New money does not have to enter the loanable funds market

It is one of the standard claims of Austrian business cycle theory that the "new money" enters the economy through the loanable funds market.  Yes it usually does, but it is important to recognize that this happens because of decisions by banks, not because government somehow forces the money to go there.

Consider an expansionary open market operation.  Banks now hold fewer T-Bills and more cash.  Presumably the cash is more liquid (though if you are puzzled by this assumption in the context of a bank, join the club, Brad DeLong is a member too), so the banks will do something liquidity-like with it.  That could mean making a loan, but it also could mean spending the money to refit the ATM machines, or for that matter increasing dividends to bank shareholders.

But no, bank managers make an independent judgment that there are loans worth making.  Of course sometimes they are wrong.  But they know they got this new money through open market operations.  And they decided to go ahead and make the loans anyway.  They didn’t have to.  They could have re-routed the new money to some other injection path altogether.  But they didn’t.

That is another reason why the Austrian theory of the trade cycle is as much a market failure theory as a government failure theory.


Friedman was right: he preferred a helicopter because it didn't matter how money entered into circulation.
In addition, as long as the Fed prefers to issue money through banks, the Fed knows what banks are going to do. It's not a market failure, at least according to the standard definition. Perhaps you prefer money to be issued to pay government expenses. I couldn't understand the point of your post.

So if the money goes into the upgrading of ATMs, the boom/bust cycle will occur in the ATM sector. The cycle is not eliminated.

My biggest complaint that the prevailing interest rate cannot be in any way "the" defining number for
the market's preference for delaying consumption. Stock returns indicate the return on delaying consumption
just the same and can be much higher. People who delay consumption will buy stocks, not just interest-
bearing investments.

Also, the "malinvestments" Austrians like to mock (for getting liquidated and turned useless in the bust)
are typically very speculative investments that demand a very high ROR agains t-bills to justify doing.
Something on the order of 50% over t-bills. So, it's not like anyone ever says:

"Well, we thought a 50% ROR would be acceptable for this project. But come on -- that was when I could
get 4% from nice, risk-free government bonds. Now that I can get 5% ... I'm ****in' pullin' the plug
on you guys. Your offer of 50% returns is joke when I can get those yields without your risk."

That is another reason why the Austrian theory of the trade cycle is as much a market failure theory as a government failure theory.

This claim does not hold, unless you let people decide freely which money do they want to make transaction with.

"Money" is supposed to have certain attributes, among others as-fixed-supply-as-possible. Government money does not meet this criteria well. Thus, on a free market, people would NOT choose government paper as "money".

It is the same as saying that it is "market-failure" when there are shortages because of price-ceilings. People would choose to change prices, if they could. People would choose different money media not susceptible to manipulation, if they could.

Other Austrian position is: Money is NOT NEUTRAL. Even if you reject austrian business cycle theory (which I personally believe is not completely correct, however it seems to me that in reality it is quite close), monetary expansion still causes dis-synchronization of market information. You cannot claim it is free-market failure when the government hijacks the synchronization mechanism (price) or even in this case the synchronization medium itself.

The inability of kittens to fetch the paper is less to do with any inherent weakness of kittens but more generally due to their lack of dog-edness!

Let me get this straight. You are saying that because the banks choose to exercise their government-granted legal privilege to create multiple property titles (bank accounts) to the same property (bank reserves) upon receipt of government-monopolized legal-tenderized paper, that the resulting economic disruptions are a free market failure? Weak.

Let me get this straight. You are saying that because the banks choose to exercise their government-granted legal privilege to create multiple property titles (bank accounts) to the same property (bank reserves) upon receipt of government-monopolized legal-tenderized paper, with the full knowledge that under conditions of "stress" that they will always have access to the "lender of last resort" with unlimited ability to print, that the resulting economic disruptions are a free market failure? Weak.

Tyler says: "Presumably the cash is more liquid (though if you are puzzled by this assumption in the context of a bank, join the club, Brad DeLong is a member too)".

I think the answer to that puzzle is that given that your LONG-TERM investment objective is to hold T-bills, and you hold T-bills NOW and you are in temporary need of cash NOW, but you have more cash coming in SOON, then it's much (by a factor of 10 or so) cheaper to repo your T-bills (i.e. borrow money using them as collateral) than it is to sell the T-bills outright and buy them back later.

