5. Maturity Mismatching Is Not the Cause of the Cycle but can Be Sustainable and Dynamically Efficient

CHAPTER 5

Maturity Mismatching Is Not the Cause of the Cycle but can Be Sustainable and Dynamically Efficient

Rallo (204–5) argues that maturity mismatching—i.e., borrowing short, lending long—along with the mismatch of risks, is the true origin of distortions in the structure of production and the business cycle (and not fractional reserve credit expansion). Yet maturity mismatching in a free market is not a problem, as there is a constant flow of (short-term) savings that can be anticipated correctly (Bagus 2012; Bagus, Howden, and Huerta de Soto 2018; Huerta de Soto 2014, 231–32). Maturity mismatching in a free market benefits society by increasing living standards. I will analyze these issues in detail in the following.

5.1 Error and Maturity Mismatching

Maturity mismatching can be excessive. As I have written elsewhere (Bagus 2010, 2), “A 100 percent reserve system can still bring about artificial booms by maturity mismatching if there is a central bank or government support or guarantees for the banking system.”

In other words, a 100 percent reserve requirement is not sufficient to eliminate business cycles, because other government interventions in the financial system could cause business cycles. For instance, the existence of a lender of last resort, government bailouts, and implicit or explicit guarantees for the banking system can promote excessive maturity mismatching outside the free market. In an intervened economy excessive maturity mismatching may cause boom-and-bust cycles.

Things are different in a free market. As Bagus and Howden (2010a, 73) argue in making the case for the free market, “A financial intermediary might borrow short and lend long by continually rolling over their borrowings, relying on the correct anticipation of the future availability of savings for success. In a free market there is no general reason why one would systematically under—or overestimate the future availability of savings, and thus, the possibility to roll over loans.”

Indeed, if there is no government intervention and moral hazard caused by the state, then there is no reason why entrepreneurs will systematically err and overestimate the future availability of savings. Bagus and Howden conclude:

On the free market, there will always be maturity mismatching to some extent as entrepreneurs try to anticipate future savings availability. Arbitrageurs earn a profit by shouldering the risk of mismatching and arbitraging between terms. Excessive maturity mismatching discoordinates the term structure of savings and the term structure of investments (the time structure of individual savings and investment plans). Three phenomena foster excessive (i.e., nonsustainable) maturity mismatching: credit expansion, the existence of a lender of last resort and government bailout guarantees. Excessive maturity mismatching caused by government interventions leads to an unsustainable misalignment of the term structures of savings and investments. As a result, financial institutions unsustainably borrow short and lend long. (Bagus and Howden 2010a, 81)

In a free market, maturity mismatching leads to a fall in long-term interest rates that is not artificial but based on the long-term availability of savings. There is no artificial boom. In contrast, excessive maturity mismatching promoted by government interventionism leads to an Austrian business cycle.

From the perspective of an individual financial institution, maturity mismatching is a risky activity (Bagus and Howden 2009). The intermediary anticipates being able to renew or roll over the short-term debt obligation on agreeable terms. The middleman can make a mistake, though, and find himself unable to obtain funding or another source of money to fulfill his obligations. In this case, there is an individual entrepreneurial error. The error will then reveal an individual malinvestment. An investment project cannot be completed because of an overestimation of the available resources. Future savings—i.e., the willingness to abstain from consumption—were overestimated. Time preference is higher than the entrepreneur had expected.

The overestimation of the future availability of savings is a risk that is not exclusive to maturity mismatching. Even in an economy with perfect maturity matching, an unexpected increase in time preference will lead to losses and restructuring. When time preference increases, the structure of production becomes shorter. Some investment projects are not profitable anymore because of the increase in time preference.

The availability of future savings may be overestimated or underestimated. In a free market, there is no reason to believe that there will be a systematic error in one direction concerning the availability of future savings. Intermediaries may err individually, but there is no reason why they should err systematically. Individual error will lead to individual losses but not to an artificial boom and widespread malinvestments.

5.2 Maturity Mismatching in an Unhampered Economy

As stated in section 4.1.5 and as is essential to capital theory, savings are needed to sustain the owners of production during the production process. The savings need not be in hand at the beginning of the project but can be secured during the lifespan of the project. Entrepreneurs have to estimate the availability of future real savings—i.e., present goods available to sustain the factors of production.

