An alternative date for the recession of 1920-1921

Ok, it's been awhile since I wrote a post in English so let’s start. In order to downplay the possibility of self-recovery from the recession of 1920-1921, some people from Keynesian and monetarist camp have claimed that, despite the fact that fiscal policy played a contractionary role, expansive monetary policy by the Fed had a significant if not fundamental role for the beginning of the recovery.

The main shortcoming I find with this story is that it only uses the dates of National Bureau of Economic Research (NBER) for the beginning and end of the contraction of early 20s. Why is that a “shortcoming”? Because NBER recession dates have been severely questioned several years ago mainly by, among others, Christina Romer (Romer, 1994). As Romer (1999) explains: “[T]he NBER’s dating procedures have not been entirely consistent over time.” The post-World War II recession dates are derived from aggregate indicators in levels while, on other hand, the prewar and interwar dates are derived from detrended (long-term trend removed) series. When you detrend data series which are generally upward sloping, like real GDP, the result is a serie which tends to peak earlier and trough later compared to the series in levels. The consequences of this inconsistent procedure are not trivial for Romer (1999): “As a result, the earlier procedure of using detrended data is likely to make pre-World War II expansions look shorter and pre-World War II recessions look longer than they would if postwar procedures had been used.” So, as we can see, the pre-World War II NBER recession dates are not as reliable as you can expect. It is true that NBER recession dates are, by far, the most widely used, but that fact does not increase their accuracy at all. Once we use the much better and modern Romer’s dates, we find some interesting things about the “Depression of 1920-1921”. As we will see, this alternative and better dating casts serious doubts about the alleged “monetary policy exit” from recession.

According to NBER the peak was reached in January 1920 and the trough in July 1921. On other hand, while the peak was also January 1920, for Romer (1999) the trough was reached in March 1921. Now we can put this new recession date and monetary policy data together and check whether or not the slump was over because of the actions of the FED.

Let’s start with Fed’s discount rate data. In the next graph, the monthly discount rate of four Federal Reserve banks are plotted for the period 1919-1922. The recession interval is taken from Romer (1994; 1999) in the usual manner as starting the immediate period following the peak. The leading bank in those days was Federal Reserve bank of New York under the leadership of Benjamin “the greatest central banker ever” Strong, so its discount rate is an important index of the ease or tightness of monetary policy. You can also see the discount rate from Federal Reserve banks of Minneapolis, San Francisco and Dallas. 

Monthly discount rates of Federal Reserve banks
and recession, 1919-1922 (Y axis do not start at zero).
Source: FRED and Romer (1994; 1999)

As we can see, if we use the modern recession dates of Romer, the U.S. was already out of the slump even when Federal Reserve discount rate was at its historical maximum of 7 %. Even when every single discount rate was still at its highest, the economy was able to manage an escape from the recession.

But monetary policy is not only about interest rates, it is also important to investigate what happened to money supply. 

Year over year growth of monetary base, M1, M2 and M3 and recession, 1919-1922.
Source: FRED, Friedman and Schwartz (1970: 16-21) and Romer (1994; 1999)

The year over year rate of growth of the monthly (seasonly adjusted) data of the monetary base and of the broad money supply M1, M2 and M3 (Friedman and Schwartz, 1970: 16-21, columns 8, 9 and 11 respectively) clearly shows that the recession ended long before the peak of the monetary contraction was reached.

Monthly monetary base, M1, M2 and M3
with January 1919 = 100 and recession, 1919-1922.
Source: FRED, Friedman and Schwartz (1970: 16-21) and Romer (1994; 1999)

Even if we plot every measure of the monthly money supply, we clearly see that the recession ended several months before the contraction of the stock of money was over. The recession lasted until March of 1921 but the broad money supply (M1, M2 and M3) contracted until September. After that the level of broad money supply stagnated and it did not start to grow in a considerable way until April 1922. Meanwhile the monetary base contracted until February 1922. In other words, according to these data, the end of the recession was not preceded, much less helped, by a monetary easing. On the contrary, the slump ended despite the fact that the money supply was decreasing continuously.

Thus, according Romer’s dates, it is highly doubtful that the termination of the 1920-21 recession was helped by the FED’s expansionary actions. Mainly because the recession was already over when, according to discount rate and money supply data, the Federal Reserve was still being contractionary.

Friedman, Milton and Schwartz, Anna J. (1970) Monetary Statistics of the United States: Estimates, Sources, Methods. National Bureau of Economic Research. New York: Columbia University Press.

Romer, Christina D. (1994) “Remeasuring Business Cycles.” The Journal of Economic History. Vol. 54, No. 3, pp. 573-609.

Romer, Christina D. (1999) “Changes in Business Cycles: Evidence and Explanations.” The Journal of Economic Perspectives. Vol. 13, No. 2, pp. 23-44.

Scott Sumner is wrong on Austrians and interest rate

Acording to the Market Monetarist Scott Sumner: 

Instead, the view that Bullard attributes to monetarists is actually the Keynesian/Austrian view. It’s Keynesians and Austrians who reason from a price change. They are the ones who insist that low interest rates are expansionary... That is, they assume that low rates are tight money, whereas Keynesians and Austrians tend to assume it’s easy money. It’s neither.

