You would think that when serious problems exist in the world, the world would be desperate to understand the causes. Yet causality, as a field of inquiry, is in decline. The great tragedy, as Finn Andreen explains in this guest post, is that discovering the real and underlying causes for social and economic problems is too often deemed unnecessary (and far too often wilfully ignored), and the public’s support instead is too often for easy, simple, and wrong-headed statist solutions ...

Libertarianism and the Importance of Understanding Causality

by Finn Andreen

Even though support for the free market has become stronger in the last decades, and a self-proclaimed libertarian just elected to President in Argentina, libertarianism itself can still only be considered a fringe movement. Most people still believe that many social problems are due to “market failure” and therefore require state intervention to be “solved.” Despite the obvious flaws of modern socialism—with its unlikely combination of a redistributive welfare state and globalist crony capitalism—and despite libertarianism’s robust philosophical and empirical foundations, the liberalism of Ludwig von Mises is still far from enjoying the majority support that it so amply deserves.

There are many reasons for this. Of course, media bias and public education prevent the dissemination of the ideas of freedom in society and limit the understanding of the free market. However, an often overlooked, yet equally important, reason is a general disregard for causality. When the real and underlying causes for social and economic problems are unknown or misunderstood, the public’s support for wrong-headed statist solutions to these problems is not surprising.

The Importance of Causes

The importance of causes to human inquiry has been grasped since early antiquity, crystalising with Aristotle and his still seminal theory of causality. Following in this tradition, Herbert Spencer considered the discovery of causal laws the essence of science; those who disregard the importance of the identification of causes, he argued -- whatever the subject matter -- are liable to draw erroneous conclusions.

In the Twilight of the Idols, Friedrich Nietzsche chastised modern society for still making errors of causality, namely, “the error of false causality,” “the error of imaginary causes,” and “the error of the confusion of cause and effect.” Unfortunately, these errors are made all too frequently in economic and political life.

In the realm of international relations, for instance, a disregard for contemporary history has led to an ignorance of the real causes of serious political events. Today’s conflicts could arguably have been avoided if their many and deep causes had been soberly and objectively considered by decision-makers. When George Santayana said that “those who cannot remember the past are condemned to repeat it” and when George Orwell wrote in his masterpiece 1984 that mastering the past is the key to mastering the present, both had in mind the crucial importance of knowing the actual causes of political events.

Nietzsche considered the error of the confusion of cause and effect to be the most dangerous one; he called it the “intrinsic perversion of reason.” This was not an exaggeration, considering the impact of this all-too-common reversal of causality. For example, this error happens when the state is absolved of the nefarious consequences of its previous actions, thereby empowering the state to legitimise policies that “solve” problems for which the state was itself originally responsible.

Examples: Recessions, Inflation, and Unemployment

As an example, it is possible to mention the boom-and-bust cycles of the typical state capitalist economy. The original cause for this cycle is the state, through its monopolistic monetary policy. As Murray Rothbard wrote, “The business cycle is generated by government: specifically, by bank credit expansion promoted and fueled by governmental expansion of bank reserves.”

Yet, during hard times—because this original cause of recessions is not generally recognised—the state itself is looked to by society to “save” the economy through measures such as bailouts or interest rate reductions (which mostly benefit big banks and strategic industries). This in turn sets the stage for the next artificial boom, and the cycle continues.

The problem of high inflation and high unemployment may be seen in the same way. Price inflation is caused by the state when its central bank increases the money supply to pay for its chronic budget deficits, with the added benefit of reducing the relative size of its enormous debt. Yet, when prices increase in the economy because of such actions, then the central bank itself is expected to come to the rescue—for instance, by artificially imposing price controls or hiking interest rates, thus slowing economic activity—to the further detriment of society.

High unemployment is also a phenomenon caused by the state, of course, when it imposes rigid labour laws and high taxation on companies, while redistributing “generous” unemployment benefits. Yet, when unemployment becomes “too” high because of these actions, then the state itself is expected to solve the problem—for instance, by providing tax incentives to companies for hiring low-skilled workers or by hiring more civil servants.

