Austrian Business Cycle Theory: Are 100 Percent Reserves Sufficient to Prevent a Business Cycle?

By Bagus, Philipp | Libertarian Papers, January 2010 | Go to article overview

Austrian Business Cycle Theory: Are 100 Percent Reserves Sufficient to Prevent a Business Cycle?


Bagus, Philipp, Libertarian Papers


Economists in the tradition of the Austrian school have shown that one type of maturity mismatching can cause maladjustments and business cycles. (1) When banks expand credit, by granting loans and creating demand deposits, they generate immediately withdrawable liabilities to finance longer-term loans. The newly created demand deposits do not represent a reduction of consumption, i.e., that characterized by real savings. As a consequence, interest rates are artificially reduced under the level they would have been in a free market reflecting real savings and time preference rates. (2) Thus, entrepreneurs are prone to engage in more and longer projects than could be financed with the available supply of real savings. Before all projects that are financed by the credit expansion are finished, a bust occurs. An absence of real savings to sustain the factors of production in the production processes and to produce complementary and necessary capital goods becomes evident. As a result, malinvestments are liquidated and the structure of production is brought in line with consumer preferences again. This is the Austrian Business Cycle Theory (ABCT) in a nutshell.

As a remedy Austrian economists such as Selgin (1988) and White (1999) have argued that a free banking system would be a means to inhibit the excessive credit expansion that causes business cycles. They maintain that the competition between banks would limit the credit expansion of the banking system effectively. Other Austrians such as Rothbard (1991) and Huerta de Soto (2006) have gone further and advocate a 100 percent reserve banking system ruling out credit expansion altogether. (3) In this article it is argued that a 100 percent reserve system can still bring about artificial booms by maturity mismatching if there is a central bank or government support and guarantees for the banking system. Even if we accept the case for a 100 percent reserve requirement, we see that the maturity mismatching of liabilities and assets (borrowing short and lending long) is itself perilous--and in the same sense that fractional reserves are perilous.

The "Golden Rule"

At the core of the traditional Austrian business cycle there is maturity mismatching in the term structure of the assets and liabilities of the banking system. In the process that underlies the business cycle, banks use short-term liabilities with zero "maturity" (i.e., demand deposits) (4) to finance long-term projects via longer-term loans. However, the current economic turmoil is marked not only by massive maturity mismatching in the form of fractional reserve banking, but also by maturity mismatching on the part of investment banks via structured investment vehicles (SIVs), that use short-term repurchase agreements or short-term financial papers to finance longer-term investments. Naturally, the following question comes to mind: If one kind of maturity mismatching, i.e., the use of demand deposits to finance loans, can cause the business cycle, would not other kinds of maturity mismatching have similar effects, i.e., the use of funds obtained from the issue of short-term commercial paper to finance longer-term loans.

in fact, Mises himself came close to considering this question as early as 1912. As Mises (1953, 263, citing Knies (1876, 242)) states about maturity mismatching in general:

   For the activity of the banks as negotiators of credit the golden
   rule holds, that an organic connection must be created between the
   credit transactions and the debit transactions. The credit that the
   bank grants must correspond quantitatively and qualitatively to the
   credit that it takes up. More exactly expressed, 'The date on which
   the bank's obligations fall due must not precede the date on which
   its corresponding claims can be realized.' Only thus can the danger
   of insolvency be avoided. (5)

Mises shows that maturity mismatching violates the golden rule of banking that goes back to Hubner (1853).

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