The Role of Reserve Assets and Commodities in an Austrian Interpretation of the Crisis

0:00This paper was the result of an email correspondence with my friend, my late friend, Suda Shanoi. You may remember that the... I'll just move forward to the title. You may remember that in 2007 there was a significant spike in commodity prices. And I suggested to Suda, aha, I said, this is not this an indication of the operational Ricardo effect. Sudha responded that no, it wasn't Robert, you're quite wrong, it was biofuels and other stuff, and then she died, so I was unable to continue the debate, I think I would have won, but I'd just like to lament the loss of my friend, and a great Austrian economist.

0:46What I propose to do is to read briefly from this paper, and I'm going to leave out the second bit, which actually applies the theory to the interpretation of the crisis, but that will be available otherwise, and I'd like to send anyone who's interested a copy of the paper, and indeed the slides. To begin, in interpreting the current global economic crisis, Austrian economists have tended to focus largely on capital structure and capital markets, but risk and the related concept of reserve assets or buffer stocks has received little attention. An analysis which includes these concepts supplements conventional Austrian business cycle theory.

1:35To a large degree, the paper is based on Ludwig Lackmann's analysis of reserve assets in his book Capital and its Structure and the analysis of commodity stocks in his paper Commodity Stocks of the Trade Cycle, which was published first in 1938. Although the latter paper is 18 years earlier than Capital and its Structure, Lackmann's analysis of the topic to be discussed starts logically with a later book. By reserve assets, Lachman does not mean liquid assets deposited by commercial banks with a central bank in the conventional banking system. Rather, he means reserve resources, or as I've relabeled it, buffer stocks, which are held by businesses against untoward events.

2:24In Commodity Stocks in the Trade Cycle, Lachman sets out a theory of how businesses deal with a problem of uncertain outcomes to business plans. Using a military metaphor, he explains that businesses have three sorts of assets, first line assets, second line assets and reserve assets. He distinguishes them as follows. By first-line assets we mean those capital goods, machines, conveyor belts, lifts, whose services provide the output of the production plan right from the start. Second-line assets are those operating assets which, like spare parts or money for wage payments, are planned to be put into operation at a definite point of time during the planned period.

3:15Reserve assets are those like the cash reserve or reserve stocks, for which it is hoped that But if all goes well, they will not have to be thrown in at a definite time. Reserve assets are therefore held against unforeseen contingencies. They are not meant to be brought into operation at a definite time. Lackman's concept of reserve assets reflects the fact that businesses face uncertainty and that their plans are continuously subject to revision. Their size thus represents the view of the riskiness of the business by the controlling mind. The less risky the business is perceived to be, the smaller the stock of reserve assets. This concept of buffer stocks fits well with Lackmann's reiterated point that often business have to reshuffle their capital as a result of their plans not meeting initial expectations.

4:07Plans will need revision and assets will need reshuffling when there is uncertainty what the future will bring. These buffer stocks of nonspecific resources have an important but little recognized role in the boom. In most descriptions of ABCT, the most important if the only Cantillon effect resulting from interest rates being depressed below the natural rate is an unsustainable elaboration of the Production Structure. All this has often been rehearsed and does not need to be described here in more detail. Another Cantillon effect is the reduction in the interest rate below the natural rate reduces risk premiums so that there is a collective misappreciation of the riskiness of business ventures. The low interest rates distort businessmen's assessment of the economic climate so they take an unduly optimistic view of business Business Ventures and they will become excessively bullish. They may thus undertake ventures which are more roundabout and riskier than they would have otherwise. It should not be thought that enterprises are necessarily more risky because they are more roundabout. It

5:27is possible to imagine a deepening of the production structure which was less risky than a broadening. The two concepts, capital deepening and riskiness, are associated but are different and there may be trade-offs between them. One puzzle is what determines the split between increased roundaboutness and increased riskiness for any given reduction in interest rates below the natural rate. There's a puzzle about this quite a lot. What actually determines the trade-off? I haven't come to any conclusion. I would be great for any suggestions. It's interesting that so few analyses of ABCT have made any reference to risk. For example, there's no mention of risk in the index of Jesus Hote de Soto's comprehensive analysis of ABCT, and actually it's also true of Rothbard too.

6:23A notable exception is Roger Garrison's 1999 paper, Hayek Triangles and Beyond, 1994. Another example is a recent paper by Anthony Evans and Toby Baxendale, great guys from the Cobden Institute in London, in which the authors introduce the concept of the error-prone marginal entrepreneur, who when given the wherewithal, puts incompetent business plans into operation, resulting in the clustering of entrepreneurial error. As they point out, is no more homogenous than capital. Credit expansion makes it possible for the second-rate businessman to experiment with defective business plans. Thus, in addition to causing an unsustainable attempt to deepen the production structure, credit expansion leads to an over-optimistic assessment of business plans in general, economy-wide appraisal optimism. Appraisal National Optimism is a good phrase and it derives from the enormous economic analysis of the British nationalised industries when they were invented and it referred to the fact that the managers of nationalised industries would go to HM Treasury with a view to getting substantial funds from the tax payer and they always had to have rosy plans. They didn't

