A Cure For Austrian Subjectivism II:
Two Marginal Prices, Two Sources of Credit
Bid and ask are the two marginal prices I discussed in the first part of this series. The bid is the lowest price in the market, that an individual who needs to sell his goods must take. It is defined by the marginal producer's unwillingness to sell below a certain price. The ask is the highest price in the market, that an individual who needs to buy a certain good must pay. It is defined by the marginal consumer's unwillingness to buy above a certain price.
Ludwig Von Mises gives the first definition in his Theory of Money and Credit, and the second in his Human Action. In both cases, the essential characteristic of money is its common use in indirect exchange, due to multiple individuals' subjective choices, and not an objective factor that makes its use desirable by individuals in the first place.
The marginal productivity theory of interest, proposed by classical economists like Alfred Marshal an J.B. Say, was based on the idea that interest rates are defined by the marginal productivity of capital, ignoring factors such as the time-preference of the marginal lender. Contemporary neoclassical economics takes multiple other factors into consideration, yet deals with them in averages and correlations, instead of margins and causal relationships.
Human Action, 1949, Ludwig von Mises, p. 524-525
By that, he means the "myth" that the productivity of borrowers is a factor in the definition of interest rates. As we will see, however, marginal productivity sets the ask price for credit, as no one is willing to borrow at a rate higher than their returns.
Contemporary Positivist models, such as the IS-LM and its derivates, replace causality for correlation, and assume that, since rises in savings often correlate with declines in interest rates, there is a necessary relationship between both - supply of credit is usually taken to be a function of savings. This is wrong however, as an individual with spare money has the alternative to hoard it, or consume it. The essential factor in the decision to lend money is not the amount saved by the lender, but the spread between the interest rate and the lender's time preference. The amount saved is irrelevant - if the rate of interest is higher than the individual's time preference, the exchange will take place.
The "final state of rest" is a hypothetical price that a good would be sold for, if every single relevant factor in the market remained
the same for an infinite span of time. It is a tool Mises uses to illustrate the fact that prices tend to reflect real market pressures, and changes in the supply and demand for goods. We covered this idea, its merits and its flaws in the first article of this series.
Monetary Economics 102: Lecture 2 The Exchange of Income and Wealth, 2003, Antal Fekete.
Consumer sovereignty is the idea that, although the producer is the one who makes decisions regarding the production of a particular good, the consumers are the ones who will determine whether or not a particular good is profitable, ultimately determining whether or not it will remain in production. Creditors are consumers of bonds as much as they are suppliers of credit, and thus ultimately determine what bonds will remain available. Just like consumer sovereignty is conditional to the consumer's ability to choose between all available courses of action, including not making any purchases, so is creditor sovereignty conditional on a lender's ability to choose not to lend.
Retailer and supplier, in this context, are not professions, but catallactic functions, i.e. relative market roles. As such, these roles can be "played" by the same individual in different contexts. A producer of bread, for example, is a retailer in so far as he sells bread directly to consumers and, at the same time, a supplier in so far as he sells in bulk to a catering service.
“The dividing line of 91 days between the two is not arbitrary. It is one quarter, the length of the seasons of the year. The difference between the two kinds of credit is fundamental, and goes far beyond the difference in the maturities of credit instruments. Mises denies that sound credit can arise outside of the context of lending and borrowing. For him 'discount rate' is just another name for the rate of interest on short-term loans. Mises denies the validity of the Real Bills Doctrine of Adam Smith. He considers circulating real bills as inflationary as any other form of credit expansion.” - Monetary Economics 101: Lecture 4 The Two Sources of Credit, 2002, Antal E. Fekete
The analytic-synthetic dichotomy is the belief that there are two fundamentally different types of proposition. Analytic propositions are those in which the predicate is contained in the subject, such as "ice is solid water" - the definition of "ice" is "solid water". Synthetic propositions are those in which the predicate is not contained in the subject, such as "the ice cube is on the table". Kant argues that analytic propositions can be necessarily true, but that they do not refer to reality, but to the "pure" relationship between concepts. Synthetic propositions, on the other hand, relate to reality, but are always contingent - in other words, one can never be certain of their truth.
