Tag Archives: Specialisation

How inflationary banking creates economic depressions and recessions

In response to my post of yesterday , a student of mine, Sankalp, had asked this question to which I responded thus. Sankalp raised an important point that I am sure a lot of people believe. With a little elaboration from my side, his question becomes this

What is the problem in banks being inflationary by nature if by engaging in such inflation, they will be able to lend much more and a lot more investment can happen? Would not an economy where lending is constrained by the actual amount of cash experience highly hampered growth in comparison?

Ordinary people see no problem in this state of affairs. Those with an exposure to mainstream economics would in fact jump to a fierce defence of this system and argue that growth would become highly constrained if the banking system were to allow cash to sit idle in the bank’s vaults while thousands of investment-worthy projects gather dust and go to rust.

The Austrian School of Economics in the tradition of Carl Menger, Böhm Bawerk, Ludwig von Mises, Friedrich Hayek and Murray Rothbard takes a radically different view of this situation. Austrian School economists explain that the much dreaded economic depression (including its modern semantic avatars, the economic recession, slowdown, downturn or whatever you wish to call it) is caused by the inflationary banking system.

The explanation, known by the name Austrian Business Cycle Theory, originated in the work of Ludwig von Mises in his book, The Theory of Money and Credit (1912) and was further developed by his student, Friedrich Hayek, in his books Monetary Theory and the Trade Cycle and Prices and Production. In fact, Friedrich Hayek went on to win the Nobel Prize in Economics in 1974 for his Business Cycle Theory, the only Austrian School economist to do so till date.

The brief version of Austrian Business Cycle Theory

In an earlier post, I had presented a stylised representation of a production system in which the original means of production, labour and land, are applied across various stages of production and eventually transformed into consumers’ goods. We saw in that case that the consumers’ goods output worth 100 oz was made possible and supported by a total capitalist saving of 318 oz.

What would happen if consumers were to decide to save 20 oz? Two things happen.
1. Consumption now falls to 80 oz
2. Capitalist savings go up to 338 oz
But what is the use of greater saving being available from capitalists when people have decided to consume less? The trick is to recognise that saving is a deferral of consumption, not permanent abstinence from consumption. In simpler terms, the saving is intended as future consumption. Saving is a decision to change the time of consumption.

This decision by consumers gets communicated to producers through a fall in the rate of interest. Producers take a cue and decide to rejig their production for a more distant future. In doing so, the production system becomes longer, with more stages of production. Hayek presented this in a highly stylised form using what are today known as Hayekian triangles as shown below.

Fig 1 - Hayekian Triangles representing the effect of new capitalist saving on the structure of production

Originally, a total saving of 160 oz churned out an output of 80 oz worth consumers’ goods. Now, a total saving of 180 oz churns out an output of 60 oz worth consumers’ goods. In our 6-stage production structure, a similar outcome would occur with a corresponding increase in the number of stages of production.

Many outcomes result. The immediate fall in demand for consumers’ goods leads to a fall in their prices. This is transmitted up the production structure, but the lower consumption does not put factors out of employment. The lower interest rate causes remoter stage capital goods prices to rise on account of much lower discounting (lower interest rates) of their imputed future contribution to revenue (called their discounted marginal value product). In the long run, greater availability of savings results in increased demand for factors in remoter stages of production.

The addition of stages implies greater specialisation and division of labour implying more efficient production thus leading to greater volume of consumers’ goods output in the future. This leads to a further fall in consumers’ goods prices in the future. However, when the greater output of consumers’ goods hit the market, the saved funds are now available to support their consumption. For the same 60 oz of spending, consumers get to consume the greater output of the longer and hence more efficient production system. This is the normal process by which an economy advances and standard of living improves.

Inflationary credit expansion and the production structure

When the banking system inflates money supply, it does so by injecting credit into the production system in the form of loans made to producers. This injection, however, takes place without saving by consumers. An injection of 80 oz of credit makes the production structure as long as in the earlier case with the 80 oz of consumers’ goods output being supported by a total apparent capitalist saving of 240 oz.

