William Barnett II and Walter E. Block, “Crash and Carry: Financial Intermediaries, the Intertemporal-Carry Trade, and Austrian Business Cycles”, in: Etica & Politica / Ethics & Politics, XI (2009) 1, pp. 455-469.
William Barnett II & Walter E. Block
Loyola University New Orleans
Joseph A. Butt, S.J., College of Business
Crash and Carry: Financial Intermediaries, the Intertemporal-Carry Trade, and Austrian Business Cycles (1)
Barnett and Block (2008) establish that not only are fractional reserve demand deposits fraudulent and create an Austrian Business Cycle (ABC), but that a certain type of mismatching between time deposits and the period for which the depository institution re-lends the deposited funds (banks or other financial intermediaries “borrowing short and lending long”) are also contrary to libertarian law. The question we address in the present paper is whether or not this type of disconnect between the period for which the ultimate lender committed funds and the ultimate borrower gained possession thereof also necessarily start an Austrian Business Cycle. Even though this does not constitute an increase in the stock of money, we answer in the affirmative.
The essence of Austrian Business Cycle Theory (ABCT) is as follows. A reduction in interest rates below what they would be in truly free markets, as a result of monetary inflation causes (2) an unsustainable boom. The boom consists in a misallocation of resources such that production is not as fully aligned with consumers’ inter temporal preferences as they otherwise would be. The boom either ends in crisis that takes either the form of a hyperinflation that destroys the monetary system or that of credit contraction. The crisis is followed by a bust during which resources are reallocated to their appropriate uses. The critical part of ABCT is the unsustainable, inter temporal, misallocation of resources set off by the initial interference with interest rates.
This paper considers three different, but interrelated, aspects of ABCT − fiat money, fractional-reserve banking and intermediation, and “real liquidity” − in order to come to a more complete understanding of the reality that is the concern of the theory: As can be seen in table 1, fractional-reserve banking, (3) to include both demand deposits and/or banknotes, is a sine qua non of traditional ABCT, whereas fiat money is not.
Section 2 is devoted to an explication of financial intermediation, and its relation to the ABCT. The purpose of section 3 is to bring dealing into this analysis. Section 4’s burden is to consider credit risk versus (financial) liquidity risk. In section 5 we contrast financial and real liquidity and in section 6 relate financial intermediation and ABC. Section 7 asks “Can fraudulent time deposits lead to an Austrian Business Cycle?” we answer in the affirmative. We conclude in section 8.
2. Financial Intermediation
This brings us to the matter of finance. Let us divide people/households/businesses into two groups: surplus units, hereinafter A, and deficit units, hereinafter C. (6) An A is one that controls more resources than it cares to at a particular point in time, whereas a C controls fewer. Assuming that the excess resources (7) take the form of currency, but disregarding its form, (8) let us examine the (generic) ways in which the transfer may take place.
A may either buy an equity stake (9) in C, or may become creditors by lending the excess resources directly to D. In either case in so doing a broker may be used, but he, qua broker, “merely” brings the buyer and seller or borrower and lender together for a fee. (10) However, brokerage is not the only form of intermediation. For our purposes, the intermediation process may be thought of as a dichotomy: brokerage and dealing. (11) Dealing involves intermediaries inserting themselves between A and C such that they acquire title to A’s excess currency and then divest the excess currency so acquired to C under a new title. Often, multiple dealers intermediate between the A that provide(s), and the C that ultimately acquire(s) the excess currency. Only dealing is relevant for business cycles; brokerage is not. Moreover, only dealing involving credit is relevant. (12) Consequently, hereinafter we consider only dealing in credit.
Dealers perform several functions.
This paper, then, is concerned with the relation between financial intermediation in which the intermediary borrows short to lend long and business cycles.
4. Credit risk versus (financial) liquidity risk
At any point in time there exists within any society a structure of more and less durable goods that constitutes that society’s structure of production and consumption. (17) Unless there is a significant, non-offsetting change in the individual preferences of the members of that society, including time preferences, or significant changes in technology that substantially increase the versatility of goods, the liquidity of the stock of real goods is relatively fixed in the short run.(18), (19) However, the liquidity preferences of individuals in terms of the financial assets they own can be volatile in the (very) short run, and increase dramatically very quickly. Keynes was, of course, correct when he said that that ‘everyone’ cannot increase their liquidity simultaneously (1936, 160). He also held that the attempt to do so is very disruptive to financial markets with attendant consequences for the real economy. But this latter claim is only true when market flexibility is abrogated by government regulations that render price and wage alterations more difficult. Moreover, there is no reason to think that such behavior would occur in a free market economy.
Barnett, William II and Walter Block. 2005. “Professor Tullock on Austrian Business Cycle Theory,” Advances in Austrian Economics, Vol. 8, pp. 431- 443.
Barnett, William and Walter Block. 2008, forthcoming. “Time Deposits, Dimensions and Fraud,” Journal of Business Ethics.
