Austrian Economics - Some questions and speculation

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I've done some reading, and I don't know how to judge all the opposing truth claims I'm getting here, on Wikipedia, and on pro-Austrian, Austrian-disparaging, and other rather vague websites. So I'm not going to say "okay, you're right" or

 "no, you're wrong" on lots of this stuff, because I don't have data to judge.

Well you know you are on to something interesting… People vehemently disagreeing

That brings me to my first concern, though. Austrian economics, as far as I can tell, rejects empirical data, modeling, etc. because the economy and human desires/choices are too complex for laboratory settings. Fine, but that seems to make it rely on a priori claims to what is real and what isn't, and no matter what happens in the economy, no data can be gathered, so you can't refine or improve your understanding. That seems patently ridiculous. Yes, models are imperfect, but with lots of data they can be pretty good, can't they?

Austrian economics doesn’t “rejects empirical data” – but it rather it recognizes that human choice is a powerful confounder of any theory that predicts action, based on past events. For example, the money supply is “empirical data”, yet no Austrian economist rejects that money exists, or that it can be measured. Rather, an Austrian might say: “The quantity of money as a fact, is less important than, the beliefs and desires of those responsible for the quantity of money.” This is more the philosophical side of the school – the practical side (ABCT) is much more relevant, more on that below.

Let's ignore the Fed for a sec and look at private banks lending out money. From an Austrian perspective, how should they determine the interest rate on the loan? By how trustworthy the client seems on that day? If it's raining? It seems silly to reject the use of economy-wide data to determine rates, since banks then couldn't tell which loans would make them more or less money.

No one is rejecting this data in figuring out what interest to charge; the assumption about the Austrian school is pulled into the question about free banking. The FED does not directly control how much interest the bank charges you for a loan.

There have been only recessions (no depressions) since World War II, and they have been fewer and farther between than pre-Fed.

Why are you starting at WWII? The FED was started in 1913 by the Federal Reserve Act – to act as a lender of last resort and prevent bank runs. The stated reason was the prevent incidents like the “Panic of 1907” which was addressed by a conglomerate of private bankers. So we formed the THIRD central bank of the United States – to give the banking sector “stability”. How did the FED handle the job? As well as the private bankers? Here again I will leave the Austrian School and call on Milton Friedman:

http://www.youtube.com/watch?v=dgyQsIGLt_w

The purpose of the institution was to prevent widespread bank failure – yet that is exactly what happened. As far as recessions being “fewer and farther between than pre-Fed”  I’ll let you back up that claim.

A lot of sources suggest that increasing the money supply during recessions has prevented depressions.

Now we are in the meat – yes, a lot of people say/believe this – it is a very important point. First some definitions: what is a recession? Defined by mainstream economics a recession is a general reduction in productive capacity. Less goods and services being produced than before (is this necessarily bad?)– if we don’t ask why, then it is easy to come to the conclusion that there is “insufficient money” to buy all of the available goods and services. If Governments spends the money up-front, that will “jump start the economy” or “prime the pump” – indeed it does, but not the way you think. Creating the money (yes, thin air) does not create the goods and services that the money will be used to buy. Thus, you have more money, chasing the same amount of goods. Average prices will go up – to the benefit of those who receive the money first and to the detriment of anyone on fixed income (whose money now buys less).

Here is an excellent example of the fundamental difference between Austrian Economics and Keynesianism. Austrians believe that productive growth can only be a result of investment/savings/deferred consumption. Someone must save for someone else to spend. NO NO says Keynes – CONSUMPTION is the source of economic growth, SPENDING! I’m not trying to attack a straw-man here, this really is the policy of our government; or as a member of Congress put it: “The more debt we have, the richer we are!” If that worked, then they would just print up 100K for every man, women and child in the US and let the good times roll.

Here is a cartoon that does a great job of illustrating the problem.

Back to definitions: an Austrian definition might run: “a decrease in the aggregate prices of goods and services”. In this light, a recession isn’t a bad thing, it is a necessary thing. Sometimes the prices of goods are too high and need to go down (like buggy whips), sometimes the opposite is true (like gold). The whole problem is exacerbated by the constant change in the unit price ($) due to the very monetary inflation we are talking about.