Objectivism rejects the analytic-synthetic dichotomy, its premises and its conclusions, in all its possible forms.
This is the second article in a three-part series. To fully understand it, I recommend that the reader be comfortable, not only with mainstream Austrian Economics, but also with the ideas presented in the first part of this series.
In the first article of this series, I analyzed how the Austrian School of Economics' epistemology changed over time, and the fundamental differences between the Aristotelian approach of authors like Carl Menger (1840 - 1921) and Murray Rothbard (1926 - 1995), and the subjectivist approach of authors like Ludwig von Mises (1881 - 1973) and Friedrich Hayek (1899 - 1992). I went over the negative consequences of Mises’ Kantian epistemology in his theories of value and money, and introduced the fundamentals of the New Austrian School Of Economics (NASOE), explaining how it revisits Menger's original Aristotelian approach.
We saw how this change in epistemology resulted in a shift from Menger’s volitive theory of value, to entirely subjective theories of value by Mises and Hayek - a change that went unquestioned by Rothbard in his attempt to reintroduce an Aristotelian foundation to Praxeology. We have also seen how the method of imaginary constructs relies on an a priori approach, at the expense of Menger’s original idea of marginalism, and how it conflicts with the idea of the marginal bid and ask prices.
With regards to the Austrian theory of money, we saw how a subjectivist epistemology leads to the conceptualization of marketability as an essentially subjective factor, and to the definition of money as the "universally employed", or "commonly used" means of exchange in a society. I then contrasted that view with the NASOE’s view of marketability as an objective social characteristic related to the spread between the two prices of money, and their focus on its use as the ultimate extinguisher of debt.
I ended the first part of this series with the NASOE’s definition of inflation as "an expansion in counterfeit credit", in contrast to the mainstream Austrian idea of inflation as an increase in the quantity of money. With inflation being essentially a distortion on the credit market, we have yet to look at its particular effects in the market for credit. Before we do that, however, it is a good idea to go over what exactly credit is, and how it originates, according to both the mainstream Austrian Economics and the NASOE.
Throughout this article, I will contrast the mainstream Austrian view of credit as an exchange between present and future value, with interest rates defined by the lender's time preference; with the NASOE’s view of credit as an exchange between wealth and income, with marginal interest rates defined by both the lender's time preference and the borrower's marginal productivity. We will then depart even further from mainstream Austrian economics, which considers saving to be the sole source of credit, and take a look at a second source, which gives rise to different type of credit: real bills of exchange.
Time Preference: Future vs Present Value
The mainstream Austrian theory of credit is based on the distinction between a present good and a future good, and considers declining temporal preference to be axiomatic. In other words, it holds the idea that an individual will always attribute a higher value to the satisfaction of a need in the present moment than to that same need at a later time, to be true a priori - a part of the structure of human action itself. The idea is that, if time preference wasn't necessarily negative, the individual would see no difference between a value now, and that value in the future, and therefore would never act.
Central to the theory is the concept of originary interest, the ratio of the value an individual assigns to want-satisfaction in the immediate future and to want-satisfaction in later periods in the future. In more concrete terms, the mainstream Austrian approach holds that an apple now is more desirable than the same apple tomorrow, which is more desirable than in the day after that - originary interest being the rate at which I'm willing to trade an apple today for more apples in the future.
The price of capital goods derive from the price of goods that it can be used to produce in the future. By that logic alone, the price of a stretch of land would take into account all future production from that land, which is virtually infinite. Originary interest explains market phenomena such as the finite price of land - their prices are finite because the further away in time that land’s production is, the less it is valued, approaching zero for the very distant future. The productivity of a particular stretch of land 10.000 years from now is irrelevant for someone purchasing it now.