The Fallacy of “Market Failure”

It seems counterintuitive to believe that an agent responsible for social problems should also be the one to solve those problems. The only reason this flawed logic continues to be accepted is because of errors of causality. The real causes for economic problems are not well understood by the general public and are often confused with its consequences. In economics, this disregard for causal connections has probably wrecked as much damage upon societies as the international conflicts mentioned earlier by giving free rein to those who see few limits to the state’s regulation of economic and social life.

The same reasoning is applicable to an aspect that is usually blamed on the free market: so-called “externalities,” or the “external” costs that third parties sometimes bear. The extreme case of this is the concept of the “tragedy of the commons,” which is often used to justify the many globalist “green” initiatives to “fight” climate change. Quite apart from whether there are apocalyptic grounds to support such extreme social top-down policies, the libertarian view is that the real cause of many “externalities” is generally that private property rights have not been adequately defined.

Since causality is disregarded, social and economic problems such as those mentioned earlier are generally attributed to so-called “market failure,” thereby reducing the credibility of libertarianism among the general public. Indeed, libertarianism is usually rejected by the majority as a political and economic system because social problems are attributed erroneously to an incapability of the free market to provide solutions. There is rarely any perception that the real causes of these problems are statist interventions in the free market in the first place.

Libertarians have always recognized the importance of causality, as per the title of Mises’s magnum opus Human Action. Carl Menger, the founder of the Austrian School of Economics, explicitly mentioned that, as an important means of gaining insight into economic processes, he had “devoted special attention to the investigation of the causal connections.” Importantly, this was not only the position of the Austrian School at the time: “the search for these causal laws of reality was very much an international enterprise among economists in the last quarter of the nineteenth century and up to World War I.” However, for several sad and tragic reasons, this focus on causal connections in economic research was then lost.

As this article has tried to show, it is essential for causality in both economics and politics to be better understood -- by politicians, economists, and the general public. 

This is key to rein in the authoritarian inroads from governments that are taking place in all areas of life. 

And by demonstrating that the market only fails when it is constantly disrupted by state intervention, a better understanding of causal connections would also lead to an increase in the appreciation and popularity of libertarianism.

In fact, it would improve the standard of thinking all round.

* * * * * 

"Monetary Policy is very difficult to understand—given it effectively operates as a political programme ... dictated by political expediency."

“'[M]onetary policy' ... is in fact very difficult to understand—given it effectively operates as a political programme within the muddled field of macroeconomics ... dictated by political expediency.
    "As for money itself, there is nothing so difficult about it conceptually. A hundred and fifty years ago Carl Menger explained how money arose as the most saleable commodity in the marketplace, with the best properties to be a store of value and medium of exchange. Thus money solved the problems and inefficiencies of barter. Forty years later Ludwig von Mises relied on Menger’s subjective marginal-utility theory to solve the circular problem of explaining how money obtained value in the first place ... explaining how commodities’ 'moneyness' value evolved from their preexisting nonmonetary uses. No government or central bank was necessary ...
    "These two concepts give us the baseline conceptual understanding of money’s origin and value. But every shrewd merchant and trader over the centuries already understood money instinctively.... Many people intuitively understand money. What they don’t understand is monetary policy. The idea that exceedingly intelligent people at central banks and national treasuries must 'run' complex monetary 'systems' surely is one of the greatest swindles ever perpetrated. It nonetheless remains widely accepted ...
    "At its core, economics is conceptually simple: humans make choices in an environment of 'scarcity' to achieve ends. Money is a means to those ends, not an end in itself. It is the market’s answer to the inefficiency of barter....
    "Today, however, the concept of money is overwhelmed and completely obscured by politics. Modern money is political (fiat) money, which is to say it is a tool of government and an instrument of political power....
    "Thanks to political money, confusion reigns.... [M]ostly we hear confusion between wealth and money, rooted in the politicised, zero-sum nature of monetary policy. More money and credit do not magically create more goods and services, more capital investment, or a more productive economy. Prosperity cannot be legislated by politicians or engineered by central bankers.
    "What to do? The best approach in a confused world is a return to fundamentals. Mises’s 'The Theory of Money and Credit' is a great place to start, as is Murray Rothbard’s 'What Has Government Done to Our Money?' and Robert Murphy’s recent 'Understanding Money Mechanics'. For most lay readers, any of these books would be sufficient to puncture today’s money mythology. Circulate them among friends and family to help build the future cadre of monetary policy deniers. What the world needs today is champions of commodity money, sound money, hard money with a high stock-to-flow ratio, all of which is to say money that retains or increases purchasing power even when held in a simple savings account. This will require all of us ... to push for a great awakening.
    "Money is simple, but opposing the political tool of monetary 'policy' is not."