Block, Walter. 2001. “Yes, We Have No Chaff: A Reply to Wagner’s “Austrian Business Cycle Theory: Saving the Wheat While Discarding the Chaff,” Quarterly Journal of Austrian Economics, Vol. 4, No. 1, Spring, pp. 63-73; http://www.mises.org/journals/qjae/pdf/qjae4_1_4.pdf.
Block, Walter and William Barnett II. 2007. “On Laidler on Austrian Business Cycle Theory.” Review of Austrian Economics. 20 (1): 43-61. http://www.gmu.edu/rae/archives/Vol20_1_2007/4-Block_Barnett.pdf.
Block, Walter and William Barnett II. Unpublished. “Milton Friedman and the financial crisis”.
Block, Walter and Kenneth Garschina. 1996. “Hayek, Business Cycles and Fractional Reserve Banking: Continuing the De-Homogenization Process,” Review of Austrian Economics, Vol. 9, No. 1, pp. 77-94.
Block, Walter, William Barnett II and Joseph Salerno. 2006. “Relationship between wealth or income and time preference is empirical, not apodictic: critique of Rothbard and Hoppe,” Review of Austrian Economics, Vol. 19, No. 2, pp. 69-80; http://dx.doi.org/10.1007/s11138-006-6094-8; http://www.gmu.edu/rae/archives/VOL19_1_2006/4- Block_Barnett_Salerno.pdf.
Carilli, Anthony M. and Gregory M. Dempster. 2001. “Expectations in Austrian Business Cycle Theory: An Application of the Prisoner’s Dilemma.” Review of Austrian Economics. Vol. 14, No. 4, pp. 319-330; http://www.gmu.edu/rae/archives/VOL14_4_2001/4_carilli&dempster.pdf.
Garrison, Roger W. 1994.”Hayekian Triangles and Beyond,” in Jack Birner and Rudy van Zijp, eds., Hayek, Coordination and Evolution: His Legacy in Philosophy, Politics, Economics, and the History of Ideas. London: Routledge, pp. 109-125.
Garrison, Roger W. 2004. “Over consumption and Forced Saving in the Mises-Hayek Theory of the Business Cycle” History of Political Economy vol. 36, no. 2 (summer).
Garrison, Roger W. and Don Bellante. 1988. “Phillips Curves and Hayekian Triangles: Two Perspectives on Monetary Dynamics,” History of Political Economy, vol. 20, no. 2 (Summer), pp. 207-234.
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Hayek, F. A. 1935. Prices and Production, 2nd ed. London: Routledge and Kegan Paul.
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Hulsmann, Jorg Guido. 2003. “Facts and Counterfactuals in Economic Law.” The Journal of Libertarian Studies. Vol. 17, Num. 1, pp. 57-102; http://www.mises.org/journals/jls/17_1/17_1_3.pdf.
Keynes, John M.  1964. The General Theory of Employment, Interest, and Money. New York: Harcourt, Brace and World.
Mises, Ludwig von.  1953. The Theory of Money and Credit [originally published in German in 1912]. New Haven, CT: Yale University Press.
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(1) The authors wish to thank Laura Davidson for editorial assistance.
(2) Monetary inflation herein refers to any increase in bank notes (or other currency) or demand deposits that are not fully backed by the relevant monetary commodity. Of course, in a pure fiat money economy any increase of such artifacts constitutes monetary inflation.
(3) Fractional-reserve banking is herein taken to refer to the time-carry trade, more broadly; i.e., it is a specific form of the carry trade.
(4) In such conditions, a boom may be both of very lengthy duration and great magnitude, before it is brought to a halt by its attendant crisis.
(5) In cases such as this, the period before the onset of the crisis is almost certain to be shorter, and the magnitude smaller, than in that of the case of footnote 3, supra. This is because a commodity money, even under fractional reserve banking (frb), serves as a leash, or a check, upon the ability of the banks, central or otherwise, to expand money.
(6) A and C refer, as appropriate, either to individual units or to multiple units.
(7) I assume that the excess resources are valuable, and therefore the disposition is not by abandonment.
(8) What “forms” can currency take? We refer, here, to cash, whether governmental or private; e.g., U.S. Notes, U.S. Treasury Gold Certificates, National Bank Notes, U.S. Treasury Silver Certificates, Federal Reserve Notes, or U.S. coins.
(9) This option is not always available.
(10) Although A and C may find each other without outside assistance, in a modern society in which, literally, billions of people are interconnected economically and financially, this is not the normal course of events. Rather, intermediaries facilitate the process. Specialization of labor is an important factor in this regard because specialization of knowledge and consequent economies scale reduce search costs.
(11) It is not uncommon for intermediaries to engage in both of these functions.
(12) Mutual and exchange-traded funds that invest in equities may be thought of as equity dealers.
(13) “Note” is used generically throughout to refer to any type of credit instrument.