Mises makes it clear that originary interest is not defined by the relationship between supply and demand for credit - on the contrary, originary interest is what defines both the supply and demand for credit and capital. In his theory, the multiple interest rates found in the market are defined primarily by the originary interest of lenders, coupled with other factors, such as risk and the expectation of change in the prices of goods. In other words, the author did not believe that an increase in savings had an effect on the interest rate, arguing instead that both savings and interest rates were ultimately defined by originary interest. In his view, changes in interest rates tend to reflect changes in the economic agents’ time preference, much like changes in prices reflect changes in production or consumer preference.
Despite making the important distinction between return on capital and the simple ratio of value over different periods of time, Mises completely rejects the influence of productivity in the market interest rates, going so far as to argue against fellow Austrian Eugen von Böhm-Bawerk (1851 - 1914) on the subject:
“Böhm-Bawerk has once for all unmasked the fallacies of the naive productivity explanations of interest, ie., of the idea that interest is the expression of the physical productivity of factors of production. However, Bohm-Bawerk has himself based his own theory to some extent on the productivity approach. In referring in his explanation to the technological superiority of more time-consuming, roundabout processes of production, he avoids the crudity of the naive productivity fallacies. But in fact he returns, although in a subtler form, to the productivity approach. Those later economists who, neglecting the time-preference idea, have stressed exclusively the productivity idea contained in Bohm-Bawerk's theory cannot help concluding that originary interest must disappear if men were one day to reach a state of affairs in which no further lengthening of the period of production could bring about a further increase in productivity. This is, however, utterly wrong. Originary interest cannot disappear as long as there is scarcity and therefore action. ”
Rothbard, despite rejecting the notion of a priori knowledge, shares the same essential aspect of Mises’s theory of credit: the idea that time preference is the essential factor in the definition of the rate of interest. The author dedicates an entire section of Man, Economy and State to what he calls the “myth of the importance of the producers’ loan market” . Both authors reject the idea that productivity is relevant to the definition of interest rates, rooting the phenomena of credit exclusively in time preference.
The mainstream Austrian approach to credit corrects a mistake very commonly made by economists, and core to Positivist economics: the belief in a direct causal relationship between savings and the rate of interest. It also demonstrates how a free credit market achieves uniform interest rates through entrepreneurial activity, and how it is subject, like any other free market, to consumer sovereignty. Just as in the theories of money and value, however, Kantian epistemology takes a toll in the Austrian theory of credit.
Just as the imaginary construct of the state of rest serves a purpose, but ignores the marginal prices in the market, the conceptualization of rates of interest as reflections of an a priori originary interest properly fulfills the role of introducing the concept of time preference, but ignores the fact that credit, just like any good that is systematically traded, has bid and ask prices. In reality, an individual that needs to borrow money - be it for investment or, more urgently, to pay off a debt - is subject to a higher interest rate than an individual that wants to lend money. Every transaction happens between the lower marginal price of the credit market, defined by the marginal lender’s refusal to lend money at rates lower than his time preference, and the higher marginal price of credit, defined by the marginal borrower’s refusal to borrow money at rates higher than his marginal productivity.
Time Preference: Income vs Wealth
In contrast to mainstream Austrian economics, the NASOE rejects the very dichotomy of present and future value, as well as the idea of declining time preference as axiomatic, using instead the dichotomy of income and wealth as a foundation for its theory of credit. As Antal Fekete puts it:
“The very idea of a dichotomy between present and future goods is false. The future is a closed book to man. He knows not what the future holds for him. He cannot know what his future needs and valuations will be. Even his taste is subject to change, and he is as ignorant about his own preferences in the future as he is of those of another person. "
Rejecting any form of a priori knowledge, the author uses observable facts as the foundation on which to build a theory of credit based on the concepts of hoardability and salability. According to Fekete, the original credit exchange of a present good for a future good put forth by Mises is reducible to two distinct exchanges: the exchange of a good for an income and a second one, later in time, where the income is returned to its original owner in exchange for the same quantity and quality of the original good. In other words, an exchange of wealth for income, and a later exchange of income for wealth. He defines wealth broadly, as property that is held for an extended period of time; and income, more narrowly, as a steady flow of goods and services.