~ Jeff Deist, from his post 'Money versus Monetary Policy'

Central banks' unprecedented monetary expansion over recent years has created damage they cannot simply undo by switching directions now - as Frank Shostak explains in this guest post, their tight interest stance now will struggle to undo the damage caused by their previously ultra-profligate position.

Central Banks Cannot Undo the Damage They Have Already Caused

by Frank Shostak

On March 16 this year, the US central bank (aka the Federal Reserve) raised the target for their federal funds rate by 0.25 percent, to 0.50 percent. According to officials of "The Fed," their increase was in response to the strong increases in the yearly growth rate of the Consumer Price Index (CPI), which in February stood at 7.9 percent (risen from 7.5 percent in January, and from 1.7 percent in February of the year before).

Most commentators believe that by raising the interest rate target, the central bank can slow the increase of prices of goods and services. Supporters of this strategy often refer to May 1981, when then Fed chairman Paul Volcker raised the Fed's funds-rate target from 11.25 percent to 19 percent. The change was dramatic. By December 1986, the yearly growth rate in the CPI, which in April 1980 had stood at 14.8 percent, had fallen to 1.1 percent (see Fig. 1 below).

Fig. 1: CPI vs Federal Funds Rate, 1980 to 1986

Note that commentators commonly identify the growth rate measured by the CPI, i.e. rising prices, as "inflation." We hold, however, that what inflation is all about is increases in money supply. 

As such, we do not say that inflation is caused by increases in money supply, as some commentators are suggesting. Instead, we hold that increases in money supply are what inflation is all about. 

The price of a good is the amount of money paid for it, but whenever there is an increase in the money injected into a particular goods market, this means that the price of the goods in money terms will tend to rise. All things being equal, however, this increase in money in one market will be offset by a decrease elsewhere. It is only an increase in the money supply itself that allows all prices to raise across all markets. This general increase in prices is itself not inflation, however, but rather the manifestation of inflation as a result of the increase in money supply, all other things being equal.

Bad as this is, what is even more important than the increases it causes in the prices of retail goods is the damage that monetary inflation inflicts to the process of wealth generation. This is because increases in money supply set in motion an exchange of nothing for something, which generates a similar outcome to what counterfeit money does. This counterfeit capital progressively weakens wealth generators, thereby weakening their ability to generate wealth. This, in turn, undermines living standards even as real capital is consumed.

Also, note that when this new money is injected, it initially enters a particular goods market. Once the price of those goods rises to a level at which they are perceived as fully valued, the money begins spilling over into other markets that are now considered under-valued. This gradual shift from one market to other markets gives rise to a time lag between these increases in new money, and their effect on the wealth generation process.

Central Banks do not set interest rates. Individuals do.

Note that contrary to popular thinking, interest rates are determined not by central bank monetary policy. Instead, they are driven by the time preferences of individuals. According to the founder of the Austrian school of economics, Carl Menger, the phenomenon of interest is the outcome of the fact that individuals assign a greater importance to goods and services now than they do to identical goods and services in the future. I is this that we call "time preference."

For example, most people will generally prefer being given $100 now rather than, say, $103 a year from now. It is this evaluation by multiple individuals that is the driving force of interest rates across all markets.

Observe that the higher valuation of present goods is not the result of capricious behaviour, but rather the identification that life in the future is impossible without sustaining it in the present. According to Menger:

Human life is a process in which the course of future development is always influenced by previous development. It is a process that cannot be continued once it has been interrupted, and that cannot be completely rehabilitated once it has become seriously disordered. A necessary prerequisite of our provision for the maintenance of our lives and for our development in future periods is a concern for the preceding periods of our lives. Setting aside the irregularities of economic activity, we can conclude that economising men generally endeavour to ensure the satisfaction of needs of the immediate future first, and that only after this has been done, do they attempt to ensure the satisfaction of needs of more distant periods, in accordance with their remoteness in time.1

Hence, various goods and services required to sustain one’s life at present must therefore be of a greater importance to that individual than the same goods and services in the future. The individual is likely to assign higher value to the same good in the present versus the same good in the future.