Fig 2 - Hayekian Triangles representing the effect of credit injection through monetary inflation on the structure of production

To achieve this credit expansion, the banking system will need to depress the interest rate. This lowered interest rate raises the prices of remoter stage capital goods as in the case of real savings, shifting factors of production there. However, the greater availability of capital without a fall in the demand for consumers’ goods results in a rise in the prices of factors of production. When the greater income is spent on consumers’ goods, their prices start going up as well, though after the prices of capital goods and their factors of production go up.

A general feeling of prosperity is created all around as capital goods prices, consumers’ goods prices, wages and rents go up and profits emerge in the economy. This is the inflationary boom like the one we experienced from 2001 to 2007.

However, inflationary pressures soon catch up and the system is forced to raise interest rates. Production processes that started in the reduced interest rate regime suddenly become impossible to continue further. To make matters worse, when the greater output of the more efficient, longer production structure hits the market, savings are not available to be spent on them. Unsold inventory piles up and businesses rack up huge losses.

The result is widespread business failure including failure of financial institutions that made loans to borrowers who end up defaulting. This is what we understand as the bust, commonly known as an economic depression or recession.

What we see

The lengthening of the production structure caused by genuine saving was stable and sustainable in the long run. Lengthening fuelled by credit expansion, however, is unstable as the manner in which it is done creates pressures that force an untimely increase in interest rates resulting in the depression stage of the business cycle. We see that once the inflationary boom is triggered by credit expansion through monetary inflation by the banking system, the bust is inevitable.

Thus, Austrian Business Cycle Theory helps us understand that it is the inflationary banking system that is the primary cause of all the misery created by the phenomenon of economic depressions. The key question now is

Are these boom-bust cycles inherent to the capitalist system of production or are they a result of intervention in the economy? Is it at all possible to eliminate the business cycle?

These important questions shall be the subject of another post on another day.

Key Concepts in Economics – 11 – Indirect Exchange and the Money Economy

In all my posts till date, I have explained concepts based on the assumption of a direct exchange economy. In such an economy, recipients in an exchange accept only goods that they intend to use. However, there are some serious and fundamental limitations that such an economy will face. One of them is the double coincidence of wants.

In simple terms, the term double coincidence of wants refers to a basic requirement that needs to be fulfilled for an exchange to happen. For A and B to engage in a direct exchange, A should want what B offers while B should simultaneously want what A offers. The wants of A and B need to coincide, failing which no exchange can happen between them. As a simple example, let’s say that A offers wheat in exchange for B’s eggs. However, if B desires butter in exchange and not wheat, there is no scope for an exchange between A and B.

How can A and B overcome the double coincidence of wants on a free market?

Let us say there is a third person C who wishes to consume wheat and offers butter in exchange. Now, A may exchange his wheat with C, offer the butter received in exchange to B and obtain the eggs that he desires. In this process, A, B and C are all better off as they have obtained the good they each sought in order to satisfy their own respective ends.

What we can note is that A accepted the butter from C not because he intended to use it but because he wanted to further exchange it for B’s eggs. Thus, to A, the butter was not a consumers’ good that he wished to consume to directly satisfy an end but a medium of exchange that enabled him to get the actual consumers’ good that he desired, i.e., eggs.

However, we also see that the butter could serve as a medium of exchange only because it was already in demand by B. This is a basic requirement that any good should fulfil for it to serve as a medium of exchange – it should be a good that is already desired for consumption by people in that society. The more widely desired a good is in a society, the more capable it is of serving as a medium of exchange in that society. What serves as a medium of exchange in any society also depends on the conditions in that society.