Hoarding is the direct conversion of income into wealth, in which an individual abstains from consuming part of his income and exchanges it for a marketable good that is not perishable. Conversely, to directly convert wealth into income (dishoarding), an individual must exchange a marketable good for consumable income. Amongst the most marketable goods in the economy, some might be better suited for the purpose of hoarding, because they can be purchased constantly and for a smaller amount of goods, matching the stream nature of income. This particular instance of marketability is what Fekete calls “marketability in the small”, or hoardability. Other marketable goods are more suitable for the purpose of storing value or dishoarding, because they can be exchanged for consumable goods at a much faster rate, with fewer transactions. This particular instance of marketability is what Fekete calls "marketability in the large", or salability.
To be able to purchase small amounts of gold every month, an individual must spend a significant amount of value, as a single ounce costs over $1,500 - an ounce of silver, however, only costs about $15, making it more suitable for the gradual hoarding of smaller amounts over time. Silver is thus more marketable in the small, or hoardable, than gold. The amount of transactions required to dishoard wealth that is made out of silver is likely to be larger, and the whole process to take longer and cost more, than it would to dishoard wealth of the same value made up
of gold. Gold is, thus, more marketable in the large, or more salable, than silver.
With the development of legal and economic institutions, credit emerges as a more productive alternative to the process of direct hoarding and dishoarding. With the advent of credit, an individual can supply his wealth to another in exchange for a steady income, through the purchase of a bond. The individual can later exchange that income for the original wealth once the bond reaches its maturity. Every credit transaction, however, comes with a risk, as its debtor might be unable or unwilling to pay what he owes. It is up to the creditor to assess the situation and make his decision based on the risks and returns involved.
In a free credit market, under an honest monetary system, particular transactions float between the bid price - the lower interest rate defined by the marginal creditor’s refusal to lend money at a rate lower than his time preference - and the ask price, the higher interest rate defined by the marginal debtor’s refusal to borrow money at a rate higher than his marginal productivity. In more concrete terms, if the interest rate is lower than the minimum rate for which a lender is willing to part with his money, the money will not be lent - he is better off liquidating his bonds and keeping his money. If it is higher than the returns a borrower expects to make by investing the money, he will not borrow it - in fact, he can profit by liquidating his capital and buying bonds, causing the available money to flow to more productive enterprises.
This ability to refuse lending money is what I call creditor sovereignty, and it is a particular instance of the concept of consumer sovereignty put forth by Mises. It is of key importance, because it constitutes a lender’s last resort when facing a credit market out of which he cannot profit. To liquidate one’s bonds and take home an actual good, such as gold, is to say “I have nothing to gain by lending my money at these rates, so I would rather keep the money to myself". The only alternative to being able to liquidate one’s bonds for an actual good is being forced to lend.
Because of Mises' apriorism, mainstream Austrian theory of credit has to be rooted on an a priori axiom - declining time preference. However, there is no such thing as a priori knowledge - all knowledge ultimately comes from sensory experience. By looking at real markets, and abstracting the fundamental characteristics of human action from which economic knowledge is to be deduced, the NASOE arrives at the two marginal prices of credit, each defined by a different marginal agent. The role of the producer in defining interest rates, however, isn't the only aspect of credit overlooked by the mainstream approach. There is an entirely independent form of credit overlooked by the apriori method, and in direct contradiction to the Austrian definition of inflation as an increase in the quantity of money: real bills of exchange.
A Second Source of Credit:
The Real Bills Doctrine
In addition to saving, Fekete identified a second source of credit, that gives rise to a completely independent market than the one based on savings: clearing. Going on the opposite direction of the Austrian mainstream approach, the author revisits Adam Smith’s idea of a source of short-term credit based on the expectation of production.
