Thursday, November 20, 2008

Misesians vs. Hayekians

Pehr asked me in the Q&A section about books on Austrian economics in Swedish to which I suggested Johan Hakelius' book "Den Österrikiska skolan" and to which Per-Olof Samuelsson also added the translated version of Alexander Shand's "The capitalist alternative". However, we warned him that these books focus on the Hayekian version of Austrian economics rather than the proper Misesian version (although that is discussed too). Pehr then came with the follow-up question of what the difference is between the Hayekian and Misesian version of Austrian economics.

That is an interesting question. For a more in-depth analysis I recommend Murray Rothbard's essay "The Present State of Austrian economics" where he analyses the difference between the Misesian version (which Rothbard belonged to) and the Hayekian version. Before I describe the difference between Mises and Hayek I should point out that there were actually "two" Hayek's, just like there were two versions of Hayek's cousin Ludwig Wittgenstein. Early in his career, Hayek was a Misesian and argued for the Austrian business cycle theory during the 1920s and 1930s. It was on the basis of this that Hayek received the Nobel price in economics in 1974. But then after World War II, he lost interest in business cycle theory and instead started to argue for the ideas described below.

In short, the Misesian version is based on what Ludwig von Mises called praxeology, which means the logic of action. Praxeology is based on a number of axioms, the most important of whom are the action axiom: the human beings act on purpose using means to achieve ends. Bases on this and a number of related axioms and laws of reality, you can then deduce a number of implications. Among the more immediate ones are that people will always choose the action they believe ex ante (before the action) will produce the best results, otherwise they wouldn't have acted that way. A second implication is that since the future is uncertain, people can't be certain that the action they perform will turn out to be the best. This uncertainty also implies that people will have to make forecasts about the future when deciding on which means to use in order to achieve the ends they want. But as people can only choose one specific form of action, every action is associated with a opportunity cost in the form of the actions they chose away.

Misesian praxeology then continues to deduce new logical implications in the above manner and apply them to more specific situations with certain specific conditions, such as the existence of money controlled by a central bank, advanced division of labor and a heterogeneous capital structure, and from that Misesians can derive advanced theories such as the Austrian business cycle theory. This approach, which is known as the axiomatic-deductive approach, is similar to the one in Mathematics and formal logic and is really no less certain than it. While Misesians can be certain of the economic laws implied by praxeological reasoning, they can't be certain of how applicable certain theories will be, but then again this is no different from how you can't be certain of how applicable mathematical conclusions like 103+201 are or for that matter how applicable physical laws and conclusions like how often airplanes will actually fly.

Misesian praxeology is thus based on logical analysis of how people try their best to use ends to achieve means and what that will mean given specific conditions.

Hayekians by contrast are not really interested in this kind of approach. For them reason is not an ally for acting man, it is a dangerous illusion and an enemy. The point of the Hayekian analysis is that acting individuals really can't alone come to any correct conclusions. Instead, truths and rules gradually evolve in a collective process governed by the anonymous spontaneous social forces, and while no one can really come up with anything individually, they can still learn somehow from the spontaneous social evolution, an evolution which is similar to the unplanned evolution we see in nature.

The Hayekian argument against socialism and government intervention consists in that socialism is based on the illusion that reasoning by any individuals (in this case politicians and other government officials) can be used to improve conditions. What Hayekians fail to see is that this argument will apply not only to government decisions but also to decisions made in any organization, including private companies. Indeed, it could even be made against any decision-making by individuals that doesn't involve simply mindlessly following what the group somehow comes up with collectively. By contrast, the Misesian case against government intervention consists in using reason in the form of praxeological reasoning to demonstrate the negative effects of such interventions.

In short, the difference between Misesians and Hayekians is a radically different view of reason and logic. To Misesians, people may be fallible, but they can and should still use reason to analyze the world around them and use these conclusions to improve the odds that the course of action they choose will turn out to be the best. To Hayekians, by contrast, belief in reason is a "fatal conceit" as Hayek puts it and the basis of socialism, while mindlessly following rules and ideas spontaneously evolved by the group is somehow the basis of a free society.

Again, I recommend you to read Rothbard's longer analysis of this subject.


Blogger SAJ said...

Isn't Hayek’s argument against socialism that a centrally planned economy would require information only available through the price mechanism and since no prices exists in a socialist economy there can be no efficient planning?

5:35 PM  
Blogger goo8734 said...

Stefan: I think you have overstated Hayek's case against reason. I have read basically everything Hayek has written, and he is difficult to understand because he's trying to maintain a multi-faceted position, but I think there is a coherent position he is articulating.

Hayek never said that 'reason is a fatal conceit'. What's a fatal conceit is the idea that reason can be used to reshape the WHOLE of society. Reason applied to 'small' things is possible. But as the problems get bigger -- in particular bigger than what one mind could possibly cover -- reason becomes increasingly impossible. His idea was that social orders (e.g. markets, property rights, language, money, customs, social morals) emerge to help men cooperate so that they can conquer problems that they couldn't conquer on their own. And when these social orders emerge, we can use our reason to understand them, and even incrementally improve them, but we CANNOT totally reshape them.

The reason libertarians have trouble with Hayek is that he doesn't provide them with a hard and fast line between what's 'allowed' for government and what's not. But that's exactly why I like him and ultimately why I think he's probably closer to right about what's really happening. Some amount of social engineering is ok, but not too much. And what that line is, is not something Hayek absolutely defines -- although he does clarify things, by helping us RECOGNIZE when we have gone too far and when we haven't.

