When I first set down to write this post, I began with a long, drawn-out metaphor about the market for beer and whiskey. It was too confusing, made me thirsty, and didn’t do much to explain anything at all.
But I liked the title enough that I’m keeping it.
So instead of the metaphor, let’s begin with something that Austrian economists and Modern Monetary Theorists agree on: investment activity depends upon expectations about the future.
“If firms are optimistic then they will formulate investment plans and build capital and productive capacity reflecting their long-term expectations of a return,” Bill Mitchell has written.
So what causes a change in expectations of future returns?
It’s at this step that Austrians and MMTers part ways.
In the Keynesian tradition, Mitchell’s answer is “animal spirits.”
Austrians would say: “interest rates.”
This division is very interesting and deserves more explanation.
Austrians think interest rates drive boom and bust cycles. The first step in this is the idea that bank lending is constrained by savings. That is, banks can only lend out some multiple of their deposit and capital base limited by the reserve requirements. Bank lending is fractionally reserve-constrained.
In this kind of system, low interest rates are evidence of high savings and low consumption, which in turn indicates that consumers will be able to access unconsumed income in the future. In other words, falling interest rates indicate higher future capital.
In response to this, businesses lower investment in “lower-order goods”—that is, things closer to the retail consumer. They raise investment in “higher-order goods”—that is, longer-term projects that businessmen think will be profitable because of all that future spending or lending that is possible, thanks to the unconsumed income today.
When the central bank sets interest rates “artificially” low, this sends a false signal to the economy. It makes it seem as if savings are rising more than they are. Businesses react as if there will be unconsumed income available for consumption or further investment in the future, so they make investment in the longer-term projects. But it turns out that the unconsumed income needed to make those projects possible in the future just isn’t available.
The MMTers look at this as a quaint view of the economy.
“Look! You Austrian guys are worried about central bank manipulation—but you don’t know the half of it. It’s manipulation all the way down,” they could say.
The MMTers would say that the Austrian view of fractional reserve banking is not really applicable in this day and age. The activity that Murray Rothbard described as “making loans out of thin air” and regarded as a form of counterfeiting is actually much more pervasive than he understood.
In the modern day and age, banks lend without regard to their reserves. The loan officer never calls the Federal Reserve to check whether reserves are adequate. Instead, banks make loans just the way other businesses invest in long-term projects—with an eye to profit. That is, banks lend according to their view of the likelihood of making a profit based on the risk factors of borrowers and the risk-premium the bank can charge them. Those new bank loans create new deposits in the banking system.
Of course, bank loans do need to be financed in some way, because of the reserve requirements that banks must meet every other Wednesday. But a bank doesn’t need a depositor to drop by on Tuesday afternoon with a check or a new investor to arrive with a briefcase full of new capital. They can meet the reserve requirement by borrowing on the Fed Funds market. And there are always enough reserves to borrow because the bank created additional reserves by making the loan in the first place. In a pinch, they can borrow from the discount window of the Federal Reserve.
“Okay! Enough already! I get it,” the Austrian might reply. “Our banking system is even crazier than I imagined. What’s your point?”
The point is that interest rates no longer reflect savings rates. The interest rate signal is broken by the operations of the modern monetary system. Increases in savings don’t show up as falling interest rates, and decreases don’t show up as rising interest rates.
Both Austrians and MMTers acknowledge, it seems to me, that this results in calculational chaos. The economy can easily slip out of whack because businesses misread how much demand or supply of savings to spend there will be in the future. This means they tend either invest too little or too much at different places in the capital structure. It all really comes down to “animal spirits” because the old Austrian economy-predicting interest rate is gone, gone, gone.
The central bank tries to set interest rates at the level it thinks will bring about the appropriate level of expansion for the future. That is, it attempts to mimic what would happen if the banking system still operated the way the Austrians think it does. This, of course, is a very difficult thing to do, even with all the data points available to central bankers.
But don’t jettison interest rates altogether. The Fed can target an overnight rate but banks set their own risk-premiums on loans, in the form of additional interest over the rate they can borrow (Fed Funds or, more typically, Libor). So the interest rate available to a business is not completely information-free. It may not directly arise from the saving and consumption decisions of the general public, but it does reflect the market price of the risk—which is to say, how bankers view the potential risk of the enterprise they are being asked to finance. And that, in turn, is often a reflection of how bankers think the overall economy will perform in the future.
This appears to give more power to bankers—and it does, in the short term. But notice that the bankers have to be right and the market has to believe they are in the habit of being right. If they are wrong too often or too severely, they risk losing access to borrowing from other banks and their share prices will fall. They can experience the bank-breaking liquidity crises we saw in 2008. Banks are capital-constrained in their lending.
You’ll notice, however, that there’s a lot of guess-work going on here. This kind of system will tend to fragility and even crisis. I don’t think either the Austrians or the MMTers really disagree with that proposition.
Where they part ways again is when it comes to remedies. An Austrian economist, realizing that the reality of modern banking is far worse than the “fractional reserve” system he was taught to hate, might throw up his hands, buy some gold, and wait for the collapse of civilization. Or, more constructively, might advocate abandoning this system in favor of one where loans were made out of savings, interest rates reflected time preferences, and business cycles were powered by pedals instead of turbo-charged credit expansion.
The MMTers are more hopeful about the ability of the government to address the fragility, proposing that the Federal Reserve act as a lender of last resort, banking regulations keep a strict eye on the quality of bank lending, government jobs programs maintain employment, and deficit spending fill in gaps where private sector demand falls short of expecations (and therefore output capacity).
The ultimate divide is partly aesthetic/moral. Many Austrians see the set of MMT—or Keynesian, for that matter—solutions as a nightmare of an ever-expanding state. The MMTers aren’t as bothered by a more expansive role for the state.
But it is also pragmatic. The Austrians just don’t believe the government is capable of adequately carrying out the economic management tasks the modern monetary system demands. This kind of heroic economic engineering is just beyond the capability of any organization. The MMTers have more confidence in the managers.
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