A real bill of exchange is an instrument of short-term commercial credit that has its origin, not in an individual’s savings, but on urgent demand for goods. It is written by a retailer to its suppliers, with a maturity of no more than 91 days. Bringing the concept to a perceptual level: a baker might notice an unexpected and urgent demand for bread on the part of his consumers, but not have enough money at hand to buy the flour needed for the production of that bread. His flour supplier can choose to accept a contract drafted by the baker, stating that he will pay for the flour after up to 91 days, once he has sold the bread. Risks aside, both individuals profit from that agreement.
Suppose, however, that the flour supplier wants to liquidate his bill before maturity, because he needs money to pay his employees’ wages. With the increasing complexity of productive chains, and the integration of different markets, the market for real bills emerges - a market in which those bills can be sold to a capitalist at a discount. In that case, all three economic agents involved profit: the baker profits by supplying the unexpected demand, the flour supplier profits by selling to the baker while being able to pay his employees, and the capitalist profits on the spread between the discounted price he payed for the bill and its value at maturity.
The discount rates, i.e the rates that emerge in the market for real bills of exchange, are not directly related to the interest rate on the long-term credit market, as the pressures at work in both markets are different. The market for real bills becomes more essential as productive chains grow longer and more complex, and the process of clearing debt between producers becomes more intricate. In the absence of a market for real bills, for instance, our baker might not have been able borrow money in the bond market in time to supply the demand for bread he identified. Even if he is able to, the cost could be too high for the transaction to be profitable, as the risk a banker takes by loaning to a businessman is usually significantly higher than that of a long-term supplier, who has more information available.
Part of the rejection of the Austrian mainstream to the Real Bills Doctrine is due to von Mises’s definition of inflation, while another part is due to ignorance over the content of the theory itself, as exemplified by Robert Blumen. We shall deal with the latter cause first, and than contrast the theory’s actual ideas with those of Mises.
In this article, Blumen cites Nelson Hultberg and Antal Fekete as modern proponents of the Real Bills Doctrine, but goes on to criticize a theory that has no resemblance with the ideas presented by those authors. In the model described by Blumen, real bills are contracts that can be purchased by banks who, in turn, can use them as backing for the emission of currency. Blumen is right in so far as currency that is backed by debt, whether it is a real bill or a treasury bond, is fundamentally bad - it is not an actual value and, therefore, cannot extinguish debt. The model criticized by the author, however, does not resemble Fekete’s idea in the slightest.
The market for real bills described by the NASOE is one where a capitalist purchases a bill, paying for it with money. The medium of exchange that goes into circulation is, in fact, money, and the original debt is extinguished once the capitalist receives his payment, also in money. This is the point at which the different definitions of inflation by the NASOE and the Austrian mainstream come into play. According to Mises, Hayek and Rothbard, the increase in the supply of money that comes from the clearing houses for real bills would bring down the value of money. As we have shown in the previous article, however, the value of honest money is virtually immutable, regardless of the amount of money in circulation.
At this point, we can trace a well defined chain of causality between the epistemology and the theories of money and credit of both the mainstream and the NASOE’s approach. The subjectivist epistemology of mainstream Austrian economics leads to a purely subjective theory of value, which leads to a subjective conceptualization of marketability, and a definition of inflation in terms of the quantity of money. In the context of an aprioristic epistemology, the mainstream subjective theory of money and inflation leads to a theory of one source credit, based solely on saving, with its rate defined by time preference. On the other hand, the New Austrian School of Economics adopts an objective epistemology, which leads to a volitive theory of value, which in turn leads to an objective conceptualization of marketability based on the bid-ask spread, and a definition of inflation in terms of government fraud. Building on these premisses, the NASOE arrives at a theory of two sources of credit, one based on saving and the other on clearing, each subject to independent pressures on each of their two marginal prices.
If inflation is the issuing of counterfeit credit, what exactly does it do to the credit market? We now understand what inflation is, and what credit is, but how do those two things relate to eachother? What are the necessary consequences of inflation? In the next, and final article of this series, I will analyze the Austrian business cycle theory, and the negative effects of Kant's analytic-synthetic dichotomy in its ability to yield specific predictions, contrasting it to the "positive feedback loops" theory of business cycles developed by Keith Weiner.