However, it is not true at all that Austrians base their judgement only on the (nominal) rate of interest in order to judge monetary policy.

Ludwig von Mises, certainly an Austrian, explicitly states in 1949 (49 years before Friedman) that you must not see only the rate nominal (arithmetical) of interest in order to acknowledge whether or not there is credit expansion:

It is the continuous increase in the supply of the fiduciary media that produces, feeds, and accelerates the boom. The state of the gross market rates of interest is only an outgrowth of this increase. If one wants to know whether or not there is credit expansion, one must look at the state of the supply of fiduciary media, not at the arithmetical state of interest rates.

And also Mises in 1955:

The interest rate may go up and up in a boom and yet it may still remain below the rate it should have attained under these conditions. A higher money rate of interest doesn't mean that the real, the pure or originary, rate of interest is higher. Nor does it mean that the policy of easy money has been abandoned.

Murray Rothbard, another hardcore Austrian, in 1962 was also very aware that a rising nominal interest is not at all a sign of credit restriction:

Similarly, credit expansion does not necessarily lower the interest rate below the rate previously recorded; it lowers the rate below what it would have been in the free market and thus creates distortion and malinvestment. Recorded interest rates in the boom will generally rise, in fact, because of the purchasing-power component in the market interest rate.

And in 1963 he states that it is possible that banks can lower interest rate and not to expand credit:

Mises points out (Human Action, p. 789n.) that if the banks simply lowered the interest charges on their loans without expanding their credit, they would be granting gifts to debtors, and would not be generating a business cycle.

Finally, Joseph Salerno, the greatest Austrian monetary theorist alive, in 2013 makes perfectly clear how keynesians fall in that error:

Unfortunately, both Keynesian and central bank orthodoxies of the 1960s focused on the nominal interest rate as an important indicator of the degree of ease or restraint of monetary policy, making no allowance for the effect of inflationary expectations on the nominal interest rate. Consequently, neither the new economists nor the monetary authorities believed that monetary policy was “unduly” expansionary because short-term nominal interest rates rose from 1961 to 1963. Indeed, the new economists were quite pleased with monetary policy during this period, an attitude typified in Seymour Harris’s observation that “the [Federal Reserve] board provided the country with a reasonably easy money policy ...”

The Interest Rate Fallacy: 49 Years Before Friedman

A delicious way to settle the
Vienna vs Chicago dispute

The interest rate fallacy means that it is a fallacy to look only to the state of interest rates as an indicator of whether or not the central bank (CB) has embarked upon an easy monetary policy. Because after a certain time period, CB can affect interest rates indirectly via inflationary expectations. For example if CB embarks upon an expansionary monetary policy and agents fully anticipate a rise in prices as consecuence of that, then the easy monetary policy will rise interest rate rather than lower it because of the inflation premium included in nominal rates. Conversely a tight monetary policy will lower interest rates if a “deflation premium” is added into nominal interest due to deflationary expectations. In this circumstances if you look only at the interest rates, you just don't know if the CB is on an easy or tight monetary policy. After a certain time period the direction of interest depends on inflationary expectations of people. The quantity of money and credit is a much better indicator. 

This discovery is usually credited to Milton Friedman, however Mises almost 50 years before him said a similar thing:

Mises (1949): "[A]t the very beginning of a credit expansion no positive price premium arises. A price premium cannot appear until the additional supply of money (in the broader sense) has already begun to affect the prices of commodities and services... The gross market rate would have to rise on account of the positive price premium which, with the progress of the expansionist process, would have to rise continually... Arithmetically, the gross rates of interest are rising above their height on the eve of the expansion."

Friedman (1998): "Initially, higher monetary growth would reduce short-term interest rates even further. As the economy revives, however, interest rates would start to rise. That is the standard pattern and explains why it is so misleading to judge monetary policy by interest rates."

Mises (1949): "It is the continuous increase in the supply of the fiduciary media that produces, feeds, and accelerates the boom. The state of the gross market rates of interest is only an outgrowth of this increase. If one wants to know whether or not there is credit expansion, one must look at the state of the supply of fiduciary media, not at the arithmetical state of interest rates."

Friedman (1998): "The Fed pointed to low interest rates as evidence that it was following an easy money policy and never mentioned the quantity of money. The governor of the Bank of Japan, in a speech on June 27, 1997, referred to the "drastic monetary measures" that the bank took in 1995 as evidence of "the easy stance of monetary policy." He too did not mention the quantity of money."

There we have both Mises and Friedman saying that if you want to see whether or not the CB is expanding credit, then you must look at the money supply rather than the nominal rate of interest.  

In Lecture 5 of Buck Hill Falls in 1955, Mises made this excellent clarification of ABCT: 

"The first thing I want to mention in this regard is that people say: "You ascribe the emergence of the boom to a lower rate of interest, to the fact that the rate of interest is lower than it should be. But if you look at the history of the business cycles over the last hundred years, you will discover that one of the characteristics of the boom periods is that there is an increase in interest rates. Therefore, your first assumption is wrong."