If the flow of future savings is correctly predicted, more long and ambitious projects can be successfully finished than would be achievable by depending just on the savings available at the beginning of the project. This implies that, if future savings are properly foreseen, maturity mismatching enables the completion of more ambitious projects than would have been achievable by relying solely on matched-maturity finance. As round-about production is more productive (Mises 1998; Böhm-Bawerk 1891), relying merely on savings available at the beginning of a project reduces the amount of wealth-creating investment projects below the level they otherwise could reach. Maturity mismatching in a free market is dynamically efficient.

The following example adapted from Bagus, Howden, and Huerta de Soto (2018) illustrates the possibility and advantage of maturity mismatching in a Robinsonian economy. On an island there are two individuals, Robinson and Friday. They both can catch 10 fish per day with their bare hands. Each of the two consumes all 10 fish every day. Friday wants to produce a sharpened stick, a capital good, that will help him to increase his productivity in fish catching. Friday believes that the production of the stick will take him 10 days, during which his fish production will fall to 1 fish per day. He also estimates that with the new stick he will be able to double his fish production to 20 fish per day. Robinson has 100 smoked fish saved. Friday has no savings and asks Robinson for a loan. Robinson offers him a loan of 100 fish for 5 days with an interest payment of 5 fish. While Friday believes that he will not be finished with his project after 5 days, he accepts the offer because he believes that Robinson will be willing to renew the loan after 5 days. After the first 5 days, Friday pays the interest and convinces Robinson to renew the loan. Thus, Friday can complete his project. Without mismatching maturities of the loan and the investment project, Friday could not have undertaken his project, because he did not secure the necessary savings beforehand. However, he expected that Robinson’s time preference would not change and that he could renew the loan. Of course, he could also have looked for another lender if there were any other savers on the island. As a result of maturity mismatching, a new capital good has been constructed, making the island community richer. The fact that there was maturity mismatching is revealed after the project is finished. Beforehand, Friday could not know for sure how long it would take him to find a suitable stick and produce it. The possibility of maturity mismatching is part and parcel of Friday’s investment project and of investment projects in general because their length is uncertain at the start.

Note that the example also holds when we introduce an intermediary, Tom, who interacts between Robinson and Friday, so that the concept of borrowing short and lending long becomes more apparent. Now, Tom borrows short 100 fish from Robinson for 5 days with an interest payment of 3 fish. Tom then lends the 100 fish to Friday for the term of 10 days with an interest payment of 10 fish. Tom expects Robinson to renew the loan for another 5 days, or he knows of other short-term savers on the island that could take Robinson’s role. Tom is borrowing short and lending long. He engages in maturity mismatching. His endeavor is risky because Robinson might be unwilling to roll over the loan and another saver might not be found. However, if Tom is right in his anticipation of future savings—i.e., the availability of fish saved that could be lent and transferred to Friday in order to sustain him during the production period—then the project can be completed. There is no business cycle, no liquidation, but a new capital good comes into existence, financed by the ongoing savings of society. Thus, if time preference and the ongoing real savings do not change, the maturity matching is successful and achieves a better intertemporal coordination than relying only on matched maturities. Maturity mismatching is welfare enhancing.

In a modern monetary economy, things are similar. Imagine that a bank borrows for 3 months from person A to invest in a project that takes 1 year to mature. After the first 3 months, A is paid back his loan and decides to increase his consumption. But must the project now necessarily be abandoned? No, because another person, B, could take on the function of the saver and abstain from consumption, releasing consumer goods for person A and granting a 3-month loan to the bank. After another 3-month period, another person, C, may take on the role of the saver, and then finally another person, D. Then the bank can successfully complete the financing of the investment project. The social role of maturity mismatching becomes apparent, as the structure of production has become more capital intensive than it would have been without the investment project. During the time of the project, time preference did not change. The real savings available did not change; there was only a change in who took on the role of the saver. First, it was person A who provided the savings by abstaining from consumption, then it was person B, then C, and finally D.

There are many ways in which the position of a saver can be transferred to someone else. There are many institutions that facilitate this change of savers (Davidson 2014, 232). Machlup (1940, 21) shows that securities markets facilitate the change of ownership of titles to capital goods. For instance, someone may use his short-term savings to buy a newly issued stock, hold it for a year, and sell it to another person, who takes the role of the first saver. The stock market encourages the investment of short-term savings, as the transfer of ownership is facilitated. Short-term savings thereby become available for the long run (Machlup 1940, 24, 65; Machlup 1932, 284).