For example, for Hayek, efforts by government to 'improve' the overall distribution of income ARE fundamentally flawed. Who is to say what the 'right' distribution is? No one knows. So progressive taxation, with increasing rates towards the top would be highly problematic -- the theory driving them has no limit. On the other hand, if people decide to tax THEMSELVES to provide a group (the poor or sick) with help, he has no problems with it. Then government is being used instrumentally to help a minority of people, and the majority are actually consenting to it, so it moves away from broad social engineering. Yes, it's a subtle line, and probably totally politically infeasible, but from an intellectual point of view, I find it very satisfying.

Examples of 'reshaping' society (bad for Hayek): the useless attempt to create a new language -- esperanto. Or the attempt by government to somehow 'simulate' the natural market in money with a central bank. The price of money (i.e. the real interest rate) can only be found out IF there is a market in the first place. Or more broadly all the various micro social engineering attempts like trying to 'create' more home ownership because we believe that's a good thing.

Jeremy Goodridge, PhD

5:47 PM  
Anonymous Per-Olof Samuelsson said...

SAJ: This was actually Mises' criticism of socialism (or at least a very important part of his criticism). But since Hayek follows in Mises' footsteps, I guess he makes the same argument. (He hasn't swayed on this, has he?)

As to Hayek's view of reason, I would direct Scandinavian speaking readers to my own essay on this subject:

(A short version of my criticism is that Hayek does not believe reason is totally reliable and should be used with some "humility". Who is then to tell us when we should proudly use our reason and when to be "humble" and let something else override it?)

7:24 PM  
Blogger stefankarlsson said...

SAJ: That was one of his arguments, yes, but there was more to it than thar.

Jeremy: I am no Hayek scholar and so haven't exactly spent a lot of time studying his books in-depth.

But the description I gave about his ideas is one that not only was confirmed by critics of Hayek like Murray Rothbard (see the essay I linked to in the main article), but also by supporters of him like Johan Hakelius and Patrik Lindqvist.

And even if I had somehow misinterpreted all of them (not likely), it really begs the question as to why the limits of reason go exactly at the point you they are, and are not applicable to for example business strategy decisions? And I don't see really why the very limited degree of ignorance you claim that politicians have and which I have heard no Hayekian before claim they have would stop at simply that? If they don't know more is right, how do they know more is wrong?

11:38 PM  
Blogger goo8734 said...


Thanks for the response!

Yes, I agree. There is, in my view, a genuine problem with applying Hayek to the real world. Politicians don't know when to stop -- and he doesn't given them a rule. So, while Hayek wanted to stop them for many things, he didn't go so far as many libertarians to just forbid any welfare state activity.

I like Hayek for his intellectual insights, and the framework he provides for understanding the social world we live in. But I think practical applications are hard.

In terms of business strategy, I think Hayek WOULD actually agree that CEOs of large companies do face genuine challenges similar to the ones the state faces (lack of knowledge about may specifics, etc). [I assume that's what you are referring to when you say, "business strategy"]. Still, despite these challenges, Hayek would probably say that the complexity problems of the individual firm are less acute than the ones faced by the state. For one, firms -- even huge ones like GM -- are still MUCH smaller than the entire state. But for another, firms have SINGLE purposes, whereas a state has essentially no independent purpose -- except the overarching one to 'enhance the general welfare'.

By the way, I should tell you -- your blog, is, for me, the absolute best economic blog around.

Thanks a lot!!!

12:55 AM  
Blogger goo8734 said...

Hi Stefan:

Just one last comment. I just read the Rothbard article you linked to. On the whole, very interesting and insightful. I haven't read much Rothbard, and have been meaning to, so it was a good link.

He does have an exaggerated view of Hayek -- that Hayek believed reason is impossible. Reason is limited but not impossible, for Hayek. Hayek contributed to this confusion because of his last book which put so much emphasis on what we know from experience or customs RATHER than reason. But Hayek never said reason was useless. In the end, I think the argument is largely semantics. For the most part, it's fairly obvious that we use reason a lot to accomplish our goals, but we also rely on habit and tradition too.

Just a side note on his discussion about 100% reserves. I am not sure I totally agree him. He believes that in a true free market, all that would ever survive would be a 100% reserve banks. But I just don't think that's true. While I agree with him that any bank CLAIMING that a depositor can always 'get' his/her deposited money should be REQUIRED to maintain a 100% reserve. But what if a bank openly DECLARED that it had a 50% reserve system? And told depositors UPFRONT, 'you might not get your money' if everyone wants it back at once. Is this really to be forbidden in a free market? It's not deceitful. The bank is REVEALING its situation. My bet is that a truly free market would be filled with fractional reserve players. In fact money-market funds are, to some extent, structured this way -- they are backed by short-term bonds, but not hard money. I imagine Rothbard's view is that the market would eventually compete away such non-deceiving fractional reserve banks. But I don't agree. What do you think?

Also, one thing I do find a bit irritating about Rothbard -- at least in this article -- is that he engages far too much, for my taste, in the use of ad-hominem attacks. For example, his whole discussion about Hayek being impersonal and not inspiring students is a rather unappealing. I'm not sure why that's necessary, nor do I think it's particularly helpful in encouraging discussion.


2:26 AM  
Anonymous Anonymous said...