Also, there was crazy boom-bust before the Fed was founded, so how can we blame the entire business cycle on the invention of fractional reserve banking?

The business cycle is not fault of fractional reserve banking, properly understood, the business cycle is a necessary re-pricing of goods and services, based on new demands from consumers. Also, it is important to distinguish between “fractional reserve banking” as a concept and the FED as an institution. Under a free banking system the depositors, bondholder and shareholders of the bank would determine the reserve rate. Thus “fractional banking” would still exist, but without a lender of last resort.

Some banks would develop the reputation of being risky, attracting investors and depositors with similar risk profiles. Others would be more prudent, attracting likewise. The net result would be less total leverage in the banking system. When repricing (recession) occurs, the riskier banks would pay for having less reserve, either with profits or their existence. The current FED reserve rate requires banks to reserve $0.25 for every $100.00 deposited. In other words, every bank is mandated to be a risky bank. Rather than a strategy to stabilize the banking system, it sounds like the opposite.

What IS the fault of fractional reserve banking is the magnitude of the cycle.

At the same time, people started freaking out about inflation during the 70s and 80s, and supply-side economics seems to also hold some truth. 

First, another Milton Friedman video on where inflation comes from. It wasn’t the inflation that freaked people out so much as the combination of high inflation and high unemployment – they had to invent a new word for it, because Keynesians economics predicts that this situation cannot occur. Stagflation was born, how to “fix the economy” without destroying the currency in the process – that was the crisis. The above video is quite informative as it was filmed right in the middle of this crisis, one of the guests in the second half is a former chairman of the FED. Their solution was to raise interest rates, dramatically.

So, while I haven't yet watched the videos Ted linked to (I will watch them), I'm not convinced yet. Beyond the question of valid data usage, here's my main concern: if the money supply has been artificially, irresponsibly, and detrimentally inflated, then we should aim for some serious deflation, perhaps even letting banks and big businesses fail and letting the economy reinvent itself from the ashes.
1) That long term creation is seriously destructive, and would do lots of damage in the mean time. Are we okay with, say, 10 years of depression, loss, squalor and whatnot, as long as we trust that at some point things will be better?

Important distinction with the word “inflation”– the word technically refers to the monetary base itself. What is being inflated is the quantity of currency units – reserve notes. The EFFECT of this monetary inflation over time, is aggregate increase in prices. It is a nice trick, because politicians can conflate these two things: “These high prices have got to go, we simply MUST whip this inflation.”  You can fix the “inflation” tomorrow – stop printing. The EFFECTS of inflation will go on for sometime after the actual monetary expansion is over. This is because market actors are responding more to expectations of future change, than evaluation of current policy. So yes, we need sound money – that is quite a bit more than just reversing inflation, but that’s a topic for another day.
We have been avoiding major repricing with inflation for quite a while. So much so that a currency crisis is approaching.

So to your question, are we okay with 10 years of depression? Doesn’t really matter if we are “okay” with it or not – the current system is system not sustainable. We are in another great depression right now, we never recovered and never will until interest rates climb. Growth is the solution, not growth based on credit, but growth based on savings and investment. But that can only happen if there is a monetary incentive to invest: interest rate.

2) Andrew blamed wage stagnation on fractional reserve banking. I don't see the connection, unless it's that all the lending has let businesses inflate their profit margins without feeling they had to up wages, too. If we go for deflation and depression, though, then profits will fall. Do we really expect business owners to let their profit margins shrink rather than lowering wages to keep margins at current levels? And how does that help the economy? 

There are two other big issues in this discussion that I have been mostly avoiding: 1) government spending (or the fiscal side) and the gold standard. These are a whole other can of worms, though quite related. I think these two are more the culprit than FRB. You are correct, under lets’ call it: “deflationary scheme” – there would be a drop in prices, profits and wages. But the drop in prices benefits consumers, true profits are lower, but so are the costs of capital goods. True, wages would fall, but so are the prices of the goods the wage earner is buying. Again, it comes back to the quantity and quality of goods and services produced. An inflationary, credit-based FRB system will, over time, degrade both the quality and quantity of goods produced as compared to a free banking system.

You should definitely watch the whole "Free to Choose" series, it is great.