At the Root of Economic Fluctuations: Expectations, Preferences and Innovation. Theoretical Framework and Empirical Evidences.

Please cite the paper as:
Carmelo Ferlito, (2015), At the Root of Economic Fluctuations: Expectations, Preferences and Innovation. Theoretical Framework and Empirical Evidences., World Economics Association (WEA) Conferences, No. 2 2015, The European Crisis, 1st October to 1st December, 2015

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“The European Crisis”

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The present paper aim to develop the Austrian Theory of Business Cycle in order to conclude that economic fluctuations are unavoidable. The conventional version of Austrian business cycle theory focuses on a temporary imbalance between natural and monetary rates of interest. When, because of the role of monetary authorities in defining the monetary rate, the two values are in a situation of imbalance, the resulting expansion stage is followed by a recession. On the other hand, if instead the expansive phase arises without any interference by monetary authorities but through re-adaptation of the productive structure to a modified structure of temporal preferences, a period of sustainable growth begins that will not be followed by a crisis. The purpose of this essay is to demonstrate, on the other hand, that because of profit-expectations and the combined action of Schumpeterian elements (imitations-speculations and the ‘creation of money’ by banks), even a so-called ‘sustainable’ boom will be affected by a liquidation and settling crisis. What distinguishes the latter situation from the conventional case of imbalance between monetary and natural rates is not the onset or otherwise of a crisis but, rather, its intensity and duration. We will define as natural an economic cycle characterised by a stage of expansion considered to be ‘sustainable’ in the Austrian theory but followed by an inevitable readjustment crisis. In conclusion we will try to link our theoretical conclusions with the crisis emerged in the Western world in 2007, to test the explanatory power of our theoretical framework.

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  • Maria Alejandra Madi says:

    Frederic von Hayek restated the relevance of concepts and ideas proposed by the classical liberal philosophy so as to rebuild the foundations of constitutional governments to face the institutional decay in contemporary societies. As a result, in the 1970s, Hayek proposed the abolition of the government’s monopoly over the issue of fiat money to prevent price instability . His defense of a complete privatization of money supply stemmed from his disappointment with central banks’ management, which, in his opinion, had been highly influenced by politics. He warned that political interference over monetary policy and price stability is incompatible with social cohesion. At that time, Hayek’s proposal of institutional reform relied on a denationalization of money in the framework of a free market monetary regime where only those currencies that have a stable purchasing power would survive. Considering this background and the ideas you developed in your paper, do you think the privatization of the money supply would be a recommendation to support sustainbale growth?

    • Carmelo Ferlito says:

      The introduction of Euro currency radically changed the scenario that had in mind when proposing the denationalization of money. We have reasons to believe that, in the present situation, Euro can work better to help countries in maintaining a path of sustainable development.

