1. How Piero Sraffa destroyed Austrian Economics, supposedly.
Bob Murphy wrote this article, which lays out Sraffa’s case quite nicely. Piero Sraffa supposedly demolished the whole Austrian business cycle theory in 1932 by pointing out that a key concept of Austrian Economics, the natural rate of interest, is flawed. There are several rates of interest, Sraffa claimed, one for each commodity.
And Bob Murphy helps us understand with the following example. [As usual, all actual quotes are in italics, all others are imaginary, there to make things understandable in simple language]:
In the faraway land Oz, which has a barter economy, one apple trades for one orange. Then a prophet comes and tells everyone that there will be a huge frost next year that will kill off most of next years crop of oranges.
Armed with this knowledge, Smiling Dave goes to market with an apple, to see what he can trade it for. Turns out he can trade his apple for an orange, and just eat the orange. Or he can find a Wimpy who will gladly pay him 2 apples next year for an apple today.
More Wimpys show up, all promising all kinds of things in the future for his apple today. One of them will give him half an orange next year for that apple today. Why only half an orange? Because oranges will be mighty scarce then, and half an orange will be very expensive. Of course, since apples now have the same price as oranges, and this Wimpy will eat anything, he will also, if Dave has an orange, gladly trade half an orange next year for an orange today.
Bottom line, there are Wimpys out there who will gladly take your apple or orange today, and give you either two apples or half an orange next year.
So right here we see how Austrian Economics is all wrong, says Bob. The interest rate for trading apples is 100%, two apples next year for an apple today. The interest on oranges is negative. You get only half an orange next year for an orange today. So there, Austrian Economics, said Sraffa, I’ve just shown you two interest rates, both perfectly legit. How can you possibly say there is some magic number, called the natural rate? Which one of those two interest rates is the one unique magic number, Austrians? QED that AE is flawed from the get go.
To quote Bob Murphy: Now, in such a barter economy as depicted in Table 1, what is “the” natural rate of interest? There is no such thing. The own-rate of interest on apples is 100 percent (one present apple in period 1 exchanges for two apples in period 2). But the own-rate of interest on oranges is minus 50 percent (because one present orange only trades for ½ future oranges). Consequently, if we were to introduce a money commodity and a central bank, and someone such as Hayek recommended that the bank set the money rate of interest equal to “the” natural rate, we would be unable to follow his advice.
Devil’s Advocate: Gotcha at last, Smiling Dave. AE is dead. Long live Sraffa! Long live Keynes, who also wrote about this stuff in chapter 17 of his masterpiece. What a buffoon Henry Hazlitt was, who mocked that chapter of Keynes.
2. Sraffa’s First Mistake. Banks Cannot Print Apples.
SD: Now you know why the smart money follows Mises, not Hayek. Hayek did not see through that apples and oranges story, but Mises did.
DA: Oh really? What did Mises say?
Mises: I’ll take over from here, Dave. Let’s look at that last sentence. If “someone such as Hayek recommended that the bank set the money rate of interest equal to “the” natural rate…”
Sraffa: I think that’s hot stuff, that sentence. What’s wrong with it?
Mises: The central bank does not “set” an interest rate. The bank prints money. I call on my good friend, Joe Salerno, to explain. Joe?
Joe Salerno: But the Fed does not directly set interest rates. This is the great modern myth, which was designed to conceal the Fed’s true modus operandi. The Fed influences interest rates by creating and injecting dollar reserves into the banking system. The additional reserves increase the supply of loanable funds relative to the economy’s demand and thus induce banks to offer loans at lower interest rates in order to attract borrowers for the additional funds. So causation runs from the increase in Fed–created base money to reduced interest rates. Lower interest rates are just one of the distortions caused by the Fed’s unrestrained power to create money ex nihilo.
Sraffa: I knew that.
Mises: And in a barter economy, can the central bank set the interest rate by printing apples? You can’t print apples,Piero.