For instance, during World War II, cigarettes served as the medium of exchange in prisoner of war (POW) camps. In ancient Abyssinia, salt served the role of medium of exchange. In fact, the term salary that we use to refer to regular income comes from the use of salt as a medium of exchange and payment. In certain fishing communities, fishing hooks have served as a medium of exchange. A variety of goods such as tobacco, sugar, cattle, nails, copper, beads, tea, cowrie shells, etc., have been used as a medium of exchange.

From medium of exchange to money

The more marketable a commodity is, the more widely it is likely to be used as a medium of exchange. A commodity that is in general use as a medium of exchange is called money. The term money is not as precise a definition as medium of exchange is. However, we see that there is a strong impetus on a free market for a highly marketable commodity to come into wider and wider use and eventually become a generally used medium of exchange, i.e., money.

The advantages that money confers on an economy

The emergence of a commodity as money greatly increases the scope of specialisation and division of labour possible in an economy. To understand why this would be so, let us take a hypothetical case where a man, A, wishes to build a house for himself and seeks to employ the services of a carpenter, a mason and many other tradesmen and labourers for the purpose. Every one of these people he employs is offering their labour in exchange for which A will have to offer them a certain quantity of a good they wish to consume to satisfy their own ends.

Each of these people could have different ends and might hence seek different means for their satisfaction. For instance, the mason may want rice, the carpenter linen, the labourers wheat, fish, eggs, leather, etc. In order to do so, A has to either produce the particular combination of goods that these people want or procure these goods from other people who produce them by offering them goods that they in turn want, in which case he will have to produce these goods first. Production takes time. Given that at the time of commencing the production, A has no way of knowing

  • which individuals will be in possession of the goods he wants so that he may produce the goods they want
  • which individuals he will actually employ so that he may then produce those very goods that these individuals want

Seen from the eyes of the mason, the carpenter and all the other labourers, how are they to know which particular employer of their services is likely to be in possession of the very goods they seek to consume? How then are they to decide to develop skills such as masonry or carpentry given whatever their ends are?

These problems, insurmountable as they seem in a direct exchange economy, are solved easily in an indirect exchange or a money economy. Since there are commodities that function as media of exchange, A can pay every person he employs in the form of a medium of exchange. Each person in turn can use this medium of exchange to buy the particular goods that he wishes to consume. That too is made possible because the sellers of these goods can in turn use the medium of exchange to buy the producers’ and consumers’ goods that they wish to procure.

With the confidence that he can earn a certain quantity of the medium of exchange which he could then use to satisfy his own ends, a person can now decide to specialise in the trade of masonry or carpentry or plumbing or any other trade where he feels he is likely to do well. Thus, the existence of a medium of exchange makes specialisation possible. This specialisation makes division of labour among all these specialists possible.

It is the emergence of money that, therefore, permits the mind-boggling level of specialisation and division of labour that makes the modern, industrial and technologically advanced economy possible. It makes it possible to have a complex structure of production with multiple stages of production, each producing producers’ goods that are used in further stages of production till, many stages and lots of time later, consumers’ goods are produced and exchanged for money. Every producer in every stage of production may use money to buy the factors of production and in turn sell the goods they produce for money. Without money, it would be very difficult indeed for any economy to proceed beyond the primitive level.

Another important benefit that stems from the emergence of money is the very possibility of economic calculation. Without money, it would be impossible to estimate if one is making a profit or a loss by venturing into a business. It would be impossible to know how to allocate resources and move them from less profitable lines of production to more profitable ones. With money, everything is now priced in terms of money. By keeping an account of how much money is earned and how much spent, it is possible for a business to know if it is earning profits or incurring losses. Calculation using money can also help entrepreneurs evaluate a business opportunity even before investing in it. Money makes comparison of investment opportunities possible and is thus indispensable in making wise investment choices.

Thus we see that the emergence of money is an event of monumental significance in human evolution. Contrary to opinion widely held, money is not the root of all evil. It is the thing that makes possible all the well-being that we experience today. In subsequent articles, I shall explore the economics of an indirect exchange or a money economy.