The Horwitz and Hill Debate: Or, Why the Austrians are Wrong about Financial Markets

Steve Horwitz, a contemporary Austrian economist, had an exchange with Greg Hill in the pages of Critical Review over the merits of the Post Keynesian challenge to the "self-correcting" properties of capitalism. Mr. Horwitz makes it quite clear that the loanable funds model guarantees that all savings will be invested save for that which is hoarded. Savings and investment are, of course, in this model coordinated through changes in the interest rate. This requires flexibility not only in interest rate changes, but also in prices and wages. But Keynes argued that an economy with perfect wage/price flexibility will still produce unemployment. And this is because there is no direct relationship between decisions to save and decisions to invest. Now Mr. Horwitz recognizes this point and seeks to refute it. Now, Post Keynesians do not mean by savings "hoarding under the mattress." Horwitz is mistaken when he attributes to Post Keynesians this view of savings. For Post Keynesians, the income earner has two decisions to make: (1) how much to consume; and (2) in what liquid forms to store that which is not consumed (i.e. saved). This saving can take a variety of forms: bank deposits, bonds, mutual funds, equities, etc. Horwitz summarizes his position by writing:

"The key to a more appreciative vision of the market's intertemporal coordination powers is recognizing that what is not "spent" does not disappear into oblivion but must be devoted to some other use; indeed, it is not spending but saving that drives economic growth."

Two things. First of all, Horwitz is accepting as true what he must first prove. That saving does generate investment and economic growth. This is not as easy as he makes it out to be. And secondly, and somewhat related, is the claim that what is not spent must, according to Post Keynesians, "disappear into oblivion." Post Keynesians have never argued this. What they say is that savings will never finds its way into the industrial sector because the industrial sector provides no liquidity, and this is what savers demand. Instead, savings find their way into the financial sector, because financial assets possess a great deal of liquidity. And depending on one's appetite for risk, one can attempt to sacrifice a little liquidity for the possibility of capital gains (speculation); but because most financial assets have orderly markets, it is relatively easy to sell these assets for money. Capital goods, however, are not easily resalable (liquid).

For Post Keynesians, the financial sector is very different from the industrial sector. The financial sector deals principally with liquidity, and aims to provide people with liquidity (savers). The industrial sector, on the other hand, deals with real tangible (not easily substitutable) capital goods. These goods do not provide liquidity, because they cannot easily be sold. People who deal with capital goods must therefore look to its prospective yield and not its liquidity properties. These people are generally capitalists, and not savers.

Next, Mr. Horwitz argues that interest rates coordinate savings and investment (loanable funds model).
He writes:

"The interest rates banks charge and pay serve as signals about the apparent willingness of savers to lend and borrowers to borrow. High interest rates suggest that savers are relatively reluctant to wait for the future ... and/or that borrowers are pushing relatively hard for funds. Low interest rates suggest that savers are comparatively patient ... and/or that borrowers are comparatively uninterested in investing in projects that will not produce output until the future."

Now what Mr. Horwitz is overlooking here is the importance of speculation in financial markets. Many people in the financial world deal in short-term speculation in the hopes of realizing capital gains. And they look to the interest rate in making their decisions. So, taking up from Mr. Horwitz's example, if savers are "comparatively patient" and interest rates are expected to fall, what is stopping bondholders, for example, from buying bonds now in order to realize capital gains when their price goes up? Nothing is stopping them, and this is what usually happens. But this interrupts the smooth picture Mr. Horwitz has presented us with. Any new savings will likely be swamped by changes in assets among existing wealth-holders.

Austrians have pushed this simplistic loanable funds model theory of financial markets for as long as I can remember. This has prevented them from "appreciating" (to use Mr. Horwitz's phrase) the complexities of the financial world. Speculation triumphs over "industry", and the financial sector is very different from the industrial sector.