It is not only the institution of the stock market that facilitates the transfer of the saver function. The same is true when bonds are resold after a short period of time. Bonds can also be reissued, and loans can be rolled over. The change of savers can also be achieved through investment funds or money market mutual funds. Different savers may buy a title to these funds, selling them later when they want to increase consumption. And other savers who buy the titles take on the role. These investment funds may continually roll over their investments—i.e., buy new bonds—when the old ones are repaid.

We have a continuous flow of savings (of different maturities from the point of view of the individual saver) that is continuously invested through financial markets. In this way, short-term individual savings become long-term savings for the economic system. So maturity mismatching does not pose any problem, as there is a constant flow of savings whose overall level is determined by time preference. Changes in time preference must be anticipated, of course.

It is probably the individual bank’s perspective that has led proponents of the real bills doctrine to believe that maturity mismatching may pose a problem. And while maturity mismatching is risky from an individual bank’s perspective, the assessment changes when the economic system as a whole is considered, where individual savers are continuously replaced by other savers.

As entrepreneurs can estimate correctly the evolution of the available savings, which is determined by time preference, they can successfully engage in maturity mismatching by rolling over the short-term loans. As Davidson (2014, 77) points out:

Consider, next, an economy where only the social time preference is assumed to be constant. The time preferences of individual actors can change, but gross saving is constant over time, as in the ERE. While the composition of the investment vehicles in which these savings are held need not remain the same, the renewal or replacement of those of finite duration with others of equal value—but not necessarily the same duration—must take place, this being the necessary implication of the quantity of gross saving being maintained. With regard to production, some processes are ongoing, others are newly initiated, and yet others are terminated, but gross saving and investment continue to equal each other in quantity— that is, in money value—as capitalist-entrepreneurs freely compete with one another to supply present money, and original factor owners freely compete to demand it.

Machlup (1940, 169) puts it similarly: “The condition for the maintenance of a given level of production, or for the continuance of a production process that has once been started, is merely that there should be a constant absolute volume of current saving.”

In sum: Maturity mismatching with constant time preference does not lead to an artificial boom-bust cycle (Davidson 2014), because the level of (gross) savings remains constant indefinitely. The fall of the longterm interest rate due to arbitrage reflects the actual social time preference; market interest rates are in line with consumer preference.

53. Maturity Mismatching versus Unbacked Real Bill Credit Expansion

After the above argument, one might pose the following question: If maturity mismatching does not systematically cause business cycles in an unhampered economy, why would unbacked real bill credit expansion cause a business cycle in an unhampered economy? If free market maturity mismatching could be beneficial for society, could free market credit expansion limited by the amount of real bills not also be beneficial for society?

One might believe that unbacked credit expansion only becomes problematic when fostered by central banking and government interventions leading to excessive credit expansion in the same way we argued that only excessive maturity mismatching leads to intertemporal distortions. Could there be unproblematic free market real bill credit expansion in line with consumer preference and excessive real bill credit expansion under central banking?

These are good and legitimate questions. The most fundamental point behind these questions is this: What is a free market in banking, really? Is it really an unhampered free market if unbacked real bill credit expansion is pursued? Or must the possibility of real bill fractional reserve banking be considered a privilege granted by the government or a criminal activity that violates general legal principles?

Following Huerta de Soto (2012), I have argued that fractional reserve banking is based on invalid or impossible contracts that would not be defended in an unhampered market.Indeed, depositories of other fungible goods, such as oil mills or grain silos, are not allowed to operate with fractional reserves (Williams 1984). An exception—i.e., a privilege—has been granted to banks (Köhler 2015). So, while maturity mismatching is legally unproblematic, (real bills) credit expansion is legally problematic.

Besides this fundamental legal difference, there are also economic differences between maturity mismatching and fractional reserve credit expansion. First, with maturity mismatching the money supply in its broader sense does not increase, as no fiduciary media are created. Real bill credit expansion, however, increases the money supply, as fiduciary media are created.

Second, while credit expansion artificially lowers interest rates by creating new fiduciary media and injecting them into the loan market, the arbitrage of free market maturity mismatching flattens the yield curve, thereby reflecting more accurately expectations about the availability of future savings (Davidson 2014, 86).