Good morning,

Although I read most of Hayek's books, I've not read them recently. However, I believe there is something overstated in your (and Rothbard's) judgement.

Let's say that I'm a "compatibilist" - Mises and Hayek are not much different to me - in line with what Yeager, Kirzner and Boettke have often written (The last one wrote a not about it several days ago on his blog).

Let's begin with the role of reason.

Hayek is against constructivism, which is the idea that reason per se can fully understand and rebuild at the root the entire social fabric. He is not against reason per se.

Let's take for example Hayek's argument against socialism.

Markets put together sparse information and this results in coordination among individual plans. The central planner can't do this, so socialism doesn't work.

The reason why it can't is that there is no market process assembling the relevant data together.

This is exactly the same argument of Mises's. Mises said that even though the planner knew all consumer's valuations, it couldn't impute values to capital goods without a price system which derives from the market process (something Schumpeter wholly failed to understand).

Rothbard claimed that the real point is not knowledge but the lack of prices. That's as right as irrelevant.

The point is that prices are only useful because people are not omniscient. It the planner were omniscient (not only about preferences, but also about technology and sparse informations), it could solve the imputation problem by computation, without prices.

A primitive society can do without prices, and it is not impossible because of this, because production is simple and no prices are useful.

There are two more points which hinges upon Hayek's interpretation of the market process, which have been taken as the proof that Mises was different.

The comment is too long so I only state them:

(1) Mises was a constructivist. The problem is that people forget all too often Mises's distinction between theory (rationalistic) and history. Let's consider that Mises thought that our reason can't say anything definite about history because we are too ignorant about the complexity of social phenomena and individual will is too erratic to be predicted. Where's constructivism? This is Hayek's argument against constructivism! Mises called these problems "history", and people live in a historical settling.

May be Hayek didn't appreciate enough the power of deductive reasoning, but I remember him writing that although the logic of choice (and all the rest of price theory, hence) is valid a priori, a priori knowledge is not sufficient in understanding business cycles.

(2) Hayek was a fallibilist (and evolutionist) and Mises was not. Mises says in Human Action that theory is always incomplete, that reasoning can be wrong, that history is so complex that theory is never sufficient in understanding historical phenomena, that the apriori (the mental structure of perception) has an evolutionary origin. This is just like Hayek.

At the end, there are minor differences in terminology and interests. But Hayek didn't change much: he believed too little in the power of apriori reasoning, that's all. All of his contributions to Austrian theorizing were misesian insights that Mises didn't develop fully (the only exceptions being his theory of law and institutions, grounded on Menger's and Leoni's theories).

I have to read again some literature on the topic, anyway.


11:15 AM  
Anonymous Andreas Johansson said...

Stefan are you using praxeology in your economic reasoning?

1:04 PM  
Anonymous Per-Olof Samuelsson said...

I'm no great Hayek scholar myself, but I have read "The Fatal Conceit" (in a Swedish translation) and based on that, I would say Stefan's short summary of his ideas is entirely correct.

It is true that Hayek starts out by stating that he is not against reason "as such", but only against certain "misuses" of reason (what he calls "constructivism"). But as he goes on and develops his ideas about what reason actually *is*, he arrives at some weird notions - such as that we should not learn from reason, but from imitation of tradition.

So it is OK, according to Hayek, to be rational "some of the time". But if you are "too rational" - if you are so bold as to rely on reason entirely (including judging "tradition" by reason) - you would end up being a socialist!

6:20 PM  
Anonymous Per-Olof Samuelsson said...

A nit-picking aside: Hayek and Wittgenstein weren't cousins. They were "cousins next-removed" ("sysslingar" in Swedish). I did some research on the net on this, just for fun.

7:54 PM  
Blogger stefankarlsson said...

Jeremy: thanks for your appreciate assessment about this blog!

Still, we clearly disagree about Hayek.

Again, with the issue of whether I have misinterpreted Hayek or not, I admit to not having read much of his books. Of the books relevant here I have only read “The Fatal Conceit” and that was a several years ago. What I remember from it was that it was boring and unconvincing and that the conclusion was that socialism was wrong because socialists believed too much in reason.

But again, the irrationalist interpretation of Hayek that I have isn’t just based on what I remembered about “The Fatal Conceit” and Rothbard’s essay. I have gotten that interpretation confirmed by supporters of Hayek. Last year, Swedish free market think tanks Timbro and Captus had an essay contest, where I came in at third place for an essay about Frederic Bastiat, while Patrik Lindqvist came in at first place for an essay about Hayek. Both in the original essay and in the lengthy conversations we had when we met during the award ceremony, he confirmed the irrationalist interpretation of Hayek. And when I today re-read the aforementioned Hakelius book, it also confirmed that while Hayek did believe reason had limited personal application, it really couldn’t comprehend the larger societal forces.

It also appears that while you read Rothbard’s essay, you didn’t read it very carefully. With regard to the fractional reserve banking issue, Rothbard’s point was not that 100% reserve banks would necessarily out-compete fractional reserve banks, but rather that fractional reserve banking is inherently fraudulent and should thus be outlawed, being a form of fraud. Fractional reserve banking means that two people are asserted to be the exclusive owner at the same time of the same base money, which is a metaphysical/ontological impossibility and thus objectively fraudulent.