Now this objection is due to the fact that people talk about a higher or lower rate of interest simply from the arithmetical point of view. This objection was very carefully criticized by Wicksell. People say that 5% interest is higher and 4% is lower. True! But arithmetic has nothing to do with the problem. The question is whether the rate of interest charged by the banks is above or below the "equilibrium" rate or, as Wicksell said, the "natural rate of interest."… At the beginning of the boom, there was a certain basic, "originary," rate of interest. However, in adopting an easy money policy, the banks made loans below this originary rate of interest, creating additional money precisely for the purpose of lending. Then prices started going up… With an additional quantity of money in circulation, there is a tendency for prices, and also interest rates, to rise. If a borrower expects prices to rise, he values goods and money in the present relatively higher than he does goods and money in the future. When evaluating present goods as against future goods, people take into consideration the anticipated higher prices of future goods. As a result, they are willing to pay a premium to have things now, to pay a higher rate of interest, to obtain things sooner rather than later. Thus, there is added to the pure, originary, rate of interest, a "price premium."… Therefore, in a boom period the market rate of interest must necessarily go up and up, as it contains now not only the originary or pure interest rate but the price premium besides. The interest rate may go up and up in a boom and yet it may still remain below the rate it should have attained under these conditions. A higher money rate of interest doesn't mean that the real, the pure or originary, rate of interest is higher. Nor does it mean that the policy of easy money has been abandoned. Nor that the banks are trying not to expand too much; they may just be trying not to increase too much the spread between the lower rate they are charging and the market rate they would have charged if they were not expanding credit. Therefore, a higher interest rate in the course of the boom doesn't mean that the real interest rate is higher."

And this is the point. Even if you see interest rates rising during the boom, that doesn't mean that banks abandoned the credit expansion. As I already explained here (short explanation) and here (full explanation), the development of the malinvestment boom is perfectly compatible with a rising interest rates. The lowering of the rate of interest is a relative one, relative to the rate of interest that would have prevailed without credit expansion. This lowering can manifest itself on an arithmetical lowering or maybe by keeping the rate constant or by increasing it (less than it would have increased). Even if the rates of interest are increasing, the boom can continue as long as there is credit expansion. That injection of credit makes the rate be below what would have been without the injection. That's why, for example, the 2002-2007 boom continued in the US even when interest rate (FEDFUNDS) started to rise in 2004, because there was still some availabilty of credit (an increasing YoY rate of growth of M2 to give an example).

Austrian VS Post Keynesians on ABCT: The Debate

In case that some readers did not notice it, there has been a debate about Austrian Business Cycle Theory (ABCT) between the Spanish Austrian School thinker Dr. Juan Ramón Rallo and the Post Keynesian blogger “Lord Keynes”.

Rallo is specially known in Spanish and Latin (America) world, and he is, in my opinion, one of its greatest Austrian economists. For those English speakers who don’t know him, he is one the bests disciples of Huerta de Soto. However it must be said that, in monetary economics, he is far from his master and the "traditional" Austrian School. Rallo endorses a theory mainly represented by Antal Fekete who founded the so called (by him) "New Austrian School", a supposedly Menger-rooted school about banking maturity mismatch, neo-real bills doctrine, liquidity, Gold Standard, among a lot other things. In other words he is neither a 100% gold-reservist like Rothbard nor a complete free banker like Selgin. Despite I also disagree with him on this, that doesn’t detract one iota of Rallo's greatness. ABCT emerged stronger from the clash of them.

On this blog post are all the links to the debate. Unfortunatelly for English speakers, Rallo's responses are in Spanish. So anyone who can't understand spanish very well can use Google Translate. He also made an excellent refutation of Sraffa's system and value theory.

Finally in a shameless act of self-promotion I will divert you to my personal opinions about the "multiple rates of interest" objections against ABCT (here is the short version, and here is the full discussion) and about "full employment assumption and all that" (here and here).

Sraffallacies: An Abridgment

Hi guys! I have seen my post about Mises-Sraffa have been seen a lot of times and given that it is sooo long, I have decided to put a condensed version of the original post. If you want to see the full story with all footnotes, references and details just click here. If you are a Post-keynesian and you want to criticize me, please read the full story, not just this post.

Introduction 

One of the most repeated anti-Austrian cliché of the internet blogosphere is the one that says basically: “Sraffa destroyed Hayek and Austrian Business Cycle Theory (ABCT)”. After that, I started to read ABCT’s original developer and creator, a guy called Ludwig von Mises, and all I found was that the reports of this death have been greatly exaggerated.

  

1. Misesian fully developed “natural rate of interest” was not a “barter-rate” 

 

Misesian ABCT is not about a monetary “natural rate of interest” deviating from barter rate of interest because of this:

a) In a barter non-monetary economy there is no space for monetary economic calculation. Without people’s monetary calculation which can be falsified, there cannot be any cluster of malinvestments and without malinvestments there is no crisis and depression.

b) In an economy without money and monetary economic calculation there is no way to even insulate interest (the value difference between present and future goods) in a unitary rate.

c) A barter economy is just a “fictitious concept”. Mises and today’s Austrians know perfectly well that you cannot calculate a barter rate.

d) An economy with money is totally different from an economy without money, because money is not just a veil (as Mises demonstrated from his very first book). You cannot compare or use one as a benchmark for the other.

e) To determine a barter rate, we need the aggregative concept of “real capital”. A concept totally rejected and criticized by Mises, so it is useless to “determine” a barter rate.

f) In his “barter wheat” example, Sraffa demonstrated that he did not grasp the essence of the theory he was trying to criticize in the first place. 

