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Tuesday, August 19, 2014 4:12 PM

Idiot's Guide to Austrian Economics

Congratulations go to Forbes columnist John Tamny and editor of Real Clear Markets for producing the "Idiot's Guide to Austrian Economics'.

Ironically, that is not exactly what Tamny set out to do. The actual title of Tamny's article is "The Closing Of The Austrian School's Economic Mind".

Point by Point Look

Tamny: "It’s well known that some Austrians have a major problem with 'fractional reserve banking' whereby banks pay for liabilities (deposits) by virtue of turning those liabilities into assets (interest paying loans). Instead, they borrow money from depositors seeking a return on their savings, and who don’t need access to their savings right away, only to lend the money borrowed to individuals who do need it right away. The profits come from borrowing at one rate of interest, then lending longer term at a higher rate."

Mish: With that single paragraph Tamny proves he does not understand AE or fractional reserve lending. In fact, he makes it clear he is clueless as to where the money banks lend even come from. AE has no beef against lending. Rather, AE does object to money being created out of thin air for lending.

I don't care, nor does AE care if 100% of deposits are lent out, as long as three conditions are met: 1) Money is not created into existence by the loan 2) Money is not lent out for terms longer than the bank has access to the money 3) Depositors who lend money to the banks for interest are the ones who pay the price should there be a default on the loans.

In regards to point number three, it should be implicitly understood that the higher the interest banks pay for deposits, the greater the risk the banks (and depositors) must take to achieve that return. If it blows up, depositors, not innocent bystanders should pay the price.

Tamny: "Banks aren’t in business, nor could they remain in business if they simply warehoused money."

Mish: Is there a need for warehousing? Even if the answer is no (which it isn't), Tamny clearly fails to understand AE does not preclude lending. AE only precludes fraudulent lending.

Tamny: To many Austrians, this non-coerced act of exchange between consenting individuals is a fraud, and needs to be treated as such by the state. The Austrians want government to restrain what they deem a violation of property rights.

Mish: No! The problem of property rights comes into play multiple ways. Let's go through some examples.

1. Banks take a deposit, say a CD that pays interest for 5 years. Then the bank lends the money for 30 years. That's as fraudulent as me leasing a home for 5 years and issuing a 15 year sublease on my lease.

2. Checking accounts are known in the industry as "demand deposit accounts". Money is supposed to be available on demand. It isn't. In 1994 Greenspan allowed sweeps, whereby banks can nightly "sweep" all money from checking accounts into savings accounts, unbeknown to the depositor, so the money could be lent out. Money people think is there for safekeeping isn't there at all. The Fed recently stopped reporting of sweeps

Sound fraudulent to you? It does to me.

It's fraudulent even if people agree to it in obscure hard to understand legalese. Why? Because it's as fraudulent as lending out 100 tons of grain when only 20 tons are in the warehouse, whether or not the owner of the 20 tons of grain signs an OK for lending out 100 tons.

3. Fraudulent lending of money causes economic distortions of all sorts, especially economic bubbles and income inequality. Those with first access to money (the banks and the already wealthy) are the ones who benefit the most. By the time money is available to the lowest guys on the totem poles, assets are already grossly overpriced. Price and asset inflation caused by lending out more money that exists is tantamount to theft. It artificially and fraudulently lowers the value of money on deposit kept for safe-keeping (checking accounts).

Tamny: The problem here is that the Austrians don’t stop at merely seeking an end to bailouts, Fed lending from its discount window, and while it’s largely bank financed, privatization of the FDIC. They once again feel that borrowing from savers in order to lend those savings out is a fraud, and that the state should abolish “fractural banking” in favor of banks backed by “100 percent reserves.” To Austrians, fractional banking leads to “excess credit creation” through what they refer to as a “money multiplier.”

Mish: Tamny keeps repeating nonsense, further proving he does not understand AE or lending. You can also safely conclude Tamny does not understand 100% reserves. Note that 100% reserves do not preclude lending as Tamny seems to imply.

Unfortunately, the "money multiplier" effect to which Tamny refers is believed by some Austrians (but also some non-Austrians). Tamny gives a ludicrous straw-man example then sets out to prove it wrong.