Naturally, each individual's time preference is different. Those with paltry means often have shorter time horizons -- they can contemplate only short-term goals, such as making a basic tool. As his means increase, however, he can consider undertaking the making of better tools. With the expansion in the pool of means, individuals are able to allocate more means towards the accomplishment of ever-more remote goals in order to improve their quality of life over time.

Again, while prior to the expansion of means, the need to sustain life and wellbeing in the present made it impossible to undertake various long-term projects, with more resources now this has become possible.

Not that few, if any, individuals will embark on a business venture promises a zero rate-of-return. The maintenance of the process of life, over and above hand-to-mouth existence, requires an expansion in wealth. Wealth expansion implies positive returns.

Is the lowering of rates the key cause behind the increase in capital-goods investment?

Contrary to the popular thinking, a decline in the interest rate is not the driving cause behind the increases in capital-goods investment. What permits the expansion of capital goods is not the lowering of the interest rate but rather the increase in the pool of savings.

This "pool of savings" comprises of finished consumer goods -- finished consumer goods produced, but not yet consumed. It is this pool of savings that sustains people employed in the enhancement and the expansion of capital goods such as tools and machinery. With these increased and enhanced capital goods, it is then possible to increase the production of future consumer goods.

Note that in an unhampered market it is not the interest rate per se that drives this pool of savings towards more (or less) future-directed production -- it is the sum of individuals' time preferences toward more (or less) future focus that compel producers to make this choice.

Individuals' decisions to allocate a greater amount of means towards the production of capital goods is signalled by the lowering of individuals' time preferences, i.e., assigning a relatively greater importance to the future goods versus the present goods. 

Hence, the interest rate is just an indicator as it were, which reflects individuals’ decisions regarding their present consumption versus future consumption. (Again, the decline of the interest rate is not the cause of the increase in capital investment. The decline simply mirrors the decision to invest a greater portion of savings towards capital-goods investment).

In a free unhampered market, a decline in the interest rate informs businesses that individuals have increased their preference towards future consumer goods versus present consumer goods. Businesses that want to be successful in their ventures must abide by consumers’ instructions, and organise a suitable infrastructure to accommodate this signalled demand for more consumer goods in the future (rather than now). 

Note that through the lowering of time preferences, individuals have signalled that they have increased savings which will support the expansion of the production structure to become more future-directed. In the unhampered market, the decline in interest rate is therefore both a signal for more future-directed production, and a reward for undertaking it.

Observe that in an unhampered market, fluctuations in interest rates will tend to be in line with changes in consumers’ time preferences. Thus, a decline in the interest rate is in response to the lowering of individuals’ time preferences. Consequently, when businesses observe a decline in the market interest rate, they respond to it by increasing their investment in capital goods to accommodate the likely increase in demand for future consumer goods. (Note again that in a free-market economy, a decline in the interest rate indicates that on a relative basis individuals have lifted their preference towards future consumer goods versus present consumer goods).

What I have described here however is what happens in a free unhampered market -- in particular, one unencumbered by a government central bank. A major reason for the discrepancy between the so-called 'market interest rate' and the interest rate described here (i.e., the interest rate that fully reflects individuals' time preferences) is caused by the central bank. For instance, an aggressive loose monetary policy by the central bank leads to the lowering of the observed interest rate regardless of individuals' expressed time preference. Businesses respond to this lowering by increasing the production of capital goods, i.e., tools and machinery, in order to be able to accommodate the demand for consumer goods in the future. Note, however, that consumers have not actually indicated a change in their preferences toward present consumer goods. The time-preference interest rate did not go down. And so a gap emerges between the time-preference rate and the market rate.

It is this gap that causes the dislocations between consumption and consumption that presage economic corrections in future, and encourage over-consumption of capital now.

Because of this breach between the time-preference interest rate and the market interest rate, businesses responding to the declining market interest rate have essentially malinvested in capital goods relative to the production of present consumer goods. At some stage, by incurring losses, businesses are likely to discover that pass decisions with regard to the capital-goods expansion were in error.