2. Misesian ABCT did not use a “unique rate”

Mises explicitly rejected the idea that in a changing economy (in a non-long-run equilibrium economy) there could be a uniform-unique-equilibrium rate of interest:

a) Originary interest is determined by (temporal) valuations of humans, as well as the price of any other good is determined by valuations interacting. As valuations are different in one determined moment and fluctuates along successive moments, also interest does (the discount of future goods). It varies as varies any other price in a changing economy.

b) The gross market rate of interest, which includes other things that are not interest, is also non-uniform in a changing economy. Actually in a changing economy we can “observe” only gross rates, we cannot “see” the pure originary rate.

c) In dealing with credit expansion we must know that it is not an equilibrium that is broken, but it is a process that is disturbed. It is the process what is perturbed, the appearance of new fiduciary media (credit expansion) makes the process deviates from what would have been without that perturbation.

3. Mises did never look for an “equilibrium-neutral rate” and actually there never can be a “neutral money”

Neither Mises nor Hayek were looking for a neutral money to avoid cycles, neutral money cannot exist in our world: 

a) Assuming neutral money is a (wrong and unreal) starting point of analysis, but it is not a goal to achieve. 

b) ABCT is based on a non-neutral money and its effect on different prices in different proportions at different moments. Assuming money neutrality means to assume a neutral rate of interest, no deviation can exist, and with no relative deviation of monetary rate there cannot be ABCT. The reason why market rate can be affected first and in a great proportion is the non-neutrality of money. In assuming neutral money, you assume away any possibility of ABCT. 

c) In order for money to be neutral, you need an unchanging economy. Non-neutrality is an essential feature of a changing economy, in a changing world there cannot be neutral money. 

d) Neutral money is an unreal, self-contradictory and faulty concept.

 

4. The policy for banks is NOT to target any “natural rate” 

You can forget the 3 points above if you like, because this last section is the ultimate demonstration of the failure of Sraffa’s “refutation”. Sraffa’s victorious final comment was that (Hayek’s interpretation of) ABCT recommended to the banks a policy of targeting the “natural rate”, but because he said that in a growing (changing) economy there are multiple rates of interest, then it is an impossible task. But that was not true at all:

a) Mises did not ask for a policy to target any “natural rate”.

b) Misesian “policy” was not that banks must not lower interest, but that they must not expand credit out of thin air. Banks can lower the interest if they want to or there can be as many as one jillion of different rates of interest, but as long as they do not expand fiduciary media they will not produce a cycle. The problem was not and has never been a problem of “accommodate” bank’s interest rate to “the” natural rate. Sraffa’s problem of multiple rates is totally irrelevant to Mises’ construction.

c) Understanding point 2) is so important that we can think in a situation where it is possible to initiate a boom-bust cycle even raising monetary rate. How? Only by expanding credit.

d) The reduction of the monetary interest rate that boost a boom-bust cycle is not a reduction in absolute terms, or in terms of a “barter rate”. What initiates a cycle is a reduction relative to a rate of interest that would have prevailed in a market without credit expansion. This is the reason why ABCT is compatible even with a situation in which the rate of interest is raising in absolute terms, because is raising less than it would rise in an environment without credit expansion.

Conclusion 

 

Sraffa’s critique of Hayek is totally irrelevant for the fully developed ABCT in Misesian sense. The canonical exposition of ABCT is safe from the Ricardian critique. Not only Sraffa did not refute ABCT, he even overlooked some of the most important aspects of it. This only reinforce Austrian's interpretation about that ABCT was never refuted in the 30s and after, it was simply ignored against Keynesian revolution.

The Posts War: A Rejoinder Post to a Reply Post from a Post Keynesian

It looks like I have unleashed Armageddon as I thought. “Lord Keynes” (LK) has replied me here. So this post is to answer his accusations. Ok LK, let's dance. You will not break me ;)

But first three positive points from his reply:

1) He spent time in reading and writing about my post.

2) He did not insult me as much as I expected :D

3) I fully agree with him in this correction: quantitative = “quantity”. Sorry, my bad.

Now let’s answer some issues:

"If I am not mistaken, Guillermo Sanchez already acknowledges that Sraffa’s critique of Hayek on the non-existence of the Wicksellian natural rate of interest is sound."

Actually what I have said was that Mises’ theory of interest was different and (much!) better than Wicksell’s. Nobody can deny that monetary rate can be (temporarily and unsustainably) deviated from the rate that would have prevailed without the intervention of (banks creating) credit expansion necessary to cause that deviation. However that deviation has inevitably unintended consequences, and the market process that acts to return to a rate not manipulated and determined for the “real” economic situation of temporal valuations of individuals is precisely the cycle. Besides the post in which I criticised LK, had bibliography against Sraffa.
 
