New Paths in Austrian Macroeconomics

0:00This paper that Walter and I are doing, it's a working paper and it draws on some things that we've done in the past and attempts to bring them together. Some of it is pedagogical, but it seems to me a pedagogical that has substantive implications and other parts of it seem to me substantive that have pedagogical implications for it. A few years back, three, four years, I don't know, Walter and I published a couple of papers on what has come to be called, or what people call, maturity mismatching. I don't like that term because maturity mismatching can be of different types and if you talk to mainstreamers and all, if you look at the duration, the calculation of the duration, you can have a situation where you have maturity mismatching, well it's okay because the asset that duration is the same as the liability duration on our balance sheet, so that's a big, you know, that's okay. But I'm always reminded of the story about the six-foot tall

1:18man who drowned while trying to walk across the river whose average depth was one foot. So, you know, we have that. Another thing that came up in this was the idea that borrowing Borrowing $10 for one year is very, very different than borrowing $10 for 10 years. We tend to measure credit in terms of the amount of money borrowed, but actually if you think in terms of dimensions, credit has a time dimension as well. $10 borrowed for one year is very different than $10 borrowed for two years. And $10 borrowed for one year is very different than $1 barred for 10 years, and this problem comes up in the finance, I know Joe teaches finance, you know, does some of that stuff with the MBAs, how do you compare two investment projects that have the same net present value, but one has a maturity of one year and the other has a maturity of 10 years? So, anyway, that gets us to the idea, and I'll be getting

2:31The idea of maturity mismatching in the form of borrowing short, lending long, Walter and I wrote a paper about that, as I said was published a few years ago, and if you think about what's going on there, what's happening is that as long as that's legal, the private sector is doing what the Fed is trying to do right now and has tried to do early. The Fed in the early 60s tried Operation Twist, right, to drive down long-term rates and drive up short-term rates. They were doing it at that time for balance of payments and reasons, but also because of the slow domestic economy. But if you think about, if we have private institutions that are borrowing short, attending to drive up short-term rates, but they take the money and lend it long, that turns to to lower long term rates, obviously that has implications for business cycles from an Austrian perspective.

3:35On the other hand, and again, you don't see that much of this, but if you borrow long and lend short, then to my way of thinking, that has implications for growth, it slows down growth because in that case, resources get diverted from long term projects to shorter term projects and consumption. That brings us to the idea that really it's credit expansion, not monetary expansion, that is critical. Monetary expansion, nobody's, if you think about it, Mises talked about the circulating credit theorem, a theory of the business cycle. He was not concerned with fiat money being lent into, excuse me, being spent into existence.

4:26If the federal government right now is running these deficits, and just saying, okay, we're running a trillion dollar deficit, let's just print a trillion dollars and spend it, well obviously we would have huge inflation problems, and everybody understands that. But it wouldn't cause a business cycle, certainly not of the Austrian style. But it's when you lend new money into existence that it enters the economy through the financial Market and distorts interest rates and that causes the distortion of the structure of prices which then leads to the unsustainable distortion of the structure of production. Now all of that leads us to think that, you know, if you start thinking about this then you say, well, there's actually all kind of ways you can characterize financial institutions But one way is to characterize them as brokers or dealers, where a broker merely brings together the borrower and the lender and charges a fee or commission for the process, whereas a dealer is a principal, not an agent.

5:40A dealer goes in and borrows money from somebody and then relends it. So if you think about a bank as a bank's a dealer, at least most people I know don't usually think about that, but the bank sells deposits and then the bank takes the funds it got from those deposits and buys notes. So really to get a real handle on that, unlike these diagrams, the first one is the typical The second one shows the typical comparison from the Austrian point of view of what happens if there's an increase in the supply of loanable funds because people save more versus an increase in the supply of loanable funds because of an increase in the money supply.