Srafffa: I knew that. But I guess it slipped my mind at the time.
Mises: And even in a money economy, the question is not, “What interest rate should the Central Bank set?”, but instead…
Sraffa:…How much money should the Central Bank print?
Mises: And the answer is?
Sraffa: None, not a penny, zilch.
Mises: And the interest rate will then be….
Sraffa: The natural rate, meaning the one that happens when the central bank gets out of the way and doesn’t print money.
Mises: And your apples and oranges story is…
Sraffa: Irrelevant. It’s comparing apples and oranges, heh heh.
DA: I bet Mises never said such a thing, or at best wrote it in some obscure German pamphlet.
Mises: No, I wrote it in Human Action, Chapter 31, section 5:
If a bank does not expand circulation credit by issuing additional fiduciary media (either in the form of banknotes or in the form of deposit currency), it cannot generate a boom even if it lowers the amount of interest charged below the rate of the unhampered market. It merely makes a gift to debtors. The inference to be drawn from the monetary cycle theory by those who want to prevent the recurrence of booms and of the subsequent depressions is not that the banks should not lower the rate of interest, but that they should abstain from credit expansion. Of course, credit expansion necessarily entails a temporary downward movement of market interest rates.
Sraffa: Now you mention it, I see you wrote in that footnote that even if the Central bank lowers the rates below the natural rate, no harm is done:
If a bank does not expand circulation credit by issuing additional fiduciary media (either in the form of banknotes or in the form of deposit currency), it cannot generate a boom even if it lowers the amount of interest charged below the rate of the unhampered market.
DA: So if they give away apples or something, as long as they do not print apples, there is no problem.
3. His Second Mistake. Hayek’s Final Response Is Right on the Money.
SD: But there are more reasons Bob’s story, which is really Sraffa’s critique, is flawed from the get go. When you go into a bank, what do you see?
DA: Huge baskets of apples and oranges, because people go to a bank to borrow apples and oranges. Just kidding, banks lend money.
Sraffa: I knew that.
SD: So even if we accept the whole many-rates-of-interest thing, which rate of interest is the one relevant to banks that lend, you know, money? The apples one?
Bob Murphy: What a silly question. The apples rate of interest is for lending apples. For money, the money rate of interest is the right one.
Sraffa: But Dave, I made it clear I was talking about a barter economy. In that barter economy, there are indeed big baskets full of apples and oranges in their vault.
SD: And if someone comes in to borrow apples and repay in apples, what interest rate should they use?
Sraffa: The apples one. And if he wants to repay in oranges, the oranges one. Oh. I see where you are going with this. So that’s what Hayek meant when he said there would be many natural rates in a barter economy. And to think I mocked him for that. Makes me want to roll around in my grave.
4. Third Mistake. The Concept of Originary Interest Clears Up All Confusion, Guys.
SD: Now there is an even deeper mistake in that whole apples and oranges story, namely going with Hayek and then saying that all Austrians are thus disproven. Hayek is not all of Austrian Economics. Piero, you know Mises had a whole different take on interest.
Sraffa: Yes, he introduced the concept of originary interest.
DA: What’s that, Dave?
SD: Mises explained that there is something called the rate of Originary Interest. Basically, it’s how much people want to be paid if they have to defer their enjoyment. Thus, if Mr Moneybags has $100, and Smith wants to borrow it for a year, that means Moneybags won’t be able to spend it today, obviously. Why will he agree to wait, then? If Smith pays him enough interest, say $5, then that $5 will convince Moneybags that it’s worth the wait, and he will give $100 to Smith today in order to have $105 tomorrow.
DA: Exactly the opposite of Popeye’s friend, Wimpy the hamburger guy. Wimpy is willing to pay more next week in order to enjoy his hamburger today. Moneybags is willing to defer eating his hamburger today to have a bigger one next week.
SD: Which is what Mises meant when he said that $5 was the rate of originary interest as far as Moneybags is concerned.