Tamny: The problem is that the very notion of a “money multiplier” is a logical impossibility; one that dies of its illogic rather quickly if analyzed in the lightest of ways. To explain what isn’t, banks are generally required to keep a 10% deposit cushion. Simplified, if a bank is the recipient of a $1,000 deposit, it can generally only lend out $900, or 90% of its deposits. What might surprise some is that the previously described loan is what has many Austrians up in arms.

Mish: Those who believe in the "Money Multiplier" theory are wrong, but so is Tamny. In a fractional reserve system banks can (and do) make loans whether they have reserves or not. Heck, banks can even borrow reserves from the Fed if need be.

From the BIS report Unconventional monetary policies: an appraisal

The level of reserves hardly figures in banks’ lending decisions. The amount of credit outstanding is determined by banks’ willingness to supply loans, based on perceived risk-return trade-offs, and by the demand for those loans.

The main exogenous constraint on the expansion of credit is minimum capital requirements.

The BIS has it correct. Any Austrians or other who believe in the money multiplier are wrong. Of Course Tamny is wrong as well.

Tamny: "Banks are generally required to keep a 10% deposit cushion."

Mish: There are no reserve requirements on savings accounts, and Greenspan allows sweeps of checking accounts into savings accounts so there are effectively no reserves of checking accounts either.

Lending is entirely based on whether or not banks believe they have a credit-worthy borrower that won't default (or that rising asset prices will cover any defaults).

On the absurd theory that consumers would not walk away from houses or home prices would go up enough to cover losses, banks made some pretty horrendous decisions. Once capital impairment set it, then and only then could banks not lend. 10% deposit cushions have nothing to do with lending, or lending restraints. The money multipliers are wrong, but so is Tamny.

Tamny: No reasonable person would suggest as certain Austrians do that banks multiply credit in lending out a large portion of the money they take in.

Mish: Total Credit Market Debt is $59.399 trillion. Base Money Supply is $4.01 Trillion. Thank God banks don't lend out a large portion of what they take in!

It seems to me that 100% lending looks reasonable compared to the 1,357% lending we have now.

Tamny: Notable here is that no one is keeping “deposit banks” backed by 100 percent reserves from forming, thus raising the question why Austrians themselves don’t fulfill what they deem an essential market need. Indeed, if fractional banks are a fraud, wouldn’t the free markets welcome the banks desired by Austrians that are apparently the opposite of fraudulent? The answer to the above is fairly simple. The markets shun “deposit banks” simply because the warehousing of cash involves a cost.

Mish: The answer is indeed easy but it's not the answer Tamny gives. The answer is banks make a profit off "legal fraud". They would make less profit if they didn't. Banks have every incentive to make money fraudulently simply because it's allowed.

People are willing to go along because of deposit guarantees, and also because the state mandates fiat money as legal tender.

In the Name of Fairness

Tamny had a bit on "fairness". And to be fair, Tamny is correct on this aspect:

To be fair here, Austrians are properly offended by bank bailouts and other governmental backstops that prop up errant banks, and it’s the politically protected nature of banks that at least partially informs their views on banking. There’s agreement on the subject of bailouts. Those that took place in 2008, and long before that, were an abomination that weakened the banking system. Precisely because we love banks and their economic function, and because failure is the author of innovative evolution, we should let them go bankrupt when they can no longer attract operating funds.

AE vs. Purported AE Writers

I can be fair too.

There is a difference between sound AE theory and what various writers propose as sound AE theory. I can claim to be a Martian. Does that make me one?

Many writers alleged to be AE writers are anything but.

Most of the hyperinflationists fall into this camp (and there is a huge number of them). The hyperinflationists range from being seriously misguided on a few points to being outright charlatans to serve their own purpose (and it is difficult at best to tell the difference).

Yet, the articles keep on coming and coming. The authors tend to have a few things in common:

  1. They do not understand the difference between credit and money. 
  2. They do not understand debt deflation. 
  3. They are overly US-centric.

In a fiat credit-based economy, reckless expansion of credit lead to asset bubbles. Then when the bubbles burst, debt deflation ensues.

Japan, the Eurozone, and the US all went through this.

Debt deflation is still underway in the Eurozone. If asset prices in the US tank (which is inevitable), the US will be back in it. Japan, after decades (and inane Abenomics) may be coming out of it.