And you have further completely missed the context of the “ad hominem” attack against Hayek. Rothbard discusses the view of Professor Karen Vaugnh that Hayek and not Mises was the one that kept the Austrian tradition alive, something which she attributed to Mises’ “emphatic style of teaching. Rothbard then explains why Mises was the one that carried on the Austrian tradition, and points to how Hayek couldn’t have done it because of his uninspiring style. That is an attempt to explain history, not an “ad hominem” attack. Or would you regard the view that a partial explanation of why Barack Obama defeated John McCain in the recent election is that McCain wasn’t as good and eloquent as a public speaker as Obama was as an "ad hominem" attack on McCain?

LF: Regarding the price issue and central planning, you really need to read the Rothbard essay that I linked to as you do not appear to grasp the difference between the Misesian and Hayekian view on that subject.

With regard to the ability to understand history with theory you similarly miss a key point mentioned in the Rothbard essay, which specifically mean that Mises thought that people can through the use of reason grasp economic laws, even though they can't know the specific applicability in all cases. For example we can through praxeology know that an increase in supply will lower prices, but we can't always know the exact quantitative effect, even in ceteris paribus terms.

That is very different from the Hayekian view that larger social forces are unknowable to reason.

As for the "evolutionary origin" of a priori views that Mises believed in, that refers to soemthing very different than Hayek's evolutionary view of social changes. Mises believed that the aprioristic ideas were a result of natural evolutionary forces. Hayek believed that society evolved in a evolutionary way which we cannot fully understand.

For the record both I and Rothbard disagree with Mises' Kantian explanation of how praxeology can be justified, but Mises still maintained that economic laws can be understood by reason, and that is the point in this context.

Andreas: Yes, I am certainly using praxeology or more specifically the conclusions of praxeological reasoning in my economic analysis.

Per-Olof Samuelsson: Regarding your nit-picking point, I should remind you that "cousin" in English is not the same as "kusin" in Swedish. "Kusin" in Swedish is the same as "first cousin". "Cousin" in English also exists in second and third form, thus also encompassing what in Swedish is referred to as "syssling". So what I wrote was not technically wrong.

Still, I had admittedly actually gotten the impression that they were first cousins, so I appreciate that you provided that info

11:16 PM  
Anonymous Per-Olof Samuelsson said...

Stefan: Well, I think we are "philosophical cousins", maybe even "first cousins", because I find myself nodding in agreement to virtually everything you write here.

And thanks for the Rothbard link! He has many really good points in this essay.

9:40 AM  
Blogger stefankarlsson said...

Per-Olof: I too think we're philosophical first cousins.

3:31 AM  
Anonymous newson said...

to p-o samuelsson:
please note in english the terminology is first cousin once removed. or second cousin thrice removed, etc.
take this pedantry as an oblique compliment on your great english.

to stefan:
nov 21, ran a piece by hayek "a free market monetary system". he makes some comments about sweden during ww1, and the problems caused by its maintenance of the gold-standard, which i found completely illogical, or poorly articulated. maybe you can do better at explaining this episode of swedish monetary history?

5:45 AM  
Blogger goo8734 said...


Thanks for the response!

I don't think we disagree on what Hayek said -- he did see limits in the ability of reason to understand the larger social forces, just as you say. But he didn't think reason was 100% useless on the social forces, just partially useless. So, how useless? It depends on how 'completely' you want to remake society. Reason works for 'incremental' remakes of society and doesnt' for total 'remakes' of society like communism. But hayek certainly believed in economic theory (e.g., to use the example you give, that an increase in supply would lower prices). And he was well aware that much of economic theory was 'derived' through a deductive (i.e. rational) process. But the actual market system wasn't really understood until it already existed. And this, Hayek believes, is true because it was probably too difficult for men to invent it from scratch. But once it is there, man can understand it, and use his understanding to improve and perfect it (i.e. by articulating why various remaining government actions are preventing it from working as it should). By the way, Hayek's position is very similar to Popper's positions in 'Open society'. I think the only disagreement we may have is that I agree with Hayek's fuzzier position, where you may not (or maybe you do??).

On Rothbard. Yes, I agree that Rothbard thought a fractional reserve system was just fraudalent. And I would agree with Rothbard on this point. But, then I jumped a step and assumed Rothbard would NOT think a bank that INFORMED its customers that it wasn't GUARANTEEING the convertability of its deposits would be a fraud. Or does he actually think that a bank that informs its customers that it is only keeping fractional reserves is a fraud?

And if he thinks that a bank that informs its customers that it keeps only a fractional reserve is NOT a fraud, then does he think such a bank would die in market competition? This isn't explicitly covered in the article, but can be inferred from Rothbard's discussion on Hayek's view on competing currencies. On the top of pg 34 of 'The State of Austrian Economics', Rothbard says that he would allow banks to issue money, but that no one would accept that money (if it isn't 100% backed by gold, or other 'hard money'). That suggests that Rothbard is just very confident that fractional reserve banks would fail -- i.e. only 100% reserve banks would succeed.

My bet is that in a truly libertarian society (whether that be a minimal state or some anarcho-capitalist society), fractional reserve banks WOULD be the more typical types of banks, or at least that the more common kind of money would be non-100% backed money. There would be a few banks that basically were like vaults for people who wanted absolute certainty (i.e. 100% reserve banks), but these would earn no interest and would have fees associated with them. But most money would be stored in some kind of vehicles like money market funds which provide some interest. And so, whatever instability is avoided by outlawing fractional reserve banks, would end up re-appearing in a free society because people would want the additional interest possible with fractional or other non-100% backed money.