Why tightening now cannot undo the negatives of a previous loose stance

According to Ludwig von Mises, a tight monetary stance cannot undo the negatives of the previous loose stance. (In other words, the central bank cannot generate a “soft landing” for the economy.) The misallocation of resources due to a loose monetary policy has already happened, and cannot simply be reversed by a tighter stance. (Mises likens the attempted correction to attempting to cure a road-accident victim by reversing over him.) According to Percy L. Greaves Jr. in the introduction to Mises's The Causes of the Economic Crisis, and Other Essays before and after the Great Depression:

Mises also refers to the fact that deflation can never repair the damage of a prior inflation.... Inflation so scrambles the changes in wealth and income that it becomes impossible to undo the effects. Then too, deflationary manipulations of the quantity of money are just as destructive of market processes, guided by unhampered market prices, wage rates and interest rates, as are such inflationary manipulations of the quantity of money.

A tighter interest-rate stance, while likely to undermine current bubble activities, is also however still likely to generate various distortions, thereby inflicting damage to wealth generators. Note that a tighter stance is still intervention by the central bank, and in this sense it still falsifies the interest-rate signal set by consumers. A tighter interest-rate stance still doesn't result in the allocation of resources in line with consumers’ top priorities. Hence, it does not follow that a tighter interest rate stance can reverse the damage caused by inflationary policy. 

Now, if we were to accept that inflation is about increases in money supply, then all that is required to erase inflation is to seal off the loopholes for the generation of money out of “thin air” by the central bank. A careful scrutiny of this is going to reveal that the culprit behind the increases in money supply is the monetary policies of the central bank. 

Policies aimed at stabilising price increases are in fact producing economic upheavals. Observe that by February 2021, the yearly growth rate of our monetary measure for the USA jumped to almost 80 percent! This is truly astonishing. Against the background of this massive increase, one should not be at all surprised that the yearly growth-rate of the CPI has accelerated. And against the background of this article, one might begin to understand why policies that aim only at slowing the growth rate of the CPI rather than arresting the growth rate of money supply are likely to undermine economic conditions rather than improve them.

Conclusion

As long as sustaining our lives remains individuals' ultimate goal of individuals (that is, as long as our species continues to breathe), they will go on assigning a higher valuation to present goods than they will to future goods -- to $100 now rather than to $103 a year from now -- and no amount of central-bank interest-rate manipulation is going to change this reality. 

But this will not stop them trying. Any attempt by central bank policy makers to overrule this fact however will undermine the process of wealth formation, and will lower individual living standards.

On the one hand, if individuals have not allocated adequate savings to support the expansion of capital goods investments, then it  is not going to help economic growth if the central bank artificially lowers interest rates. It is not going to help, because it it not possible to replace real savings with more money and an artificial lowering of the interest rate. It is not possible, because it it not possible to generate something from nothing. 

Likewise, by raising interest rates the central bank cannot undo the damage from its previously easy interest-rate stance. A tighter stance will likely generate various other distortions. Hence, what is required is that policy makers should leave the economy alone -- and let the market be completely free from central-bank tampering.

* * * * 

Dr Frank Shostak is a leading Austrian economist and director of Applied Austrian School Economics Ltd, which aims to assess the direction of various markets using the Austrian School methodology. AASE aims to make Austrian economics accessible to businessmen.

Versions of this post previously appeared at the Mises Wire and Cobden Centre.

Quote of the afternoon: Menger on economic progress

“The quantities of consumption goods at human disposal are limited only by the
extent of human knowledge of the causal connections between things, and by the
extent of human control over these things. Increasing understanding of the causal connections between things and human welfare, and increasing control of the less proximate conditions responsible for human welfare, have led mankind, therefore,
from a state of barbarism and the deepest misery to its present stage of civilisation
and well-being, and have changed vast regions inhabited by a few miserable,
excessively poor, men into densely populated civilised countries. Nothing is more
certain than that the degree of economic progress of mankind will still, in future
epochs, be commensurate with the degree of progress of human knowledge.”
- Carl Menger, founder of Austrian economics, from 
his Principles of Economics (1870)