The US-centric authors point out soaring money supply in the US but ignore soaring money supply elsewhere, especially in China. The US is certainly not alone in economic madness. With nearly every major country doing the same thing, and with money supply soaring in China at an even faster rate than other major countries, it is ridiculous to signal out the US for hyperinflation.

There are conditions that could cause hyperinflation (defined as a complete collapse of currency), but it would take a political event to cause it.

For example: Congress could vote to give every US citizen $1,000,000 per year, indexed to price inflation. That would surely do it.

$4 trillion in QE when the total credit market is $59 trillion, hasn't (and won't) produce hyperinflation.

For a discussion of the political aspect of hyperinflation and what causes them, please see Reader Questions On Hyperinflation; Would Printing $50 Trillion Tomorrow Do Anything?

Money Multiplier and Reserve Madness

When it comes to the money multiplier and reserves, it's important to understand that in a practical sense there are no reserves.

One might dispute this by looking at Excess Reserves of Depository Institutions as shown below.

It appears banks have excess reserve lending capacity of $2.6 trillion dollars.

Economically illiterate writers (including some of the purportedly AE writers) make inane claims "Just wait till this money comes pouring into the economy 10 times over".

Yeah right. The fact is, lending comes first and reserves second. As I stated before (and the BIS agrees) when it comes to bank lending, reserves are essentially irrelevant.

Note that with every injection of QE, alleged excess reserves go up. They are "real" in the sense banks collect free interest on the reserves. In a "practical" sense, they are vaporware. The Fed can produce as many reserves as it wants, at any time, out of thin air.

If banks wanted to lend, they would lend, and then the Fed would create adequate reserves after the fact.

Excess reserves are simply free money to the banks who collect interest on them. 

What bank doesn't want free money?

And who pays the price? Taxpayers via asset bubbles and inflation.

Property Rights

Let's return once more to property rights.

If I give money to a bank and it promises my money will be available on demand, and the next moment it lends a large portion of it out, my property rights are clearly violated.

What happens in such instances is twofold.

  1. I own my money.
  2. Someone else owns my money too.

Logically that is impossible. And that is precisely why it's fraudulent. I challenge Tamny to dispute that simple math!

It doesn't matter that most of the time not enough people show up for withdrawals to uncover the fraud. It is still fraud, every bit as fraudulent as someone subletting an apartment for 15 years when their lease is 5 years.

Moreover, the boom-bust cycle, caused by the creation of fiduciary media (deposits backed by nothing, out of thin air), harms completely innocent parties as well. It also impinges on their property rights and the value of their money and assets.

Finally, it should be clear that zero economic advantages can accrue from creating money from thin air. Not one iota of new capital can be created in this manner, it only redistributes already existing real wealth to those first in line for the money.

Reason for Rising Inequality

Looking for the reason behind rising income inequality and the decline in real median wages? Look no further than the Fed, free money to the banks, deficit spending, and fractional reserve lending.

Rothbard Chimes In

For more on the case against Fractional Reserve Lending please see

On page 46 of the book Case Against The Fed Rothbard says "By the very nature of fractional reserve lending, banks cannot honor all its contracts".

Since that is known upfront, in advance, how is that not fraud?

My easy-to-understand examples show precisely where and why Tamny is wrong. Nonetheless, I also recommend  the above eBooks by Rothbard. They are generally easy to read, and cover related topics in depth.


Tamny did not write "Idiot's Guide to Austrian Economics", rather, he wrote a guide guaranteed to make you an AE idiot, assuming you believed much of what he wrote.

Mike "Mish" Shedlock

1:30 PM

Ukraine Overnight Interest Rates Soars to 17.5%; External Debt Cannot Be Paid Back; Ukraine Demands Rebels Surrender

It's crystal clear Ukraine has no interest in a ceasefire under any terms. Instead it demands rebels lay down weapons and for Russia to stop intervention. In short, Ukraine demands surrender.

Thus death and destruction will continue, possibly long after Ukraine takes over Luhansk and Donetsk (or rather what's left of Luhansk and Donetsk).

Please consider Ukraine Says It Makes Gains Against Rebels in Luhansk.

The Ukrainian government said its forces took control of one of four districts in the pro-Russian separatist stronghold of Luhansk and are fighting in the city center as diplomatic efforts to end the conflict intensified.