Mike, that is questionable. If you put your money into the bank and while the bank lends the money, you are not allowed to use it - that is not fraud and it does not expand money supply. However: if you allow fraction-reserve banking - the money is lent, you are still allowed to take it from bank - then you base your decision on the assumption that you still own the money and you can use it. This expands the monetary base and arguably leads to business cycles.

Whether it is fraud or not is another question, I would argue that if the banks were not bailed out by the government, if they stated openly how would they react in case of bank run, if they failed for bankruptcy if they were not solvent and if the government did not impose any "banking holidays" - you could expect much higher reserves, much more responsible lending standards and actually less volatility of the money supply. It would be roughly equivalent to an open fund.

I'm confused? Everything I've read about ABCT by Garrison states that the problem is discoordination caused by the manipulation of the safe rate of interest. The thing that causes the business cycle, as I understand it, is not directly related to where the new money goes. Of course, banks face strong incentives to lower interest rates when the Fed lowers rates, so we all know a decrease in the Federal Funds Rate generally means more loans are going to be taken out. The "new money" could be spent on hookers for bank executives, while more of the "old money" goes into loans. I don't see why it would matter.

Why does it seem like a GMU economist is beating up a straw-man of Austrian economics?

If Tyler does not believe the rate of interest coordinates intertemporal action, what does he believe DOES coordinate such actions? Perhaps if there is no such coordinating mechanism inherent in loan markets (as Tyler seem to be suggesting), there might be a market for businesses which would provide such information? But, according to Hayek, such a firm would face an insurmountable knowledge problem...

But no, bank managers make an independent judgment that there are loans worth making. Of course sometimes they are wrong. But they know they got this new money through open market operations. And they decided to go ahead and make the loans anyway. They didn't have to. They could have re-routed the new money to some other injection path altogether. But they didn't.

Wouldn't you agree that banks face very strong incentives to lend what they can profitably lend? After all, the total harm from a credit crunch is not kept internal to the banks who give out bad loans. Also, most publicly-traded companies have a ton of trouble justifying poor short-term earnings to shareholders.

Person, I've never seen any attempted explanation of why many modern bubbles seem to be concentrated in a single sector, have you?


Most people don't understand what Title Insurance companies do either. That doesn't make them fraudulent. There is nothing illogical about fractional reserves. Every dollar issued is backed by a dollar's worth of bank assets, so the bank always holds enough assets to buy back every dollar it has issued, should the need arise. Of course, I'm assuming we're talking about solvent banks, but that's another issue.

As interest rates fall, demand for loans increase. The hurdle rate is lower so projects that did not make sense at a higher interest rate now make sense to the investor. Banks respond to this increased demand. Although their margins on the loan stay about the same, they make it up in volume.

But say that you lend to restaurants, knowing that 20% will fail. Is the fact that 20% fail a government failure that requires intervention? No. Is a 20% failure rate a market failure? No. The potential gains from a winning bet compensate for the potential losses. We see restaurants open all the time.

The problem with the housing market is that the externalities, damage to community housing values, is a market failure. But that has little to nothing to do with the Fed actions. In the past, think It's A Wonderful Life, community based lenders had an interest in making loans that protected the loans they already made in the community. The new lenders have little if any interest on the impact of their actions (think of block busting real estate sales of a previous period) on the community because they have no long term interests in any community. They shed their risk in financial markets and they have geographic diversification.


An obligation to pay out a precise sum of money, on demand, at all times, for everyone, cannot be logically satisfied at every moment by any mechanism involving first the sale into the market of assets whose value is indeterminate and revealed only at the time of their sale. The only means by which a bank can logically and rationally fulfill its obligation of 100% availability of funds to everyone at all times is via 100% reserves. Further, consider the logical extreme situation where 100% of the gold on the planet is in bank vaults, and the banks lend out 10 fold that quantity in deposits. When the entire population demands their rightfully-owed gold no sale of assets would cover the obligations.

