The Keynesian Circular Flow Model vs. The Austrian ERE

The Evenly Rotating Economy is an important tool used in Misesian economics. Rothbard demonstrated to us in Chapter 5 of his magnum opus MES, that the ERE was definitely a tool superior to the circular flow model of the ballyhooed Keynesian School. The Keyensian Circular Flow Model is blatantly collectivist and coercive in nature, attempting to delineate the flow of goods and services within a system of predicted certainty. It assumes unrealistic and ineffective equations such as Y=C+I+G+NX move in tandem and if properly applied can avoid downturns, or thus save economies from them. The ERE is a basic model that sticks to the fundamentals, while making an assumption of certainty, yet it always holds intact the importance of praxeology. Through this unique Austrian axiom capital theory is illuminated, and capitalism becomes more pronounced and vital within a truly free society. This serves to further derive an explanation of the importance of uncertainty and the entrepreneur. Not only does the ERE trounce the circular flow model, it also allows us to see the unimportance of collectivism in our lives as well as the utter validity of the truly free-market.

The Circular Flow Model is found in every economics textbook taught by statist economists subscribing to orthodox economics. It is a shame they even teach this gobbledygook since it is run amok with coercion and collectivist idiocy. Sadly the first most absurd mistake is to think that Firms and Households are themselves actors. Humans are actors, Firms and Households are entities filled with various actors. Secondly, to homogenize capital indeed leads them to think economies should be planned (refer to figure 41 below to better understand capital theory). To think that GDP properly takes into account the effects of certain distortions to the economy by the government, overlooks the importance of money. Money is central to an economy, not the government and its distortion of it (this distortion I speak of is what they find pertinent when calculating GDP). Sadly the circular flow boasts the ineffectiveness of closed economies as some sort of interesting movement of money from the hands of consumers toward consumption. It is not the interest rate that does equilibrating in this model, but income. The complete lack of respect for the fact that fiat money distorts income and creates the booms and busts in an economy through inflation, allows them the excuse to insert a third party into the mix, their central planner, the government. This entity tyrannically waves a wand and allocates “scarce” resources magically, somehow increasing one coefficient like C and decreasing another like G. Naively G and C can increase together, yet in dire consequence to the long run. The calculation of such coefficients is so broad, numbers get distorted and the booms and busts are never seen. The ineffective system continues to be relied on, because income is more important than the interest rate. The robbery (taxation and borrowing) and coercion, continue without any understanding of the complexity of an economy and the various stages of the capital structure.

Superior to this fallacious model, is the ERE, evidently designed to demonstrate to the Keynesian that even with the assumption of certainty of the future the government creates in their model, the free market still allocates resources better and avoids booms and busts. The ERE is primarily used to distinguish profit from interest. Entrepreneurs earn pure profits when they judge future conditions better than their rivals, while they suffer losses if they exercise poor foresight. In an uncertain world, a man may anticipate that consumer demand for a new product will be higher than others expect, and he will buy the factors necessary to produce the good and reap a much higher payment when he sells the finished product to consumers. This phenomenon is impossible in the ERE, because everyone knows exactly how much each good will fetch from consumers in the future. However, because capitalists advance present money to the owners of factors in order to sell goods to consumers in the future, the capitalists still earn more money from consumers than they had to pay to all of the factor owners who contributed to the production of the good. This excess would appear as a “profit” to an accountant, but not to an economist. It merely represents the interest earned by the capitalists on their invested funds. In the ERE the rate of return (per unit time) will be equal in all lines of production. The most significant fact to remember is that every person is a capitalist, insofar as their bank makes loans with the consent of the storer of money and his savings. Furthermore, to render profit from an economist's point of view, the entrepreneur must use artifice to calculate the market in a manner which renders them not just interest, but further profit outside of the ERE.

Now all this said, Austrians are aware that humans act due to the uncertainty of the future. Man does not know enough about natural phenomena to predict all their future developments, and he cannot know the content of future human choices. All human choices are continually changing as a result of changing valuations and changing ideas about the most appropriate means of arriving at ends. This does not mean, of course, that people do not try their best to estimate future developments. Indeed, any actor, when employing means, estimates that he will thus arrive at his desired goal. But he never has certain knowledge of the future. All his actions are of necessity speculations based on his judgment of the course of future events. The entrepreneur is the driving force of a market economy, and he takes center stage in the ERE. It is the entrepreneur who judges that something is missing in the market, and decides to start a new business or develop a new product. The entrepreneur uses savings (either personal or borrowed from capitalists) to hire workers, rent land and equipment, and purchase raw materials, electricity, semi-finished goods, and other inputs. Thus this uncertainty so dear to the free market, diminished and practically cancelled out by government in the circular flow model, affords us this ordered liberty and plethora of choice in the real world.