European leaders are pushing to halt the conflict that’s killed more than 2,000 people and fractured Ukraine since Russia annexed Crimea in March.

“Ukraine’s armed forces have been beating the separatists for weeks now and are moving deeper into the east,” Karl-Heinz Kamp, academic director at the German government’s Federal Academy for Security Policy in Berlin, said by phone. “Something must have happened that’s boosting their fighting skills. My gut feeling -- and I don’t have any concrete evidence -- is that the Ukrainian forces are getting support from the outside.”

Ukraine’s government says it will declare a truce only if the pro-Russian rebels lay down their arms and Russia stops supplying them with weapons. Russian Foreign Minister Sergei Lavrov, meeting with his Ukrainian, French and German counterparts in Berlin, repeated calls yesterday for an unconditional cease-fire. Russia denies it’s aiding the rebels.

Ukraine Rates

The conflict has cost Ukraine $8 billion, Prime Minister Arseniy Yatsenyuk was quoted as saying today by the Unian newswire. Ukraine’s central bank raised its overnight refinancing rate to 17.5 percent today from 15 percent as it seeks to support the hryvnia. The Ukrainian currency fell as much as 1.6 percent before trading little changed at to 13.03 per dollar, taking its decline for the month to 5.8 percent.
Hryvnia vs. US Dollar

From mid-2007 the hryvnia crashed from 4.50 to the US dollar to 13.03 to the US dollar. That is a decline of 65%.

Given that Ukraine's external debt is not priced in hryvnia, but rather euros or US dollars, this currency decline really hurts.

Ukraine External Debt

Rule: When you have massive (relative to the size of your economy), external debts denominated in foreign currencies, very bad things happen.   

Ukraine's external debt as valued in US dollars has risen from under $40 billion in 2005 to nearly $140 billion today. Yet, I hear no mainstream media reporting on how Ukraine is supposed to pay this back.

Here's a hint. It can't.

And that is why interest rates are totally out of control, and why Ukraine will be beholden to the IMF and other creditors for decades unless it defaults.

As we all know ... This is a "small price" to pay for "peace".
And in case you missed it, please consider the Rule of Small Prices.

Mike "Mish" Shedlock

1:33 AM

Recovery Mirage in Spain Dissipates Into Ashes

The mirage in Spain pretending to be a recovery, has officially dissipated into wind-blown ashes.

Spain's trade deficit doubled in the first half as imports soared. Spain is again dependent on foreign financing.

Via translation from Libre Mercado, Spain Again Borrows Abroad to Finance Consumption.

One of the main and genuine green shoots making the Spanish economy begins to show the first worrying signs of weakness. It is the foreign sector, one of the few economic engines of the country in recent years. And not because of the export slowdown , as the significant increase in imports.

Spain recorded a trade deficit of 11.882 billion euros in the first half of the year, almost double a year ago now, when this same gap stood at 5.824 billion.

According to the Economy Ministry report released Monday, exports slowed their growth, after rising just 0.5% yoy. Imports, meanwhile, rose 5.3%.

"Spain is still in debt," says economist Juan Ramón Rallo. "That 6 million unemployed can only increase imports, not domestic production illustrates our problems," he warns.

In the same vein, economist Javier Santacruz adds that the most worrying of these data is that we are not competitive (exports stagnate), but "imports soar to finance domestic consumption," as shown by the increase internaual foreign car purchase (+ 17.6%) and non-durable consumer goods (+ 19.1%).

In fact, overall imports do not even account for energy products, which fell by 4.1%.

Spain has been living on borrowed time for years, accumulating a huge debt to maintain their level of consumption and investment-their standards of living. Between 2002 and 2007, Spain was amassing a growing external deficit, as more and sell less abroad (exports) and bought more (imports), bringing its foreign debt grew.

This imbalance is reflected in a very specific indicator, the current account deficit, which in 2007 reached a record high close to 10% of GDP. That is, the entire country that year said external financing close to 100 billion euros to cover their consumption and investment.

The fact that the trade deficit has risen again after the minimum economic rebound in recent quarters is a sign of weakness, because it demonstrates the strong dependence Spain still external financing to maintain their level of consumption and investment.
Think Spain is going to meet its budget deficit goals for 2014? If so, think again.

Mike "Mish" Shedlock

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