Let's go to a point by point response:

(1) He makes a totally false accusation. There is no “red herring”: Until this post, he did not mention the fact that Keynes was a Wicksellian when he criticized Hayek or ABCT. My point was to demonstrate that he, in his post criticizing ABCT because Hayek used natural rate, did not say anything about Keynes also using Wicksell’s natural rate; and LK did not do it (until now). That’s undeniable. Then he says that Keynes abandoned that idea, something I clearly also said in my post. Again: the point I made was that he did not mention Keynes’ “dirty” Wicksellian past; he was a natural rate theorist in exactly the same moment in which Sraffa was attacking Hayek for been a Wicksellian. So LK should have mentioned Keynes’ antecedents in at least one of his 20 blog posts (I don’t know the exact number) dedicated to criticizes another guy (Heyek) because he (along with Keynes) was using the Wicksellian concept. Did he mention that fact? No, and it is easy verifiable, just look at his posts criticizing natural rate and you will see that he did not mentioned that. So there is absolutely no red herring here.

(2) The only point to demonstrate was that LK attacked Hayek because he used Wicksell’s natural rate, but he did not attacked Keynes (until his post criticizing me) for using it in his analysis. My objective was to show his arbitrary criterion of choosing Hayek as his victim, but “forgetting” Keynes. My accusation of him using a “double standard” was based in the fact that: If you made a post attacking someone (Hayek) because he used Wicksell’s natural rate, and you do not attack other guy (Keynes) who also used it at the same time, you have been dishonest with your readers. My accusation of dishonesty from his part in those previous posts is still standing. However he confessed it in replying me.

(4) 

"The word “scarce” can have two meanings: (1) finite, and (2) insufficient quantities available in relation to demand. When I say that something is “relatively abundant,” I mean that it is available in a quantity that exceeds the demand for it."

LK did not, I repeat did not, use the words “relatively abundant”, you can look for it in the whole post and you will not find it. His actual words were: “Mises still fails to address the issue of what would happen had the factor inputs or consumer goods NOT been SCARCE.” If, in saying "not been scarce", LK is talking about factors been “available in a quantity that exceeds the demand for it” then he talks about a surplus of them, which is exactly what Mises was talking about! [“At times, even on the unhampered market, there are some unemployed workers, unsold consumers’ goods and quantities of unused factors of production, which would not exist under “static equilibrium.” (quoted and coloured by LK himself)] So that makes me wonder: What in the world was LK criticizing then? He attacked Mises for not “assuming” a surplus of factors of production when the austrian actually clearly and explicitly was doing that!

The phrase LK used (“not scarce”) can also have two meanings: (1) infinite, and (2) sufficient quantities available in relation to demand. The (2), and also (1), can actually be the definition of a free good!

"Free goods are things that exist in superfluity, that is, in quantities sufficient not only to gratify, but to satisfy all the wants that may depend on them.”[1]

This is more than a semantics problem. What is called a “free good” is actually the opposite of a scarce good i.e. an economic good (scarce in relation to its demand). When LK said “not scarce” the “not” word implies opposition, so I was perfectly right in talking about he assuming Garden of Eden. Another easily verifiable fact just looking at his post. There is no straw man here (and if you read my post you will see I "predicted" he will try to scape his own Land of Cockaigne assumption in this way), anyone can check the phrase “factor inputs or consumer goods not been scarce”. 

“But relative scarcity and relative abundance in these senses exist, and an economy can have a relative abundance of certain goods in any time outside a boom. [At times, even on the unhampered market, there are some unemployed workers, unsold consumers’ goods…]

Pay attention to what is in brackets, that is what Mises said in 1928. It is actually what LK is asserting! 

LK says: 

"Nor do I deny that as an economy expands and reaches a boom, inflationary pressures build up as resources become less available."

But he himself had said:

“All that Mises does is admit the fact that capitalist economies do have idle resources, but then says that his cycle effects require that this abundance declines and the relevant factor inputs become scarce.”

“If an economy with significant idle resources has investment via fractional reserve banking or central bank creation of excess reserves (without prior saving in loanable funds), how will these inflationary pressures happen if productive resources simply do not need to be freed in the stages close to consumption? Such factor inputs will be available or quickly made available through increasing capacity utilization in the relevant industries.”

“the charge against ABCT is that its cycle effects do not occur if the factor inputs and consumer goods required by expanded demand are not scarce.”

“Versions of ABCT dispensing with a Wicksellian natural rate of interest fail to explain why the cycle effects would happen if factor inputs were not scarce and available through international trade.”

Does everyone notice the contradiction here? He is criticizing misesian ABCT because “his cycle effects require that this abundance declines and the relevant factor inputs become scarce” and that “its cycle effects do not occur if the factor inputs and consumer goods required by expanded demand are not scarce” and also that “The objection that an economy where factor inputs are relatively abundant still poses a serious problem to the Austrian business cycle theory”. He even ask “how will these inflationary pressures happen if… factor inputs will be available or quickly made available through increasing capacity utilization in the relevant industries?"

However later on he acknowledges that “as an economy expands and reaches a boom, inflationary pressures build up as resources become less available”. In other words he says ABCT is false because it assumes factors becoming scarce in the boom, but he asserts that in the real world factors can be not scarce. However suddenly he says that he doesn’t deny that an economy that expands in a boom will face scarcity of factors.

If Mises’ “cycle effects require that this abundance declines and the relevant factor inputs become scarce” during the boom phase and LK has admited that “as an economy expands and reaches a boom, inflationary pressures build up as resources become less available”, then Mises theory is totally correct! I have to repeat this because it is an obvious “Lord Keynes Kontradiction”.