(14) This is not universally correct. Even in a society with a fiat money, such as the U.S.A., there are multiple monies in the sense that a U.S. penny, a $1.00 Federal Reserve Note (FRN) and a $100.00 FRN are each money, but, nevertheless, different. In that case a particular money may not be very liquid: try buying a new car with pennies or a can of Coca-Cola® with a $100.00 FRN.
(15) For example, Keynes (1936, 239-242). Has a concept of liquidity in a “non-monetary” economy. See footnote 15, infra.
(16) Keynes (1936, 240) has a different concept of the liquidity of real assets: “In [a ‘nonmonetary’] economy capital equipments will differ from one another … in the rapidity with which the wealth embodied in them can become ‘liquid’, in the sense of producing output, the proceeds of which can be re-embodied if desired in quite a different form.”
(17) Orthodox Austrian Economics concerns itself only with the structure of production, although see Hayek (1935, 11, 54), Hayek (1932, 241, n2), Hayek (1978, 212-213) and Garrison (2001, 47-49).
(18) Although liquidity is subjective, it is safe to say that in general a pickup truck is more liquid than a locomotive, as it can more readily be shifted to alternative uses. Similarly for hand-tools compared to oil tankers. Thus a change in technology that would substantially increase the versatility of locomotives or oil tankers would increase the liquidity of the society whose members owned these capital goods. However, the structure of assets, both capital goods and durable consumers’ goods, in a society was/is designed to produce a stream of consumers’ goods, including services, that is in accord with the preferences, including the time (and liquidity) preferences, of the members of that society. If peoples’ preferences change in non-offsetting ways then the current structure of assets will be less well suited to producing the newly preferred consumers’ goods. Therefore, the asset structure of that society will be less liquid in that it will not be able to convert resources into the newly preferred consumers’ goods as quickly and with as much value as it was previously able to convert resources into the consumers’ goods preferred prior to the changes in preferences. Regarding time preferences, this same analysis holds for non-offsetting increases in time preferences, and for non-offsetting decreases in time preferences. However, this does not hold in the latter case if the preferences shift only with respect to the timing of the preferences for consumers’ goods and not for the types thereof, if such preference changes are with respect to durable consumers that that can be stored at zero resource cost for the entire period of time by which the time preferences have changed.
(19) Generally speaking, poor societies’ structures of goods are probably less liquid than those of wealthier economies. In modern societies, there are opposing forces at work re liquidity of real goods. In some cases productivity is best promoted by highly specialized machines; e.g., elevators; whereas in others it is best promoted by highly versatile machines; e.g., pickup trucks.
(20) Is it always “unwittingly?” Or is it sometimes knowingly with the expectation of “front-running?” For the view that, absent the full rational expectations model of perfect future knowledge (a logical contradiction, since we cannot know what we will know in the future, otherwise we would already know it), the misallocation can be “witting,” or made “wittingly,” see Block (2001)
(21) Another thymological, but not praxeological relationship in Austrian economics concerns that between wealth and time preference. They tend to be inversely related, but this is not a necessary association. See on this Block, Barnett and Salerno, 2006.
(22) Waste here is used in the Misesian sense; i.e., although as a science economics eschews value judgments, it is scientific to note that certain actions can not possibly achieve the ostensible end(s) thereof.
(23) In reality, some intermediaries would continue to perform the other intermediary functions for which they would either have to have an interest rate spread or charge fees.
(24) Saving and investment have (at least) two dimensions: a quantity dimension and a time dimension. Financial saving of $100 dollars for one year is less than financial saving of $100 for two years. Therefore, voluntary saving can increase without the quantity increasing if the average term-to-maturity of loans increases.
(25) In contradistinction to the International System of Units, these can not be combined into derived dimensions. For example, in the equation for force, F = ma, a mass of 3kg accelerated at a rate of 2ms-2 = a mass of 2kg accelerated at a rate of 3ms-2 = 6n. However of a loan of $3.00 for 2 years is a quite different thing from a loan of $2.00 for 3 years. And, neither is equal to a loan of $6.00- for 1 year.
(26) Mismatched time deposits refers to the type of financial intermediation in which the financial intermediary “borrows short and lends long.”
(27) See on this Barnett and Block, 2005, 2006; Block, 2001; Block and Garschina, 1996; Carilli and Dempster, 2001; Garrison, 1994, 2001, 2004; Garrison and Bellante, 1988; Hayek, 1935; Mises, 1998; Rothbard, 1993.
(28) In the U.S. this is done by the Federal Government’s bastard child, the Federal Reserve System.
(29) We choose a higher interest rate for longer durations, since, ceteris paribus, there is a greater risk of non payment, as well as necessarily, greater loss of liquidity, which we assume is a positive benefit.
(30) See Hulsmann (2003) for the view that economics largely consists of making such contrary to fact claims.
(31) We confess: we love that phrase.