Lecture at New Economic School - Georgia
Tbilisi, Georgia
Salient Features Of The Business Cycle
Fluctuations in output are:
of a specific pattern: boom-crisis-bust
generalised
unintended
recurrent
Analytical implication: a theory of recurring generalised errors (cluster of errors)
Early Austrian Approach: Mises’s Theory Of Money And Credit (1912)
Bank credit expansion lowers the market interest rate (in counterfactual terms) – a monetary cause
Additional processes of production are expected to be profitable (boom)
Structure of production longer
Prices revolve
Recognition of the malinvestments (crisis) – physical impossibility
Unavoidable restructuring of investments and of consumers’ preferences (bust)
Analytical Advantages
Reconciles monetary and real approaches
Links monetary, banking and capital theories
Convincing explanation of the inevitability of crisis and bust as caused by changes during the boom
Rich and realistic explanation of observed price dynamics
Explanation of the recurrence of the cycle
Specific Austrian Messages
The cause is in the banking system
The boom only gives the illusion of growth, while it is a misallocation of existing resources – lost opportunities for growth
The boom destroys value – consumers’ real preferences are not satisfied, investments in non-convertible capital are doomed to be lost
The crisis is only the recognition of errors committed in the past – no countercyclical policy could be effective in the bust
The bust, though painful, corrects past errors and marks the return to compatible decisions
Hülsmann’s Essentialist Critique (1998)
Problems with a consequentialist account of cluster of errors:
« changes cause error » contradicts choice
despite uncertainty, individuals can anticipate the future
Implication for the inflation-induced business cycle theory
inflation’s effects can be anticipated and reflected in a higher price premium
not a matter of logical necessity, but of historical contingency
The Austrian « theory » is no theory at all because the recurrence of errors remains a matter of historical accident
Essentialist Theory Of Error Cycles
Implications of error versus explanation of error
Individual error cycle: commitment of error seperate from recognition of error
Main issue: account for « the repetitive occurrence of more or less synchronous errors of many persons by deducing them from a common cause »
Identify permanent patterns of action (institutions) in which error is inherent
An erroneous institution must be time- and place-independent, i.e. built upon an illusion
Definition Of Securitization
Put together relatively illiquid assets
Use the pool as collateral for backing the issue of new securities
Use the proceeds from selling these securities to fund the owners of the illiquid assets
Use the income from the illiquid assets to pay the investors in the securities
« The process of pooling and repacking loans into securities that are then sold to investors »
Securitization Through T-accounts
SPV issues asset-backed securities (ABSs)
Pass-through versus pay-through ABSs
Senior versus junior tranches of an ABS
Firms use proceeds for consumption, investment or repayment of existing debt
Scene Set Of The Banking Industry
A does not respect the liquidity reserve requirement
An open-market operation: increase in CB’s liabilities
or
Securitize existing credits
How does it function at a systemic level?
Securitization At A Systemic Level
No shortage of liquidity
Sequential use of fiduciary media
Banks’ clients purchase ABSs by means of fiduciary media (deposits)
Banks cede loans to the SPV in exchange for fiduciary media
Therefore, securitization decreases the amount of fiduciary media of exchange
A Numerical Example
10% of credits are securitized, i.e. 1 250 are ceded to the SPV
Deposits shrink by 1 250, down to 10 750
Reserve ratio increased from 2% (240/12 000) to 2.23% (240/10 750)
Capital adequacy ratio increases from 8% (1 000/12 500) to 8.89% (1 000/11 250)
Excess liquidity while no intervention by the central bank
Improved debt-to-equity ratio despite lack of additional savings
Securitization And Bank Credit Expansion
Because of freeing reserves, securitization allows for another round of bank credit expansion
Does not require consent by the central bank
Eliminates the visible impact of bank credit expansion on the money supply in the broad sense, i.e. creates an illusion
Crucial point: banks create both the object to be sold (credits) and the means by which it can be purchased (deposits)
The Illusion Of Savings-Driven Growth
Securitization hides inflation despite growing indebtedness
A bank credit-driven boom is portrayed as non-inflationary savings-driven growth
A factor in the generation of the error-induced boom-bust cycle
Recognized by central bank researchers as « weakening the impact of any policy move »
Spread Of Securitization
Mainstream approach:
circumvent capital adequacy regulations
« originate and distribute » preferable to « originate and hold » because of higher frequency of fees
ABSs as additional investment opportunity, increasing market efficiency
Critique:
fractional capital adequacy ratios allow for multiplication of credit
« originate and distribute » leads to loss of interest
ABSs offer the same risk-return profile as investing in the banks
Main point: origination and funding of the securitized loans are two analytically inseparable aspects of FR banking
The Austrian View
Motivation inherent in fractional reserve banking
Quality of ABSs as perceived by investors
Factors that change investors’ preferences:
government
rating agencies
credit-default insurers
