austrian Economics.Vol.9. No.2. Murphy, R. (2010) The Fed: The Chicago Schools Achilles Heel. Mises Institute, Daily Articles 13th December 2010. Rothbard, M.N. (2001) The case for a 100 percent gold dollar. Cambridge, Mass:Harvard University Press , 1962. Reprint by the Ludwig Von Mises Institute. Schneider, F & Kirchgassner, G. (2009) Financial and world economic crisis: What did economists contribute? Published with open access at Springerlink.com Sechrest, L. (2006) Explaining Malinvestment and overinvestment. Quarterly Journal of Austrian Economics. Vol.9. No.4. Thornton, M. (2006) Cantillon on the Cause of the Business Cycle. Quarterly Journal of Austrian Economics. Vol.9. No.3. Van den Hauwe, L. (2006) Review of Huerta de Sotos Money, Bank Credit and Economic Cycles. Munich Personal RePEc Archive. MPRA Paper No.49, Posted 07. November 2007. Walras, L. (1965) Correspondance of Leon Walras and Related Papers. Edited by W. Jaffe, North Holland, Amsterdam, Vol.II. White, L. (2007) Did Hayek and Robbins Deepen the Great Depression? Journal of Money, Credit and Banking. Vol.40. No.4. Yeager, L.B. (1997) Austrian Economics, Neoclassicism and the Market Test. Journal of Economic Perspectives. Vol.2. No.4. Zimmermann, G. (2003) Austrian Monetary Policy Views: A Short Critique. Quarterly Journal of Austrian Economics. Vol.6. No.4.

Richard Whittle

Page 10