(3) Do you think I forgot point three? Of course not! I left it to the end because is amazing. LK makes an impressive statement:

“Interest is a monetary phenomenon, not explained by time preference.”

The absolutely refuted fallacy that interest is a monetary phenomenon must be in the Top Five of the Greatest Economics Myths of all times. One of the greatest achievements of economic science was the discovery that interest is not merely a monetary phenomenon. We know that since, at least, the days of Hume. The economists had completely destroyed that fallacious explanation from the prescientific days of economic science until Keynes revived it. But as it is completely impossible to revive a person from death, all you can do is to create a zombie, and that is what Keynes did in “reviving” that old fallacy.  

That "theory" has serious problems: 1) If interest is only monetary, then we can make interest disappear lastingly only by increasing money supply offered to loans. That's all! And finally we can achieve the paradise of “gratuitousness of credit”. The fact that theoretically and in practice that is not proved at all and has never happened, is enough proof to refute such machination. 2) In thinking this way he necessarily is implicitly denying interest! 3) Interest would prevail even in equilibrium, in contrast to money. Money (as we know it) disappears in equilibrium to transform itself into a numeraire, but interest prevails as a unique-uniform-equilibrium rate. And, as Sraffa acknowledges [“I pointed out that only under conditions of equilibrium would there be a single rate… If money did not exist, and loans were made in terms of all sorts of commodities, there would be a single rate which satisfies the conditions of equilibrium...”], even in barter economy in equilibrium there will prevail a unique rate of interest (and outside equilibrium there would be "multiples", acordin to him of course). So even in a world of equilibrium there must be interest and has nothing to do with money (which does not exist as our "money") 4) Without interest there would not be maintenance or reinvestment of capital. With zero return, those things would be impossible. 5) The fact that interest is normally paid in money, is not evidence at all that it is a monetary phenomenon. Wages, profits and rent are also paid in money. As Hazlitt said: “Keynesians might go on to object that interest is paid not only in money but for money; that in this sense the phenomenon of interest is "purely monetary," and is merely to be explained in terms of the supply of, and demand for, loanable funds. This type of supply-and-demand theory, often met with in current economic textbooks, is not incorrect, but it is superficial and incomplete. When we go on to ask what in turn determines the supply of, and demand for, loanable funds, the explanation must be made largely in real terms. But Keynes explicitly denies the relevance of these real factors… It is true that interest is paid in money, and on a capital sum usually specified in money, and that therefore monetary factors have to be considered, especially when considering dynamic changes in the rate of interest. Keynes's fallacy consists in assuming that because monetary factors can be shown to affect the rate of interest, "real" factors can safely be ignored or even denied.” No respected and serious economist has ever dedicated more than a chapter or a subsection to this superficial myth.

Fisher in 1907 was certainly right in calling this a “Crude Theory” of interest. It is so superficial that can deceive man-on-the-street or a business-man, but should not deceive any respectable economist:

"A special version of the theory that interest depends on the "use of money" is found in the very persistent belief that the quantity of money in circulation governs the rate of interest, - that the rate is high when money is scarce, and low when money is plentiful. The shallowness of this theory has been exposed repeatedly by economists from the time of Hume to the present. It requires only a little reflection to see that, although an increase of the quantity of money in circulation will increase the supply of loans, it will also equally increase the demand. For instance, a piano dealer who borrows $10,000 in order that he may add to his stock in trade 50 pianos costing $200 a piece would, if the supply of money were doubled, require a loan of double the amount; for such an inflation of the currency would double the cost of his stock, and in order to obtain 50 pianos - costing now $400 apiece instead of $200 he would have to borrow $20,000 instead of $10,000. In spite of such reasoning, showing that an inflation of the currency must act on the demand for loans as surely as upon the supply, the theory that an abundance of money lowers the rate of interest is nevertheless widely accepted even among intelligent business men. Yet facts do not, any more than a priori reasoning, lend support to this belief. The probable reason for the persistence, among business men, of the opinion that an abundance of money reduces the rate of interest is the observed fact that the rate of interest is high when the reserves in banks are low, and vice versa, and that the rate in a loan center can be materially reduced by bringing to that center a supply of actual money to relieve the "stringency." This is true, and it is not denied that money plays a part in determining the rate of interest. But the part which it plays is chiefly as a puppet of other and mightier factors. The fundamental causes at work in a "money" market are not monetary at all, but economic. The economic causes operate through money and seldom show themselves save under a money disguise; but, generally speaking, money is only their instrument, not an independent factor. If money is plentiful for loan purposes, it is because its owners decide to apply it for these rather than for other purposes, and not because money in general is plentiful. The owners of money determine the purpose to which it shall be applied. To understand the real causes at work in the loan market, we must go back of the money itself and learn the reasons for bringing it into that market instead of spending it in other markets, - the meat, fish, fruit, or grocery markets, for instance. The abundance or scarcity of money for loan purposes is merely a sign or symptom of those more fundamental causes operating upon the rate of interest… In the present chapter we are content merely to point out that the theories of which it treats are crude and superficial. They contain a modicum of truth, but they do not reach the root causes of interest. It is true that explicit interest is dependent upon implicit interest; but this being so, the question still remains, What determines implicit interest? Again, it is true that the rate of interest, like every other ratio of exchange, depends on “supply and demand"; but the question, is, What constitutes the supply and demand? And again, it is true that interest varies with loanable funds; but what causes the variation of those funds?" (Italics and bold added)[2]