      Today we are forced to admit that a return to pre-EURO national currencies would be worse than keeping the single currency.
      The optimal solution, of course, would be a return to the gold standard or in any case to a natural money (originating as a spontaneous order). The return to gold is also the main solution suggested by Huerta de Soto, in the fullest Austrian tradition, along with restoring a 100% cash coefficient for all banks and the abolition of central banks.
      Huerta de Soto states: “All of the above theoretical analysis yields the conclusion that the current monetary and banking system is incompatible with a true free-enterprise economy, that it contains all of the defects identified by the theorem of the impossibility of socialism, and that it is a continual source of financial instability and economic disturbances. Hence, it becomes indispensable to profoundly redesign the world financial and monetary system, to get to the root of the problems that beset us and to solve them. This undertaking should rest on the following three reforms: (a) the re-establishment of a 100-percent reserve requirement as an essential principle of private property rights with respect to every demand deposit of money and its equivalents; (b) the abolition of all central banks (which become unnecessary as lenders of last resort if reform (a) above is implemented, and which as true financial central planning agencies are a constant source of instability) and the revocation of legal-tender laws and the always-changing tangle of government regulations that derive from them; and (c) a return to a classic gold standard, as the only world monetary standard that would provide a money supply which public authorities could not manipulate and which could restrict and discipline the inflationary yearnings of the different economic agents.
      As we have stated, the above prescriptions would enable us to solve all our problems at the root, while fostering sustainable economic and social development the likes of which have never been seen in history. Furthermore, these measures can both indicate which incremental reforms would be a step in the right direction, and permit a more sound judgement about the different economic-policy alternatives in the real world”.
      However, a return to a natural money system seems to be rather complicated and difficult to implement, as already recognized almost forty years ago by Hayek himself . It would be equally complicated to implement what Hayek hoped for at a conference held in Lausanne in 1975 : the free issue of currencies in order to create a competitive currency system in which citizens are free to choose which unit of account to use for their transactions. Hayek would have preferred this solution to any European monetary union. Yet today, the EURO is a reality and we must therefore deal with it and be satisfied with a second best solution.
      Again, quoting Huerta de Soto, “we must make every attempt to bring the existing monetary system closer to the ideal, both in terms of its operation and its results. This means limiting monetary nationalism as far as possible, eliminating the possibility that each country could develop its own monetary policy, and restricting inflationary policies of credit expansion as much as we can, by creating a monetary framework that disciplines as far as possible economic, political, and social agents, and especially, labour unions and other pressure groups, politicians, and central banks”.
      To do this, the Austrian policy is very different from the policy of the Chicago school. Monetarists sustain the need for flexible exchanges in a system of monetary nationalism because they believe it is more compatible with a free market regime. By contrast, the Austrians believe that until it is possible to abolish central banks and return to a gold standard, it would be preferable to settle for a system of fixed exchange rates, as an approximation of the gold standard. By hindering real consumption and investment flows, flexible exchange rates make an effective allocation of resources on an international scale impossible. Additionally, they are cause constantly growing nominal prices because of the competitive depreciations (writedowns) implemented by governments; they therefore generate inflation. As argued by Hayek, fixed exchange rates are therefore a potential brake to the monetary expansions (inflation) continuously implemented by the democratic political class always seeking for consensus through so-called full employment policies .
      The advantage of the single currency is that of enforcing, within the monetary union, a system of fixed exchange rates, which, at least, restrain and discipline the arbitrariness of politics. Austrian school economists support the gold standard because it slows down and limits the arbitrariness of politicians and governments. With the EURO, EU States have transferred and lost their monetary autonomy, i.e. the possibility of manipulating their own currencies by placing it at the service of the political needs of the moment. In this sense the EURO began to act and still does in a manner very similar to the gold standard.
      Although the EURO was launched as a social engineering project, violating the natural currency system tradition which is the only one proven to be efficient and respectful of the freedom of peoples, today the single currency seems to be the lesser evil in a system that, if allowed to exit the monetary union, would swiftly lead to collapse. Those countries keen to return to the pre-EURO situation are unaware, in bad faith, of the damage that such a measure would cause.
      If Greece or other countries were to leave the Union, with the sole purpose of being free to spend and devalue their national currencies, they would find themselves facing extremely violent bankruptcy. In fact, the only goal that “centrifugal” governments seek is to regain national sovereignty (which may seem to be an inviolable principle) for the sole purpose of devaluation. In this, they are supported by irresponsible classes of entrepreneurs, who expect to receive competitive advantages from devaluation but do not realize that they are not out of the market for currency reasons but, above all, because of a lack of innovative processes.
      Once again, it is the Keynesian influence that has re-launched the allure of monetary nationalism. Hayek responded promptly to Keynesian arguments, according to which monetary nationalism and independence in exchange rate can bring about collective well-being, in a series of lectures in 1937. The Austrian economist discussed three possible currency regimes at great depth: fixed exchange rates, flexible exchange rates and the single currency. In the first instance, in the event that a country loses its international competitiveness defending the exchange rate will require a deflation, with adjustment costs that affect all industrial sectors . In the case of flexible exchange rates, on the contrary, a decline in competitiveness weakens the currency, resulting in higher prices (inflation). Once again, a price adjustment process will affect all sectors, thereby weighing down on the general economic system. For a single currency, on the other hand, it is not possible only to realign one currency in relation to the others by means of deflation or inflation. Rather, any declines in performance in certain areas compared to others will simply lead to a realignment of relative prices in those areas. With the new structure of relative prices, declining enterprises will be forced to accept lower margins or leave the market .
      So the three options are clear. Relative wage and price adjustments (within a single currency area), an economy-wide deflation (under fixed exchange rates) and a currency depreciation (under flexible exchange rates) are means to effect the structural adjustments to accommodate changes in demand patterns that leave some sectors uncompetitive. Only with a single currency area can adjustments take place without general deflation/inflation.
      It is therefore evident that monetary nationalism is a way of creating instability on an international scale, while a single currency area may permit greater stability by preventing the succession of deflation and inflation, devaluations and revaluations typical of situations where the exchange rate is potentially in the hands of politicians.
      Thus, even if many mistakes can be attributed to Europe, first and foremost its continual support of a social engineering policy aimed at “harmonising” the variegated realities of Member States, today we find ourselves having to defend the EURO as an approximation of a natural currency system. The brakes imposed by treaties, and in particular by Germany, in fact restrict the resumption of inflationary policies implemented for “competitive” purposes by individual countries. What may seem very painful and even unfair (the loss of so-called monetary sovereignty), is today the best brake against inflationary policies that would do none other than create further suffering and, ultimately, a general social revolt. In the past, we enjoyed clear constraints (the gold standard, the balanced budget, limits to the money supply): they allowed monetary authorities to say no to the pressing demands for inflation from governments. Today, all these constraints have fallen by the wayside and are even ridiculed. And, unfortunately, people seem unable to realize that painful measures are now more than ever necessary; without this assumption of awareness, every attempt at reform will be vain.