Yes, the Austrians represent the irritating thorn of truth in the side of fallacious doctrine. You can tell you have destroyed the opposing argument when the only response is name calling. Economics is a social science. Which do you prefer, an apple or an orange? You cannot quantify that. MV != PT. The prevailing doctrine is destroying the country, and you STILL hasn't figured out how to eliminate bubbles and busts or why Deutsche bank owns Cleveland. Good luck surviving the dollar crash. You didn't fail to anticipate the best-performing asset of 2007 did you? M3 growing at 17% now. Won't mean much to you. Raise rates, lower rates. Rusting factories, super SIV, sub-prime, foreclosures, falling dollar, expensive food, expensive fuel, squandered wealth. THESE are the fruit incorrect borne of incorrect theory.


1) If you print another $100 and blow it in a casino, then your liabilities have risen by $100 while your assets have stayed the same. If you had no other assets, so that you have a total of $100 in gold backing the $200 you have issued, then you've committed fraud, and each of your dollars will be worth only half of a gold dollar. On the other hand, if you had some other assets, like a house worth $100, and if holders of your dollars could take that house from you in court, then you'd have $100 in gold, plus a $100 house, as backing for 200 of your dollars, so there would be no fraud and no inflation.
2) Bank runs happen when assets are insufficient to cover liabilities. In the case above, say you've issued $200, but your assets, for some reason, fall to only $199. Then each of your dollars will have a fair market value of .995 gold dollars. If you continue to pay out 1 full gold dollar for each of your dollars, then there will be a run, as everyone rushes to get their full gold dollar before you run out. This is described in the link I told you about, in the paper called "Introduction to the Real bills Doctrine"
3) I wrote part of that wikipedia article, but most of it is incorrect--mainstream, but incorrect. Anyway, if you deposit 100 paper dollars in your bank, you now have 100 checking account dollars to spend. If 80 of those paper dollars are lent out, then the borrower has $80 to spend. The money supply increased from 100 paper dollars to $180--100 checking account dollars plus 80 paper dollars. The really important thing to appreciate is that even though there is more money, there is no inflation, because bank assets move exactly in step with the amount of money. There's more money, but there's also more backing, so each unit of money is worth the same.


But the Fed doesn't buy government debt because it believes it is valuable, it buys it because it is trying to manipulate the rate of interest. The government can sell as many T-bills as it wants and the Fed will buy them, not because it believes they are as valuable as the paper it pays for them, but because it is commanded to do such things by Congress. The vast majority of the money the Fed receives from holding debt is given back to the Treasury Department, so the system's ability to create new dollars is effectively unlimited by things which might limit normal banks. I don't see how anyone could say Fed credit expansion isn't inflationary.


1) Be careful when you say "the" interest rate. The fed keeps its eye mostly on the overnight rate on loans between banks--the federal funds rate. If the fed becomes worried about inflation, it will tighten up the money supply by selling bonds (or buying fewer bonds). This causes the overnight rate to rise, and the fed uses the overnight rate as an indicator of how tight they are being. The fed might, for example, declare that they will continue tightening until the overnight rate rises to 5%. That way they avoid the Volcker mistake of letting the overnight rate rise to 21% in the name of reducing money growth at all costs. The fed is not so much manipulating the overnight rate as it is using the overnight rate as an indicator of whether they are being too tight or too easy.
2) The fed does not buy bonds because congress commands, and since the fed buys bonds in an open auction, it can hardly help paying fair market value for them.
3) The fed can, in principle, issue unlimited amounts of money. So can a private bank. But they don't, for fairly obvious reasons.
4) If you'll look up the real bills doctrine by clicking on my name below, and if you come to understand that the dollar is backed by the fed's assets, that there is no such thing as fiat money, and that the fed's assets automatically move in step with the quantity of paper dollars issued, then you might come to understand why I say that credit expansion by the fed is not (normally) inflationary.

Mike, to reiterate the point: Imagine that the government issued that $1 is redeemable either for 1oz of gold or 15oz of silver. That would be price-fixing and it would be wrong. Now suppose that you 'privatized' this price-fixing and said to the banks that they can issue the dollars if it is backed by gold/silver at 'market' price. That is weird idea, because you wouldn't be able to determine the actual backing - one bank would issue $1 for 0.5oz, other for 1.1oz. The whole concept would be meaningless.

The 'real bills doctrine' seems to do the same - but it includes not only silver and gold, but any asset. But the only thing it does is price-fixing the asset at the moment of using it as a collateral.