Do you agree that non-deceitful fractional reserve banking is fraudalent? What do you think would happen to banks in the ideal libertarian society?

On the 'ad-hominem' attack issue, I take your point. Rothbard was making a broader point.

Well -- if you have got other things to do (like new posts!), don't feel obliged to respond.


6:03 AM  
Blogger goo8734 said...

Oh one other point, Stefan:

I don't deny Hayek can be confusing. He maintains multiple positions. At some points he needs to defeat 'reason' and then he writes things like 'Fatal Conceit', but at other times, he needs to defeat conservatives -- read 'Why I am not a conservative' in 'Constitution of Liberty'. There, he explains why he wants not just to accept what tradition provides (as many conclude he believes from Fatal Conceit), but instead argues for affirmative libertarian action. And in 'Law Legislation and Liberty' -- his last work before Fatal Conceit -- he articulated the case for a totally new constitution that would (in his view) be more effective in protecting liberty. This is hardly the proposal of someone who just believed reason was useless to analyze or perfect social life.

Anyways, it's my view that there really aren't two Hayeks, but one Hayek who saw the limits of reason, but also believed in something positive (libertarianism). And so, on the one hand, he wants to be cautious, but on the other hand, he wants to more strongly state that we have learned something about why freedom is important.

6:54 AM  
Blogger Brian Macker said...

I agree with Jeremy Goodridge, Hayek never said that 'reason is a fatal conceit'.

I also think that Mises is mistaken in how reason proceeds. Mises didn't deduce all of Austrian economics wholesale from some set of axioms. If you believe that then you should also believe that deducing Austrian Business Cycle theory is just as likely for an individual to do having never actually observed bank runs, or businesss booms and busts. What in fact really occurred is that there were unexplained things occurring out in the real world, empirical things, for which Mises sought to create a model. Without realizing it he was in fact proceeding along Popperian lines of reasoning.

All scientific models must be self consistent in order to work. Mises appreciates this fact, which Popper also appreciates. Mises didn't appreciate that he was actually following Popperian procedure in building up his model. That doesn't really matter however if he came up with a good model.

The whole purpose of science is error reduction. The reason for checking reason against reality isn't because there is a problem with correct reasoning. The problem is that humans are fallible and we can make mistakes in our reasoning. We can make mistakes in our assumptions, which assumptions are most important, in our logical deductions, etc. That is why we need to check against reality. Especially because we are trying to model reality.

My contention would be that all economic schools fail at some aspect of science, and that mainstream economics is failing the most in that it's models aren't even self consistent, let alone consistent with reality.

6:17 PM  
Blogger Brian Macker said...

"But as he goes on and develops his ideas about what reason actually *is*, he arrives at some weird notions - such as that we should not learn from reason, but from imitation of tradition."

I read the same book and I didn't take this uncharitable reading away from it.

In fact I thought his theories are pretty much in line with Mises on the economic front. I agree with the comment by "Anonymous" and that is how I took the book.

I've only read one other book on Hayek and it wasn't written by him, but about his theories. I never picked up on this idea that Hayek was an anti-rationalist.

My view is that Mises was a great economist and a not so great philosopher of science. He really had a poor understanding of what the other philosophers were getting at, like Popper.

Meanwhile other economists like the Keynesians were even worse philosophers of science and also bad economists.

6:57 PM  
Blogger Brian Macker said...


On 100% gold reserve banking I think you do not understand Rothbard as has been pointed out.

You are making what sounds like a reasonable argument but I think there is a flaw.

Sometimes deceptions can be open and still be deceptions. There are well known cases where people are exceptionally bad at predicting the odds of certain things happening.

Do you think that Ponzi schemes should be legal, just so long as the parties involved agree to the deception?

I think it is prima facie evidence of the incompentence of the signator to a contract if they were to sign a ponzi scheme contract.

Likewise a pyramid scheme. One might fully understand the contract and know that you were an early adopter and therefore less likely to be screwed. However, the very fact you think this is evidence that you are counting on finding additional people to join the scheme who are incompentent to understand the swindle.

I believe that fractional reserve banking is one of the most sophisticated swindles going on. It is extremely hard to understand why it is a con game. It is non-the-less a con game.

How exactly do you plan to make sure the recievers of banknotes in payment for their goods are fully aware of the consequences of the con?

You going to print something like this in fine print on the notes: "This bank note entitles the holder to only half the face value printed. There is a great possibily that this note is being used to bid up the price of your good by 100% without full intent to pay you for that good. The full repercussions of this arraingement and the economic theory backing it is printed herein. Blah, blah, blah. Do you fully understand these conditions. If so fill in one of the blank lines below with your signature indicating that you are willing to take zero dollars in payment or perhaps wait as much as fifteen years for full payment."

Another possibility is to make it the law that only the fractional reserve amount can be printed as the face value of the note, and that by law that reserve amount be kept available, with open books and mandatory banking insurance required for fractional reserve banks.

Thus the note might have a face value of say "Reserve Note for One Ounce of Gold". and say "Bearer entitled to one ounce of gold that is being held in reserve. You may be entitled to up to 100% more than the face value of this note, but the bank may, at it's descretion fail to pay you this additional amount. Depending on economic conditions and the condition of the bank there is even the possibility you will not receive the face value of this note. Please sign this note below indicating that you understand these conditions. Blah, blah, blah. ..."