7:48have rosy plans, they wouldn't get the money, so they had a natural inclination to be overly is very optimistic, and it seems perhaps the credit expansion can do rather the same effect. Plainly, the perceived risk in its ventures will affect the amount of buffer stocks which businessmen will think it necessary to carry, and this amount can be distorted by the reduction of interest rates below the natural rate. The existence of buffer stocks can help to explain, this analysis of buffer stocks can help to explain what is otherwise a puzzling feature of ABCT. This is the problem of production above the production possibilities frontier, in Roger Garrison's diagrammatic description of Austrian capital-based macroeconomics. It will be remembered that in his book, Time and Money, Garrison uses three Garrison panels to illustrate how changes in the money supply shift the apparent supply of savings, savings which in turn determines the division between consumption and investment. In turn the proportion of investment relative to consumption then determines the slope of the Hayekian Triangle. With this schema works in a

8:59moneyless economy it's more difficult to interpret when misinformation has been fed into the system by increase in new bank loans in the excess of actual and Foregone Consumption. The problem arises particularly in the interpretation of the second Garrison panel illustrated here. It's not appearing very well. However, I will attempt to explain how it operates. This is the production possibilities frontier, running down here. This represents the move from savings and investment, and this represents the move to the Hayekian Triangle, to the left.

9:52What I have done, and I'll elaborate a little bit, is to add a third time dimension to the sustainable production frontier. But I will just, I will come on, I will come on to that. Additional funds injected into the loan market have the effect of pushing production beyond the PPF, which appears an impossibility. At worst, or paradox at best, one solution is to interpret the production possibility frontier as a sustainable production frontier, but this in turn raises the issue of what is meant precisely by sustainable production. The problem appears connected to a rarely stated paradox of ABCT. During the boom, when according to the theory, malinvestments are being made, there is the experience of great prosperity.

10:46One obvious explanation is that it is not clear during the boom that the investment plans of many are doomed to failure. Still, it is puzzling that the exuberance of the boom should be so great. The solution of this puzzle is to focus on the consequence of interest rates being pushed below the natural rate in reducing risk premiums. This has the effect of leading business to reduce their buffer stocks on the grounds they are in a less risky business environment than they had thought. These resources released by the reduction in buffer stocks can be used to maintain the boom. But it's important to note that the drawdown in buffer stocks can only continue for a limited period of time. That gives you the element of sustainability. It can't be sustained forever, it must only be a temporary boom time phenomenon.

11:37At some stage, buffer stocks will be reduced to a minimum below which businesses will be reluctant to let them fall. It follows that this reduction in buffer stocks permits aggregate production to move outside the sustainable production frontier and allows the boom to develop in an unsustainable fashion. This figure shows how the drawdown in buffer stocks In the figure, a time dimension is added to the SPF, which is assumed to remain unchanged over time. The thick vertical and horizontal lines, respectively the share in the SPF of investment and consumption at the end of the period, under consideration at the end of the boom. The curved line represents the production outside the SPF and the area between the line and the successive SPFs represent the drawdown of buffer stocks during the boom. The drawdown reflects in turn the effect of the reduced and the approach to the minimum appropriate buffer stocks for that degree of risk.

12:59The rundown of buffer stocks may be slow, allowing apparent prosperity of the boom to continue for some considerable time. Lackmann's paper Commodity Stocks in the Trade Cycle gives intriguing confirmation of this analysis from the period before the Second World War. Lachman shows that in the period between the 1870s and the late 1930s, commodity stocks, which constitute an important part of buffer stocks, were at the lowest at the end of the boom, and were the highest before the recovery. Lachman was arguing against Cain's theory that commodity stocks had to be drawn down before the recovery could begin, and used a statistical analysis of and Commodity Stocks to prove his point. He concluded that the main conclusion emerging from the statistics we've presented appears to be that our stocks are inversely correlated with the cycle. As a rule, they reach their lowest level very shortly before the outbreak of the crisis, while their peak level is to be found towards the end of the depression.

14:07The theory of stocks, buffer stocks, outlined above, explains why businessmen deplete their buffer stocks during the boom. Under a misapprehension that business ventures are less risky than is actually the case, it appears safe for them to run down their buffer stocks. When it becomes clear they have underestimated the riskiness of their projects, it is only natural for them to rebuild their buffer stocks as a priority before the recovery can start. bring buffer stocks back to levels which accord with actual rather than misperceived risk. This theory provides a useful supplement to standard ABCT. It explains the degree to which a market economy can absorb untoward unexpected events. Its resilience to shocks depends on the size of the buffer stocks held. Interest rates pushed below the natural rate have a of a tendency, amongst other things, to make the economy more vulnerable to shocks.

15:08Following a prolonged boom in which buffer stocks are reduced to very low levels, the economy's shock absorbers will have a reduced ability to dampen the extremes of the economic cycle. What I won't do is to continue, but what I then did was to attempt to illustrate this theory by an analysis of commodity prices which is not particularly satisfactory because I didn't have as yet reasonable access to inventory stock data which would I think have been more useful. What I can say though is that in my judgment the movement in commodity prices was in fact consistent with this interpretation of the with this with this theory they also also clearly indicated the operation of the of the Ricardo effect but that I think is a story for another day thank you