6:39But actually, if you're going to show this kind of situation in the banking system, you really need two figures for each of those. Let me see if I can get to the next one. One thing this leads us to do is to think that perhaps it would be more useful pedagogically to get away from loanable funds models where the price of the loanable funds is the interest Interest Rate, and you have a demand for loanable funds and a supply of loanable funds, but loanable funds are money, and the price is an interest rate? Far better to put it in terms of financial assets, where you have a demand and supply for financial assets, not in terms of an interest rate, but in terms of a price, right? And of course, the price This then is a real money price. It's so many dollars for a bond or whatever it is. So that's one of the things where we think there's something to do both where the pedagogy and the substance

7:54are linked there and we need to do that. The next thing that we thought about was that the standard model that we use when we're talking about growth in the Austrian model is, we say, well, growth comes about because of a decline in time preference, which leads to an increase in saving, which reduces the interest rate, and we get an increase in investment, but it's not an increase in investment, it's using the typical language or the standard language, it's an increase in the quantity demanded of investment. We slide down the investment curve. The supply of savings shifts out and we slide down the investment curve. In point of fact, I do believe that history would show and reality shows, and obviously Schumpeter agreed with this and all that, but the dynamic force for growth in the economy is not the household and not the consumer who is increasing savings, perhaps because wealth is going up or whatever, but the dynamic force in the economy is the entrepreneur, and the entrepreneur sees opportunities for

9:10profits and shifts out the demand for loanable funds, okay, and when they shift out the demand for Loanable Funds, then the quantity supplied of saving obviously rises to meet it. So in either case, with either one of those models you use, whether it's the increase in saving or the increase in investment, they're both going to end up, the actual quantities have to be the same. Saving and investment in the real world are the same thing, okay, so they have to be the the same thing, but the model, thank you, Joe, the model where the demand for investment or the investment demand curve shifts out, if you look at the new equilibrium at the higher quantity of saving and investment, interest rates have gone up.

10:08And we all know that everybody in the financial world, everybody in business understands that as soon as they think there's going to be growth is coming, interest rates go up. Why? Because the demand for investment funds are going up. So we think that that's both pedagogy to show what's going on by saying, look, it's not the increase in the supply of loanable funds because of savings increasing, because of a decrease in time preference, but it's an increase in investment demand because entrepreneurs see an increase in profit opportunity. So we think that's that. And that just shows the same idea in terms of financial assets, I guess. This is a slightly different one, and we do it first in figures 6a and 6b in terms of loanable funds, and then in terms of 7, we do it in terms of financial assets, but I'll do it in terms of the one I don't understand it because I think most people are probably aware of that, and that is that what happens, we always talk, and this is why I think it's important to focus on credit, not money, loanable funds or not.

11:25If the supply of loanable funds, the supply of savings increases, we say well the interest rate goes down, and you know, if this is due to an increase in money, okay, There's another possibility, and we see this in the real world, and that is that financial institutions don't necessarily lower interest rates. Financial institutions are interested, among other things, in maintaining their net interest margin. So it is not uncommon, and we saw this in the middle of the last decade in the housing market, that rather, I mean, yes, interest rates went down some, but then what did they do?

12:20Remember, the demand curve for loanable funds, if we look at it in that term, is not determined strictly by the borrowers. I, as the lender, can cause the demand curve for loanable funds to shift out. Why? Severus Paribus. Demand curves show things, Severus Paribus. That demand curve for loanable funds is an assumption that the risk profile of the borrowers is the same all along that demand curve. Well, what happens if I, as the banker, decide I've got more funds to I don't want to lend out. I don't want to lower the interest rate. I'll cut my net interest margin too much. You know what? Rather than cut my interest rate, I'm going to allow lousier borrowers, people with lower credit risk to borrow.

13:12Well, that shifts out the demand for loanable funds. I think that's important substantively that we recognize that and look at the implications of that. I think it's also something that we need to take a look at in our pedagogy.

13:32I have some other things I could say, but you know, I think, they're not directly relevant to, oh, well, I'll just, as long as I have a minute, can I make two points? One of them is that we talk about the purpose of, you know, investments in saving and investment and all, and all is that lowering the interest rate is to lengthen the structure of production. If we understand that, that there's initial structure of production and there's a transition phase and then there's an end stage, although that may be the case sometimes that we want to lengthen the structure of production, the permanent one, in point of fact what we do is we lengthen the structure of production temporarily, but the ultimate ideal end state structure of production in terms of the Hayekian Triangle is a vertical line where Barnett says I wish I had a Rolls Royce and boom there it is it's produced right there the time period of production is reduced that we want the

14:35time period we want that the value of consumption to go up but we want that triangle to get steeper and flatter we have to go with that and my time is up Thank you very much.