Now you could certainly do this, and it may outcompete metallic coin, but I very much doubt it.

8:01 PM  
Anonymous newson said...

to goo8734:
i recommend you download jesus huerta de soto's "money, bank credit and economic cycles".
it's the most comprehensive damnation of the frb system i'm aware of.
he spends a lot of effort in showing how tortured the law has had to become to accommodate what is in essence an aleatory contract.

as brian macker says, only if the notes had "lottery ticket" instead of "bank note" printed on their face would they not be misrepresenting their true economic nature.

4:07 PM  
Blogger goo8734 said...


Thanks for the reply -- I'm glad to see you read Hayek the same way I do! Because of Hayek's confusing style (which is one area of criticism I think he is deserving of), there are many who misinterpret him.

On reserve banking, your point is very interesting: Is it even possible to make clear the fraud embedded in reserve banking?

Here's one thought. What if we required 100% reserves for 'deposits'. But then if anything below 100% was kept, the word deposit was not allowed to be used? And instead words like, 'bond' or 'loan' were used? I have a Vanguard money market fund, and it is clearly stated that there is a certain amount of time that may elapse when I try to get my money. It's never called a deposit, but rather an investment. I think if people realized that deposits are really just loans to the bank, the whole system would change. People would understand why and how they could even be earning interest. And people would also understand that they might lose money if the bank defaulted. What do you think?


4:57 PM  
Anonymous Per-Olof Samuelsson said...

Newson: "take this pedantry as an oblique compliment on your great english."


7:03 PM  
Anonymous Per-Olof Samuelsson said...

Jeremy: "[Hayek] didn't think reason was 100% useless on the social forces, just partially useless. So, how useless? It depends on how 'completely' you want to remake society. Reason works for 'incremental' remakes of society and doesnt' for total 'remakes' of society like communism."

Yes, that was Hayek's view. But I certainly think a stronger response to communism is to point out that it is not rational at all!

The problem with Hayek's view is that it actually adds up to criticizing socialism and communism for being "too rational". That's an assault on reason, and - for some strange reason - I'm not fond of assaults on reason. It is not possible to be *too* rational!

7:26 PM  
Anonymous Per-Olof Samuelsson said...

One of the good points in Rothbard's essay is that he points out that many economists who call themselves "Austrians" (including Hayek) have not understood the "calculation problem", i.e. the fact that a socialist society couldn't calculate prices in the absence of an actual price mechanism.

Hayek and his followers believe this is only because of "lack of knowledge". But the point is that even if the socialist planners were omniscient, they could not set prices. There would simply be no price mechanism for them to have knowledge about!

(Of course, the assumption of omniscience is itself totally unrealistic. But take it simply as a thought experiment or as what Mises himself would call an "imaginary construction".)

7:40 PM  
Anonymous Anonymous said...

Does the ponzi scheme of fractional reserve banking really rely on what's told to depositors?

Pretend for a second that we're not in the digital age, and that actual paper money must be printed for exchange.

There could be no multiplication of currency at banks unless banks had printing presses running!

Thus the issue isn't strictly about promises to pay depositors, it is that banks are permitted to create new "money" from nothing.

If this privilege is revoked, and banks are not permitted to create money from nothing, then that forces 100% reserves right there. Banks simply could not loan money they did not have.

The only way around it would be for the bank to create ITS OWN NOTES rather than US GOVERNMENT NOTES.

In a free market, a bank would only be able to create new currency if that currency were explicitly a note of that bank, rather than some government institution.

Then trust in that bank would go hand-in-hand with the strength of that bank's notes, and indeed such a fractionally-backed currency would not compete well against 100% reserve bank notes backed by something real.

But, you ask - what about the interest? Where would it come from - wouldn't inflation be necessary to repay interest on a loan? The interest would indeed need to come from somewhere, and in a 100% reserve environment, default rates would be high on high-interest-rate loans.

8:00 PM  
Blogger stefankarlsson said...

Jeremy-On Hayek and reason. Again Hayek believed in a limited role for reason as I wrote before. But he really couldn't give any convincing argument for that limitation, and the arguments he used against a wider use of reason could actually be used against any use of reason.

As for fractional reserve banking, the essential point is that it is again an objectively fraudulent system that benefits the people involved at the expense of others, similar to counterfeiting to paper money.

In the essay Rothbard pointed out that it may be difficult for legal authorities to guard against the various forms of "financial innovation" used to hide the fractional reserve nature of various financial products. So he suggested that whenever the people pursuing de facto fractional reserve banking practices run into liquidity problems because of that, they should be prosecuted and not bailed out as banks are now.

A good idea, except it overlooks how the de facto fractional reserve bankers are likely to claim -like they do now- that unless they're bailed out, we will see financial armageddon in the form of masive deflation. Which in the end means -given the reality of the political decision making process- that as long as we have fractional reserve banks, we will have central banking and bailouts.

Brian-You are wrong about deducing Austrian business cycle theory from axioms. It certainly can be done. Now, I'm a busy man so I don't have time to explain the long chain of deductions here, but if you read for example Rothbard's "Man, Economy and State" you can see how he step by step deduces it from the basic axioms to the specific situations where todayäs realities are assumed.

And as for "trying to explain real world, empirical things" that is entirely consistent withe the axiomatic-deductive procedure I described in the original post, of applying the basic axioms to specific situations with specific conditions. That is certainly not the same as the Popperian approach, which viewed axioms as meaningless or tentative.