The fallacy is so evident that aroused the ire of Frank Knight who accused Keynes of committing a basic and foolish textbook mistake:

"Mr. Keynes bases his whole argument for the monetary theory of interest on the familiar fact that open market operations can be effective. Mr. Hicks makes the error more palpable by saying explicitly that new currency injected into an economy "at first" and "in the first instance" lowers the rate of interest, or discount, but afterwards raises prices and “therefore tends to increase discount.” But in his entire subsequent argument, Mr. Hicks assumes without qualification or reservation a definite (inverse) functional relation between the quantity of money and the interest rate. It is a depressing fact that at the present date in history there should be any occasion to point out to students that this position is mere man-in-the-street economics. The position is analytically absurd, and any respectable textbook in economics explains why. The rate of interest in its normal aspect as the rate of return on investment is the ratio between two value magnitudes, income and wealth. A change in the unit of value can affect this ratio only as it affects one of its terms more than it affects the other. There may (or may not) be such a differential effect for a time, after a monetary change. Of course if created currency is used exclusively to buy bonds, or even to construct new equipment, it can temporarily raise the relative price which the principal, or source, will yield. Such an occurrence is a temporary disturbance only. As a monetary change diffuses through the economy, it comes to affect all classes of prices in the same way, and at equilibrium any relative price will be the same as before the monetary change occurred –except in so far as in the meantime changes may have occurred in the factors which really control the price relation in question... That a monetary theory of interest should be defended by economists of repute is especially mysterious in view of the facts, which are directly contrary to what the theory calls for." (Italics and bold added) [3]

Please note that Fisher’s and Knight’s explanation assumes a uniform and proportional increment in prices as money increase, a phenomenon completely refuted by Mises (despite the fact that for those two “neoclassicals” the interest rate is affected first and before other prices are reached), but that does not affected the “essence” of their explanation.

And here is Mises:

"There were schools of thought for whom interest was merely a price paid for obtaining the disposition of a quantity of money or money substitutes. From this belief they quite logically drew the inference that abolishing the scarcity of money and money-substitutes would abolish interest altogether and result in the gratuitousness of credit. If, however, one does not endorse this view and comprehends the nature of originary interest, a problem presents itself the treatment of which one must not evade. An additional supply of credit, brought about by an increase in the quantity of money or fiduciary media, has certainly the power to lower the gross market rate of interest. If interest is not merely a monetary phenomenon and consequently cannot be lastingly lowered or brushed away by any increase, however large, in the supply of money and fiduciary media, it devolves upon economics to show how the height of the rate of interest conforming to the state of the market's nonmonetary data reestablishes itself. It must explain what kind of process removes the cash-induced deviation of the market rate from that state which is consonant with the ratio in people's valuation of present and future goods. If economics were at a loss to achieve this, it would implicitly admit that interest is a monetary phenomenon and could even disappear completely in the course of changes in the money relation… For this theory alone answers the question of how an inflow of additional money and fiduciary media affects the loan market and the market rate of interest. Only those for whom interest is merely the outgrowth of an institutionally conditioned scarcity of money can dispense with an implicit acknowledgment of the circulation-credit theory of the cycle. This explains why no critic has ever advanced any tenable objection against this theory." (Italics and bold added) [4]

Keynes’ theory was so wrong that it was refuted beforehand just some decades before by Mises himself. Here is The Lord:

"Interest today rewards no genuine sacrifice, any more than does the rent of land. The owner of capital can obtain interest because capital is scarce, just as the owner of land can obtain rent because land is scarce. But whilst there may be intrinsic reasons for the scarcity of land, there are no intrinsic reasons for the scarcity of capital. An intrinsic reason for such scarcity, in the sense of a genuine sacrifice which could only be called forth by the offer of a reward in the shape of interest, would not exist, in the long run, except in the event of the individual propensity to consume proving to be of such a character that net saving in conditions of full employment comes to an end before capital has become sufficiently abundant. But even so, it will still be possible for communal saving through the agency of the State to be maintained at a level which will allow the growth of capital up to the point where it ceases to be scarce." (Italics and bold added)[5]

I will totally pass over the obvious fact that Keynes (just like “Lord Keynes”) has just denied scarcity, to show what Mises responded to that in 1912:

"To one group of writers, the problem appeared to offer little difficulty. From the circumstance that it is possible for the banks to reduce the rate of interest in their bank-credit business down to the limit set by their working costs, these writers thought it permissible to deduce that credit can be granted gratuitously or, more correctly, almost gratuitously. In drawing this conclusion, their doctrine implicitly denies the existence of interest. It regards interest as compensation for the temporary relinquishing of money in the broader sense - a view, indeed, of insurpassable naivety. Scientific critics have been perfectly justified in treating it with contempt; it is scarcely worth even cursory mention. But it is impossible to refrain from pointing out that these very views on the nature of interest hold an important place in popular opinion, and that they are continually being propounded afresh and recommended as a basis for measures of banking policy." (Italics and bold added)[6]

and Fetter in 1927: 