  • pasbaxo says:

    The gold-standard back: A good idea to Europeans, as for in most European countries no gold treasuries are hidden in bottom or mountains. They should be bought in other world parts to be forced to buy it in natura to be payed inclusive exploitation costs, as such to attack the EU economies’ competitivity position.
    A natural economical cycle would restrict the gravity and durance of an economic crisis, an artificial course would force a longer endurance.
    But in crisis situations shortening on financial means could influence all sectors if money enlargement is not permitted to take place as independent manipulatable variable within total economic-financial household. This approach could be defined as artificial and dangerous,
    but a unchangeable finance-restricting politic ( except marginal interest lowering measures) seeming careful could not guarantee a solution to a problem still included in the existing approach. This problem : the pure wish to fund and maintain a union of countries on a nearly moneyless economy, as a pure prove of economic competency, could be changed at the moment of its catching during political monetary decision processes, but seems to survive on misty grounds.
    This EU financial-economic policy seems to exist more rigid than in other parts of the world.
    Emitting uncovered money could serve as grants , as published recently by World Bank Statistics, varying from 20-80-% of GDP, External
    Debts and Governments’ costs, and as exception not distributed to most of EU countries (virgin blanco).

    • Carmelo Ferlito says:

      Thanks for your message.
      Gold standard issue is not really the focus of my paper. I just mentioned some pro-gold standard points in reply to prof Madi, who was raising the issue because in my paper I often refer to Hayek.
      The central point of my contribution is that business cycles are generated by a disproportionality in the intertemporal structure of preferences. Such a situation can be created via money supply manipulation (as in Misesian view), but also because of changing expectations. My point is that Schumpeterian imitative/speculative processes make business cycles unavoidable.
      Gold standard could limit crises intensity but it could not, according to me, totally eliminate economic fluctuations.