11:47 PM  
Blogger goo8734 said...


On reserve banking: Yes (just as you mention towards the middle of your post) I was envisioning a world in which banks could print their own notes. The notes wouldn't be hard money, but could BECOME 'soft' money as long as buyers found sellers willing to accept those notes. And in a free market, I don't see any justification for limiting the contractual details behind those notes -- as long as it wasn't deceitful and fraudalent. So, to me, it does really matter what is told to the depositor. Some notes may have provisions that they are not always redeemable for hard currency. Some notes may be marketable instruments that can be sold for other bank's notes or hard currency on the open market. My point is that I don't think 100% hard-currency reserves would characterize the entire system (in a laissez faire world)-- although I do think reserve ratios (or at least capital ratios) would be significantly higher than they are today. And the main reason that more than 100% hard currency backed money would exist is that people want to earn interest. And as long as that's the case, people will tolerate some level of insecurity. Perhaps bank notes would never be backed by the long-term type investments that back bank deposits now (i.e. mortgages). But it seems likely to me that money would be backed by short-term investments (like < 30 days -- (just as the money market funds of today are backed) in addition to being backed by hard currency.

Per-Olof: I am not sure I think the phrase *too rational* really captures it. Hayek is saying that socialists are using reason to construct things that just can't be constructed using reason alone. In a way, one could say, that Hayek's argument is just a defense of the empirical, something done by many before him. Hayek is a popperian -- he believes that science progresses by proposing deductive hypotheses (using reason) and then comparing those hypotheses to the evidence of the real world (using reason as well). As time goes on, various hypotheses get rejected and in that sense, progress is made. And that's, for him, the problem with 'total remakes' of society -- they really have no basis in experience -- they aren't 'tested' in any way. They're just invented in a laboratory or in someone's brain.

I'm not sure socialism/communism isn't 'rational' per-se. I think it's not rational if you accept the Miseian assumption that individuals have goals and take action to drive towards those goals (which I do). Then it's hard to imagine a communist/socialist world existing without massive coercion or fantastical assumptions about the abilities of state planners.

12:15 AM  
Blogger goo8734 said...


On fractional reserve banking: do you consider money market funds fraudalent in the same way, say, checking deposits are?


12:21 AM  
Blogger Brian Macker said...

"but if you read for example Rothbard's "Man, Economy and State" you can see how he step by step deduces it from the basic axioms to the specific situations where todayäs realities are assumed."

I have read it and I do see that. I've read 'Human Action' also.

I just agree with what Popper would have to say about it. That's a philosophical issue and not an economic one.

I just think you can be a Popperian and a Austrian economist. I think they are compatible.

I would really like to see Austrian economics break out of the shell that Mises put it in.
Seems to me that his philsophy has engendered a certain attitude amoung most Austrian economists that I find troubling.

I'm a computer scientist and I have very good intuitions about how complex systems work. It's obvious to me that the Austrian model is the only credible working model of the economy. Unfortunately most people do not have the ability to mentally model systems. Thus they just cannot understand Austrian economics, and for precisely the same reason they cannot understand the real economics being modeled by Austrian economics.

I think it would go a long way towards giving AE more credibility if a simulation (not model) of how it works was build on a computer system. Yet, I don't know about any such programs and I'm not sure why. I suspect because there is just an assumption in the AE community that they don't need that because it's obvious that their logic is correct.

Problem is that everyone else is not going to trust in that. They'll be certain you've made some small error somewhere that is wrong.

In fact, that might just be the case. When an actual model is build it may turn out that there is some aspect that is slightly wrong, and then one would have a tool with which to identify what is wrong.

I would really like to see a running simulation that has a situation where a bunch of 3rd world countries open their markets while the most developed nation in the world sets interest rates below market. Would that have the effects that I think I've deduced when actually simulated?

3:04 AM  
Blogger Brian Macker said...


Every scheme I've thought of for using paper money seems to fail. It's almost as if the only system that would work and not cause a business cycle is to use metallic coin.

Problem with 100% is that you would have storage fees. So when you redeem the note you are not going to get 100%. Which is extremely problematic for a society without computers. Not all $1 notes would be equal in value and transaction costs go up.

I was thinking that the note could indicate it's face value, date of issue, and storage fee rate. If it had a bar code then one could know how much it was actually worth. This however creates issues with non-computer transactions.

Paper notes with 100% reserve is also open to fraud regardless of what is done.

On the reverse now that we are a computerized society we are much more able to deal with coin. I also think that materials technology has advanced to the point where it might be possible to coat metallic coin in such a way as to prevent wear and tear.

Objections to the quantity of gold are easily refuted by saying, "Well use other metals also."

Heck you could even use tiny flakes of gold imbedded in pyrex coin if you really needed to get to small denominations.

The main problem however is fractional reserve. It needs to go. With fractional reserve I also think the main problem there is the fact that it causes discoordination of peoples temporal plans.

Not only that but it in fact introduces an instability into the pricing system. Lowering reserves causes asset inflation that leads banks to think they are doing well on their books, which leads them to think they can lower reserves, which leads to more asset inflation, etc.

This runaway process is not self correcting except by a system wide bank run as far as I can see.

Of course a system wide bank run under a regime of FDIC insurance and government bailouts looks a little different from back in the old days but it's pretty much the same phenomenon.