Sraffa: And this is relevant to my apples and oranges story how?
SD: Let’s have a closer look at those interest rates in your story. One apple today gets you two apples next year. So the rate of originary interest is 100%.
Sraffa: With you so far.
SD: Now if one orange today gets you a half an orange next year, does that mean originary interest is minus 50%?
Sraffa: Of course not. That would be saying that a person is only willing to defer his enjoyment if he will get even less enjoyment in the future. Nobody is that crazy.
DA: Then where did that minus 50% number come from, if not from originary interest?
SD: Obviously, minus 50% is not a rate of interest. It has nothing to do with interest. It’s an adjustment for “inflation”. Since the price of oranges is known to be four times that of an apple in the future, and the payment will be in the future, when that orange is worth four apples, then a 100% interest fee will be half an orange, which is exactly two apples. The rate of originary interest is 100% for both apples and for oranges.
Bob: But Dave, when a bank anticipates inflation, and they charge you more because of that, they call that extra charge interest. So an adjustment for inflation is interest, too.
SD: Let us not confuse things with mere semantics. The bank calls the adjustment for inflation by the name of interest. So what? Is it originary interest? What has that to do with what we are talking about? How does what the bank calls something refute Austrian Economics?
5. Huge Fourth Mistake. Adjustment for Inflation is Not Interest.
Sraffa: You know, once we realize that in Mises’s definition of originary interest, that minus 50% is not originary interest at all, then why not go all the way? Why not say that no matter how you define interest, an adjustment for inflation is a stupid thing to include in the definition of interest? And that if a bank introduces an adjustment for inflation, that does not refute Austrian Economics. So that my whole story is pointless.
DA: People are used to thinking that whatever money you collect in the future for handing over a good today is principal plus interest. So if next year all you get is half an orange for your original orange, that must be a negative interest rate. What you’re saying, Dave is that it’s not interest at all, it’s adjusting for inflation.
Hazlitt pointed out that Keynes mistakenly thought [in chapter 17] that whatever extra you have to pay because there is risk involved is also interest. Again, it’s not interest, it’s a risk premium. Mises’s basic insight is that interest is what you have to pay because the other guy will have to wait, and only that is interest. Everything else is, well, everything else. He first published his insight in 1949, and it has still not sunk in yet in some circles.
SD: I knew that.
6. Reisman in His Classic Work “Capitalism” Explains Why the Futures Market has Nothing to do With Interest.
It’s in Chapter 2, Section 7. What have you to say, Prof George Reisman?
GR: The principle of time preference is not contradicted by the fact that the prices of commodity futures are usually higher than the prices of the corresponding “cash” commodities available for immediate delivery. For example, in the month of September, the price of corn for delivery in December is always higher than the price of corn for immediate delivery, while the price of corn for delivery in the following March is still higher than that for delivery in December. Such a price structure does not mean that, other things being equal, people prefer commodities in the future to commodities in the present.
DA: Why not?
GR: On the contrary, month by month they are consuming the stocks of commodities, demonstrating that they prefer present consumption to future consumption.
DA: So why are futures more expensive?
GR: The ascending price structure of commodity futures is the reflection of the prospectively increasing scarcity of commodities between harvests, and/or of the need to compensate those who store supplies of commodities for future sale for the costs they incur in so doing and for tying up their capital in such investments. In the absence of such an ascending price structure, time preference would result in the unduly rapid consumption of stocks of commodities.
SD: In other words you’re paying a storage fee, which I hope even Sraffa understands is not interest, or you’re paying more because the supply is dwindling and prices are going up, exactly what happened to the oranges in the fable. And the good professor is making it clear that paying more because of those things has nothing to do with time preference, obviously. And paying because of time preference is what interest is all about, as Mises explained in section 4 above, where we talked about originary interest.
For more deep stuff about time preference that is related to this article, see https://smilingdavesblog.wordpress.com/2014/12/25/deep-stuff-about-time-preference/.