Is there any problem with me, in my basement, printing up a perfect counterfeit US $100 dollar bill, and loaning it out at interest (the loan terms insist the debtor finds and repays the counterfeit bill). I will be sure to underbid all the other legitimate savers offering loans and offer a "beneficial" low interest rate to the borrower. If asked, I'll respond that I hold the debtor's IOU "as backing". After some times, when the loan (with interest) is returned I destroy the counterfeit $100 dollar bill and pocket the interest payment. Has anyone been harmed? What, if any, is the fundamental economic difference between this activity and that of fractional reserve banks?

If you completely eliminate money and look at the underlying activity in the economy, it is possible to see the fractional reserve banking does not create inflation. Every loan is backed by assets. You loan the bank $100. They loan $190 to a businessman who produces more than $190 worth of goods and services.

Matt, I think your example is fraud because you are issuing a note backed by the Federal Reserve, not yourself. If you print up a Bank of Matt note worth US$100 and loan it to a friend, and it is accepted by a merchant who eventually asks you for the $100, which you then get from your friend, and then burn the IOU, yes, there's no problem. The people involved are trading with you based on your reputation and good credit. You have not created money, you have created credit. The compesantion for the service you provided is the interest.

8, perhaps my activities constitute fraud, perhaps not. If all participants were fully-informed of my activities and therefore nobody was deceived, would it still be fraud? If everyone knew how could it be fraud? The fundamental question here is, "who is harmed"? Was it the borrower who enjoyed a lower interest rate? The merchant whom the borrower patronized? Does everyone win? Don't get hung up on the counterfeiting aspect. The "counterfeit dollars accepted at par" activity is ***economically equivalent*** to printing and loaning receipts for nonexistent dollars which are "accepted at par by knowing participants."

Andy, that's a good point on collateral. DeSoto discusses the aspect of collateral pricing at length in his "Money, Bank Credit, and Economic Cycles". In particular, he discusses how the "law of large numbers" does not apply to banking because the act of credit expansion itself generates non-independent market processes which guarantee the ultimate crisis.

8: gold IS an asset. It happened to be generally accepted, that's why it became money.

The second point: let's try an example: $1 = initially 1oz of gold. Capitalist(has $1), Bank (has nothing), Enterpreneur (has $1), Producer (has an asset).
Situation 1: Capitalist buys an Asset for $1 from Producer. He lends this asset to the Enterpreneur and asks him to pay it back within 10 years. Total amount of money: $2.

Situation 2: Enterpreneur buys an asset. He goes to the Bank and assures himself a collaterized loan - the Bank creates $1 of new money. Total amount of money: $3.

Considering that the first situation couldn't be called neither inflation nor deflation (the money supply is kept constant), I tend to conclude that the second situation is inflation.

It is quite possible that we are using different terms - the austrians typically don't mean by inflation rising CPI but rising money supply. The ABCT explicitely condemns money supply expansion/contraction, not rising/falling CPI.


So let a fractional reserve bank accept either gold or IOU's from its customers, and promise each that they will be able to get gold 99.99% of the time. In return for this inconvenience, the bank will pay them interest, and probably do a better job of preventing robbery than the customers themselves could do. I think that handles your objections.

I wasn't sure what you meant by inflation for that reason.

I think situation 1 and 2 are the same.
In 1: C ($1 note), E (asset, $1), P ($1), B (nothing).

In 2: C ($1), E (asset, $1), P ($1 note), B (nothing).


Matt: "I don't see how anyone could say Fed credit expansion isn't inflationary."

Sophie: "Just where did I say that."

You didn't; but you should have.

Mike, I don't agree with your explanation of Mints (and mine) objection.
The real bills doctrine allows following operation: Bank prints money, customers buys an asset with this money which is used immediately as a collateral.

This immediately removes budget constraint on the demand side and will bid up the price of the collateral assets REGARDLESS of the total CPI impact.

You seem to assert that this does not happen, but in my opinion you must have an error somewhere, because this would deny law of supply and demand. Rising prices of these collateral assets will allow for even more money expansion (by re-financing existing loans). I just do not understnad, how could this not end with inflation.

The market sets the price of wheat, and bankers accept it as collateral, knowing that they are gambling on the direction of future prices.

The borrowers are the market. You are essentially saying that the borrowers are setting the price of the collateral!