Sources Used:

Lessons for the Young Economist, Robert P Murphy

Man, Economy and State with Power and Market by Murray N Rothbard

Macroeconomics by Gregory Mankiw (statist economist)

How Fractional Reserve Banking is Fraud and an Invasion of Property Rights

It is important to point out that many orthodox economists quickly desire the idea of a state before they attempt to vet which form of banking is sound and just in a free market. As a student of Austrian Economics, I have come to the conclusion that those that desire a state (more precisely known as statists), have already failed in their analysis and prescription of economics in general. I have found that praxeology not only sums up Austrian Economics, but that Rothbard's MES truly made economics more fun and applicable. Rothbard took it into his hands to better the Austrian theories and bring them all together to show the uniqueness and viability of the Austrian School and its mechanics. To think that the ABCT can be used with IS-LM curves is not only a violation of its methods, but also renders the ABCT no longer Austrian. What happens is that those statist mechanics are used to attempt to give credence to the very expansion of credit and booms and busts which the ABCT attempts to prove wrong. It is important to remember that the mechanics need to all go together since they derived from each other. Mises created the ABCT, while Hayek furthered it. Rothbard then demonstrated how Hayek’s price theory could be used to demonstrate the importance of praxeology and the ABCT. Whether people pick and choose dynamics of the Austrian School to try to excuse fraudulent bank notes and statist mechanics does not make them Austrian, nor does it make their methods just or accurate.

Fractional-reserve banking is the greatest tool disposable to bankers by which they can exploit and swindle their clients. The problem becomes worse when a state exists, since of course the state allows for these types of practices and exacerbates the credit expansions and creation of money out of thin air, which leads to the economic booms and busts. In order for a person to get a better understanding of how fractional reserve banking works, I suggest reading Robert Murphy's precise explanation here.

Furthermore, Geroge Selgin and Larry White, two notorious economists for the mixing of statist mechanics with Austrian tools, make those arguments about 100% reserves only existing when states impose it with limited and very terrible evidence. If one ever read Carl Menger's book On the Origins of Money, one would find that he explains the arising of money onto the free market because it has weighted value.[i] As Ludwig von Mises further evidenced and conclusively demonstrated in 1912, money does not and cannot originate by order of the State or by some sort of social contract agreed upon by all citizens; it must always originate in the processes of the free market. Before coinage, there was barter. Goods were produced by those who were good at it, and their surpluses were exchanged for the products of others. Every product had its barter price in terms of all other products, and every person gained by exchanging something he needed less for a product he needed more. The voluntary market economy became a latticework of mutually beneficial exchanges. In barter, there were severe limitations on the scope of exchange and therefore on production. In the first place, in order to buy something he wanted, each person had to find a seller who wanted precisely what he had available in exchange.

To make transactions easier, and to allow for proper division of producer's and consumer's goods, mediums of exchange arose to benefit in the process of indirect exchange (where one person trades a good indirectly for one of his choice). In this way, a commodity used as a medium feeds upon itself and its use spirals upward, until before long the commodity is in general use throughout the society or country as a medium of exchange. But when a commodity is used as a medium for most or all exchanges, that commodity is defined as being a money. In this way money enters the free market, as market participants begin to select suitable commodities for use as the medium of exchange, with that use rapidly escalating until a general medium of exchange, or money, becomes established in the market.

Which commodities are picked as money on the market? Which commodities will be subject to a spiral of use as a medium? Clearly, it will be those commodities most useful as money in any given society. Through the centuries, many commodities have been selected as money on the market. Fish on the Atlantic seacoast of colonial North America, beaver in the Old Northwest, and tobacco in the Southern colonies were chosen as money. In other cultures, salt, sugar, cattle, iron hoes, tea, cowrie shells, and many other commodities have been chosen on the market. Many banks display money museums which exhibit various forms of money over the centuries. Amid this variety of moneys, it is possible to analyze the qualities which led the market to choose that particular commodity as money. In the first place, individuals do not pick the medium of exchange out of thin air. They will overcome the double coincidence of wants of barter by picking a commodity which is already in widespread use for its own sake. In short, they will pick a commodity in heavy demand. Thus this overall analysis shows that the demanded commodity will be something of storeable value.