"Interest was thought of as paid for the use of money, as land rent was paid for the use of land. But money "cannot breed money," as land can breed crops and feed flocks; money is the "barren breed of metal." Even to scholars, as well as to the populace, the price paid for the use of money (quite like that of other things) seemed to depend on the plenty or scarcity of the precious metals. Certainly this notion still is the natural, naive, popular view, coming to the surface again and again, as in the Greenback program of the 70's and 80's, in the Populist movement of the 90's, in many contemporary pamphlets sent for the enlightenment of academic economists by amateur reformers, and even promulgated by distinguished inventors and manufacturers, who are novices in economic theory." (Italics and bold added)[7]

If any doubts are left about “Lord Keynes”’ and Lord Keynes’ unrealistic Land of Cockaigne assumption, see this statement by Mises:

"Originary interest cannot disappear as long as there is scarcity and therefore action. As long as the world is not transformed into a land of Cockaigne, men are faced with scarcity and must act and economize; they are forced to choose between satisfaction in nearer and in remoter periods of the future because neither for the former nor for the latter can full contentment be attained."(Italics added)

In denying the existence of originary interest, keynesians deny scarcity. And saying that interest is just a monetary phenomenon is exactly like saying that Earth is flat.

Why did all this happened? According to LK, all this is a misunderstanding:

"Critics of my posts on the ABCT have simply misunderstood my critique. The non-existence of the natural rate of interest is one of the reasons why Hayek’s early business cycle theory is wrong. That critique applies to all Hayekian forms of the theory that use the natural rate, and even these Austrian critics are admitting this point." 

Now I must say that “critics of [his] posts on the ABCT have simply misunderstood [his] critique” because of his own writings! I have already shown in my post that he criticized the whole ABCT (not only “Hayek’s version”) because “it is using Wicksells natural rate”, so here we go again: 

“And Austrian business cycle theory (ABCT) also employs the Wicksellian concept of the natural rate of interest. With the invalidity of the concept clear, it follows that ABCT is also invalid. I will have more to say about this in future posts.”

Where is Hayek’s name or reference in the whole post from where I got that extract? 


In the post showing all “versions” of ABCT (Hayek’s included of course) he said:  

"They are all subject to these flaws: (1) They assume a single real natural rate that does not exist in a growing, money-using economy..."

This is a false statement in a double way: 1) Mises' fully development of ABCT is not based on a single natural rate. 2) About different versions of ABCT, LK has said that all they are subject to Sraffa critique of a single natural rate. He did not said that only Hayek’s “version” is subject to that critique. 

In other post “criticizing” ERE he said. 

"Yet ABCT requires a single natural rate of interest in the real world for the market/bank rate to coincide with, in order that we can avoid the cycle effects allegedly caused by ABCT."

Once again there is no signal of “Hayek’s version” of the ABCT in the whole post. He said that the whole theory requires a single rate. There is no reference to Hayek. He was forced to try to clarify that in the comment section: “ABCT, in the versions propouned by Mises (2009 [1953]: 349–366; Mises 2006 [1978]: 99ff.) and Hayek (1931) uses Wicksellian monetary equilibrium and the natural rate of interest concept.”
  

It must be obvious that in various occasions he said that all ABCT used one single-barter-Wicksellian rate and he did not clarify that he was referring to Hayek’s “version”. The “misunderstandings of his critiques” are, in some extent, LK’s own fault.  However I must say in his defense that he had clarified that his critiques apply to Hayek's "versions", or others that use "natural rate of interest in Wicksellian fashion", in many other occasions.

Let me end this post with an excellent quotation of Hazlitt: 

"No doubt Keynes's "system" owes part of its popularity to the impression that he has at last provided not only that Economics of Abundance, of which the Utopians have been dreaming from time immemorial, but has combined with it a Conspiracy Theory according to which the Moneylenders keep everything scarce in order that they may continue to receive Interest. But if everybody could have Complete Abundance of everything simply by ceasing to "keep capital scarce," then this Conspiracy must certainly be the most stupid and pointless in history. Did Keynes seriously believe all this?"[8]

PD: Just for the record, I did not say that Hayek’s presentation of ABCT is flawed. I think his reply is a total refutation of Sraffa’s evident misunderstanding of the theory he was trying to criticize. What I did was to show that misesian theory is totally immune to the italian critiques.

PD2: What about that marxists do not deny scarcity?

A quick search demonstrates that, starting with Marx himself, this is not totally true:

“In a higher phase of communist society” there will be so abundance that the society can “inscribe on its banners: From each according to his ability, to each according to his needs!” 
 
As Boettke and Leeson says:

"The socialists informed us that by rationalizing production and thus advancing material production beyond the bounds reachable under capitalism, socialism would usher mankind into a post-scarcity world… In short, the writings of Marx and other socialists were concerned (in part) with demonstrating the productive inferiority of the  capitalist system relative to what socialism could achieve.  The organization of production under capitalism still reflects the  “kingdom of necessity,” but the social  organization of production under socialism will deliver mankind into the “kingdom of  freedom” where, through rationalization of production, scarcity will be overcome."[9]