3) No rational banker would make that "1 oz.=15 oz." mistake. That is a misguided criticism of the RBD

If the market sets the price, it could set it to $1=1oz today and $1=1.5oz tomorrow and $1=0.5oz the day after. That is not a mistake, that is good banking according to your principle.

The RBD says that the new $100 is adequately backed by the $100 lien, so there is no effect on prices.

Do you claim that law of supply and demand does not work? BTW: By allowing such bills, you have effectively dropped interest rate close to 0. (and that is, btw, the answer to Fed's free lunch - they, and only they, can drive interst rates close to 0, the other banks must keep CONVERTIBILITY of their own money into Fed's paper money.)

Or one could say that if the new money had not been wanted, it wouldn't have been issued.
See my example. The new money didn't have to exist, the enterpreneur could have obtained a loan from the capitalist. However, if we add your real bills doctrine, there can be 2 enterpreneurs - one will obtain a loan from bank, the other from the capitalist. Considering that only 1 asset was produced, these 2 people will bid the price of the asset up.

Second, I absolutely disagree with you that backing is important and convertibility is not. If something is not convertible THEN backing is absolutely unimportant. GM stock has it's price because of expected future income and in the worst case because of it's convertibility. Why should I care about the assets of the bank issuing the money when I have absolutely no claim on the assets?

Third: If GM issues too much stock, nobody would continue buing stock for the $60 price - and the price would fall. REGARDLESS if it is backed by the newly imported $60 or not. However: if I consider the real bills doctrine, I could buy unlimited amount of GM's stock, because I would continue buying the new stock for $60 and the price would not fall.

Stock is definitely an asset. Do you see what you could expect if banks started accepting stocks as a collateral?


1) If a bank issues dollars that are equal in value to 1 oz. of silver, and then a customer asks for a loan of $100, and offers some farmland worth $200 as collateral, then any sane banker would accept that land as collateral. If it happens that the land falls relative to silver, the banker might go broke. That's life, but bankers should not be prohibited from the practice because of occasional disasters.
2)The laws of supply and demand apply to actual goods, actually produced with scarce resources and actually consumed by people. They do not apply to pieces of paper, bookkeeping entries, and computer blips that can be produced and destroyed instantly at no cost.
3) There is nothing about the RBD that even remotely relates to dropping the interest rate close to zero.
4) When one guy borrows $100 from a bank, he must give the bank collateral worth at least $100. When another guy borrows $100 from a capitalist, he must give the capitalist collateral worth $100. There is a total of $200 of "new money" backed by a total of $200 worth of assets. Each dollar is adequately backed, so there is no inflation.
5) Money-issuing banks close every weekend, and their dollars become temporarily inconvertible for 2 days. But the bank still has assets, so people still value those dollars because they are backed, even though temporarily inconvertible. The Bank of England suspended convertibility from 1797 to 1821 (The period when the fallacious idea of fiat money took hold) but the bank always kept its assets, so the pound was backed but inconvertible. Find a central bank, or any other bank, that ever operated without assets, and then you can start to make your case that backing doesn't matter.
6) GM would only (rationally) issue the new stock if it had a good use for it. In this case the new issue would not affect the price of GM stock. Yes, of course you can say that if the practice is carried to extremes, there will be problems, but the extreme is not what we're talking about.

"Banks now hold fewer T-Bills and more cash. Presumably the cash is more liquid(though if you are puzzled by this assumption in the context of a bank, join the club,...) "

I assume that what the author is getting at is that T-bills are liquid because you can sell them. I would say that cash is more liquid than T-bills in the same way that stocks are less liquid than cash. Sure, there is a market for them in that you can liquidate them, but if I buy stock, I do so knowing they could go down tomorrow, so I only buy with the understanding I may have to hold them for 5 years.

Or, is he saying that T-bills are liquid because to buy them you send money to the government and this stimulates the economy? To this I would paraphrase Milton Friedman, that we are lucky the government is so innefficient, or they'd do more damage.

Print and sell one piece of unbacked paper and the mob burns down your house. But print two and loan one, and the bewildered masses can't figure it out.

Very nice article! Thanks for this!

It is enlightening!

It seems we will be in economy ression for quite a long time. We can see the economy crisis effect everywhere.

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