In all countries and all civilizations, two commodities have been dominant whenever they were available to compete as moneys with other commodities: gold and silver. At first, gold and silver were highly prized only for their luster and ornamental value. They were always in great demand. Second, they were always relatively scarce, and hence valuable per unit of weight. And for that reason they were portable as well. They were also divisible, and could be sliced into thin segments without losing their pro rata value. Finally, silver or gold were blended with small amounts of alloy to harden them, and since they did not corrode, they would last almost forever. Thus, because gold and silver are supremely “moneylike” commodities, they are selected by markets as money if they are available. Proponents of the gold standard do not suffer from a mysterious “gold fetish.” They simply recognize that gold has always been selected by the market as money throughout history.[ii]

Furthermore, under free banking FRB is 1) either cancelled out by bank runs and loss of reputation in the continuous violation of property rights, or 2) a lame duck that leads to coercion and central banks, something the free market would not tolerate since the state is force. Selgin argues the reverse method, he suggests that by denationalizing the money supply one will reach FRB and it will be viable and proceeds to give examples where the gold standard was adopted by the state, then central banks arose, and FRB proved to be a better alternative.[iii] Rothbard understood that denationalizing money would move people toward commodity money, whilst also suggesting the state was to blame for the deception of the gold standard and the problems that arise in the process because people choosing FRB as a better alternative. Thus on a free market, free of government, it would only be logical that 100% reserve banking be the favored form of banking, while also quelling the creation of central banks. As I demonstrated, 100% reserve banking was what existed when banking began and interpersonal exchange arose. As states started arising, and central banks came to be, the gold standard arose within the central banks of the state (even Selgin admits this). Selgin was using the evidence of a state with a central bank that adopted 100% reserve banking to prove it as a statist and forced method of banking, but his research is lacking in further detail. He was picking and choosing his evidence. It is important to understand the Mises Regression Theorem to find how 100% reserve banking is free-market oriented, while fractional reserve banking is a system created by swindlers. Yet Selgin and White both need to realize that if they continue to see the state as of prominent importance and needing to exist, then indeed their ideas of the 100% reserve banking will be sadly inaccurate and seem anti free-market within their statist models.

Finally let me explain how FRB is a violation of property rights as explained by Rothbard.[iv] Firstly, loaning money out that does not match up to the backed commodity in the bank is violation of and robbery of a person’s money in the bank. Secondly, saying that it is not a violation of property rights is akin to saying the state’s existence itself is not coercion. Let me show you how. Let us suggest that people in this nation by becoming citizens are voluntarily submitting to the contract of the constitution and therefore the force of the government. A person is unaware that the government is force, that they hold a monopoly of law and defense services, and that taxation is robbery. They are also unaware of the mechanics of economics to see the ramifications on the economy of the state, like less jobs, more poverty, more crime, less savings, central banks and inflations…etc. If it were not for the educating of intellectuals on how government is force, and an invasion of property rights (i.e. your body), then people would go on accepting the government and its force, and the ramifications that ensue. This is absolutely the case today, more people see the government as necessary. Since people entrust their money to the bank, they of course are subject to the contract they sign, but today everyone is only aware of FRB to a limited degree, and are not aware of its alternatives at all. Regardless of if they signed the contract to store their money at the FRB bank, the loaning out of money to others without the consent of the saver is robbery. Since they hand out loans to people based upon debt, the spongeability of money spreads to all sectors of the economy. So as more and more banks make more and more money off of debt, the person that stored their money in the bank is coming up more and more shorthanded. This collapse and short handedness occurs when people default on their loans.

As the citizen of a nation is subject to practices of the state, the naïve storer of money is subject to the practices of banks. How does a person realize their body is their property, or that the state is coercion and their practices violate property rights? By being educated on this. Since the state holds a grapple on the education programs, fractional reserve banking is the only form of banking taught there today. 100% reserve bankers intend to make people realize that their property is floating around in inflated loans that carry more in their superficial perception than is reserved. Thus if one does not understand the fraud and violation of their property being floated around and used to the benefit of a central planner (in this case the bank), they will continue to think that because they get benefits in return for their deposits, they will continue to take part in this fraud. It is akin to the citizen of nation thinking that because he gets certain services from the state in return for their taxes being taken. It is the absence mindedness of the contract they take part in that is absurd, and only teaching this will make others understand the abuse of their property by fractional reserve banks. The most important thing to understand how and why 100% reserve banking is free-market oriented, and why it is the only sound and just form of banking, is to remove the idea of a state being necessary in our lives. Otherwise one will rely on statist mechanics to get the perception that fractional reserve banking is not robbery, and is indeed fair and free of booms and busts. Fractional reserve banking creates the booms and busts.

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[i] Carl Menger’s Development of Money: http://mises.org/resources/4984/On-the-Origins-of-Money

[ii] Murray Rothbard, The Mystery of Banking: http://mises.org/Books/mysteryofbanking.pdf

[iii] George Selgin, The State and 100 Percent Reserve Banking: http://www.freebanking.org/2011/05/31/the-state-and-100-percent-reserve-banking/

[iv] Murray Rothbard, Fractional Reserve Banking: http://www.lewrockwell.com/rothbard/frb.html