3:26 AM  
Blogger Brian Macker said...

I'll give a concrete example of where reason and logic fails to properly predict the real world based on axioms.

Here's some axioms:

a) "Whole apples are countable entities and obey the laws of positive integer arithmetic."

b) If you have a pile of n apples and add an additional apple you will get a pile of n + 1 apples.

As the axioms state the rest of arithmetic similarly works. If you add five piles of 100 apples you get a pile of 500 apples.

This seems to be all fine and dandy, but is it?

The answer is no. This only works for small numbers of apples in the real world. When you get to really large numbers you will not be able to predict what happens based on the axioms.

If for instance you have as many piles of apples as there are hydrogen atoms in the sun, with each pile having 100,000 apples and then you add them all all together well you don't even end up with a pile of apples.

You end up with, depending on the total mass, a planet, or a star, or a neutron star, or maybe even a black hole.

So you need to check your axioms and your models against the real world. You are, after all, modeling the real world and not some fantasy world. Human's are fallible and make mistakes.

The verification against the real world is just one of many error reduction procedures. As would a simulation be.

4:15 AM  
Blogger stefankarlsson said...

Jeremy-Money market mutual funds that allows investors to write cheques and otherwise use their holdings as means of payment does qualify as fractional reserve banking in my view.

Brian- I think you are blinded by an over-belief in computer simulations. Humans do not act according to computer simulations. Non-Austrian economists have tried to do that for decades and they have failed miserably to predict anything about the real world. Computer simulations made in 2007 generally for example predicted steady growth in 2008.....

As for your example about apples, it doesn't disprove anything as it is still the case that another apple increases the total number of apples. Your example of an almost unlimited number of apples is simply a specific case with specific condition, and that is entirely consistent with the procedure of using praxeology for analyzing real world events. New conditions does not refute praxeology, it only that different theories derived from the same axioms must be applied.

8:20 AM  
Blogger goo8734 said...

Stefan: Just so I understand the view: Money market funds represent fractional reserve banking if they allow you to write checks, correct? But if they don't allow you to write checks, then that would not be fractional reserve banking, correct?

I assume Rothbard thought money lending was not fraudalent (i.e. bonds, etc)

3:55 PM  
Blogger goo8734 said...

Just to clarify further: do you think money market funds are actually fraudalent?

3:56 PM  
Anonymous Anonymous said...

> And in a free market, I don't see any justification for limiting the contractual details behind those notes

Yes, so to me it seems that the pro-central-bank camp engages in wanton distraction and redirection of the conversation away from this single question:

Who has the right to create a new unit of currency backed by a specific group of people?

In my eye, the fraud is that banks are permitted to create new US dollars as liabilities for US taxpayers (witness recent events, and feel free to substitute the nation of choice)

If the bank were non-100% reserve, but couldn't create new currency in any name but its own, then the problem would be mostly isolated to that specific institution and the people who decide to do business with it despite knowing the contractual risks involved.

More concisely, if a bank committed hijinks in its own name, then it only harms itself and the people who do business with it.

Whereas today, banks commit hijinks in the name of the US taxpayer, in a scam backed by the US government, which is an outright shakedown of those taxpayers in the most egregious sense.

- Steve

9:44 PM  
Blogger stefankarlsson said...

Jeremy-Yes-you've understood my positition correct. And money lending per se is not fraudulent, only lending which allows both lender and borrower to simultaneously use the same base money as means of payments.

Steve-you're wrong about fractional reserve banking only hurting those involved. First of all, the additional purchasing power if those involved creates in the initial stage additional purchasing power for them similar to what happens with counterfeiting of paper money.

And then when a later crisis and bank crash happens, the contractionary effect of that will cause a more widespread economic contraction. Which will create political pressure to avoid this scenario through government bailouts of banks, similar to for example the one we saw the other day with Citigroup.

9:58 PM  
Blogger Brian Macker said...

"Humans do not act according to computer simulations. Non-Austrian economists have tried to do that for decades and they have failed miserably to predict anything about the real world."

Animals do not work according to computer simulations either. Yet it is possible to create a simulation of natural selection on a computer that proves that the theory can actually work in practice. That is, using just reproduction and random mutations an evolutionary simulation can solve design problems.

This proves that the theory can work 'real world'. What the simulation does not do is provide predictions about what will evolve in the real world. You cannot create an simulation of natural selection that would tell you what rabbits will evolve into next.

That is the simulation is not trying to model the real world situation.

A good simulation of Austrian Business Cycle Theory could put to bed, once an for all, ridiculous claims by non-Austrian economists.

As an example, Krugman argues about ABCT:
"Here's the problem: As a matter of simple arithmetic, total spending in the economy is necessarily equal to total income (every sale is also a purchase, and vice versa). So if people decide to spend less on investment goods, doesn't that mean that they must be deciding to spend more on consumption goods — implying that an investment slump should always be accompanied by a corresponding consumption boom? And if so why should there be a rise in unemployment?"

A computer simulation would completely clear up this issue. One can make a simulation in which all the numbers add up and that works exactly according to ABCT. They there would be no question of whether "the numbers add up".

I certainly not blinded by an over-belief in computer simulations. I consider myself a hard core Austrian economist. I'm just suggesting that the professionals broaden their tools.

I know that I could write such a simulation. I've thought about it quite a bit. Problem is that I'm already making a living as a professional computer programmer, so I don't really have the time.

2:46 AM  

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