Third, as we have seen, financial intermediaries that engage in maturity mismatching will be successful and the structure of production sustainable if time preference does not change. In contrast, fractional reserve credit expansion with constant time preference leads to an intertemporal discoordination because new fiduciary media are created and lent to entrepreneurs without a prior increase in real savings. With (real bill) credit expansion, no one gives up buying power, but the borrower receives new buying power. In contrast, in maturity mismatching, someone abstained from consumption for the short term by giving up buying power. The expectation is that this position will be taken by another saver in the future. And indeed, another saver will take this position if time preference remains constant.

The key point is that with real bill credit expansion, no one abstained from consumption and freed resources for new investment projects, but someone receives new purchasing power in the form of newly created fiduciary media. Interest rates fall below the level they otherwise would reach. More investment projects appear to be profitable than with higher interest rates. While consumers continue to consume in rhythm (as time preference remains constant), entrepreneurs invest as if real savings had increased. The result is an intertemporal discoordination. An Austrian business cycle is set off. The structure of production becomes too capital intensive and unsustainable because there are no additional savings to maintain the additional investment projects. Only if time preference falls and real savings increase will the new structure of production become sustainable a posteriori (Bagus and Howden 2010a, 67). In other words, if, after a credit expansion, time preference decreases sufficiently, there may be no bust.

Take the following example as an illustration. Imagine a fractional reserve bank that creates $1,000 of new fiduciary media and discounts a real bill from an entrepreneur. The entrepreneur’s equity that was bound up in financing transportation is released. He invests in a 10-year project (it could be a 3-month project; it does not change the principle) and pays his workers at the end of the first month. When the workers spend their money on consumer goods, consumer-goods prices rise relative to capital-goods prices. The profitability of shorter-term projects (in the consumer stage and stages near consumption) rises relative to that of longer-term projects (in stages of production far away from consumption). Consequently, the 10-year project may be abandoned. If this happens systematically in the economy, a recession sets in.

However, as mentioned above, there is a chance that a recession does not occur. This is because workers could increase their cash balances and hold on to the newly created fiduciary media without increasing their spending and bidding up consumer-goods prices. Or they could save the money and lend it to the company that pays down the real bill after month three. Or they could buy the investment project from the entrepreneur. In this case, workers reduce their consumption and save all their additional fiduciary-media income. Then the investment becomes backed by real savings. Yet, if workers spend even a part of the fiduciary media created by the real bill credit expansion on consumer goods, then consumer-goods prices will rise relative to capital-goods prices, manifesting intertemporal discoordination.

Hayek (2008, 378, 394) remarks on the conditions in which credit expansion does not trigger a business cycle:

It would also be necessary [in order to prevent an adjustment of the structure of production—i.e., a recession] that the increase in incomes [due to the increase in credit expansion] which would be caused by this increased spending should not lead to any further increase in the demand for consumers’ goods and a further increase of their prices. Otherwise the prices of consumers’ goods would always keep a step ahead of the prices of factors. That is, so long as any part of the additional income thus created is spent on consumers’ goods (i.e. unless all of it is saved), the prices of consumers’ goods must rise permanently in relation to those of the various kinds of input. And this, as will by now be evident, cannot be lastingly without effect on the relative prices of the various kinds of input and on the methods of production that will appear profitable. . . .

All that is required to make our analysis applicable is that, when incomes are increased by investment, the share of the additional income spent on consumers’ goods during any period of time should be larger than the proportion by which the new investment adds to the output of consumers’ goods during the same period of time. And there is of course no reason to expect that more than a fraction of the new income [created by credit expansion], and certainly not as much as has been newly invested, will be saved, because this would mean that practically all the income earned from the new investment would have to be saved.

In other words, the new investment projects financed by credit expansion are only sustainable if all the newly created $1,000 is saved for the term of the investment project. Then the investments are backed by real savings. If this savings happens, the proportion of income spent on capital goods will increase relative to the proportion of income spent on consumer goods. Consumer-goods prices will fall relative to capital-goods prices, reflecting the fall in time preference. The interest rate that has been reduced because of credit expansion now has a real reason to fall. As relatively more is spent on capital goods and relatively less on consumer goods, consumer goods are liberated to sustain the investment project. Entrepreneurs have more buying power and can control a larger portion of resources and dedicate them for investment purposes by taking them away from the consumer sector. In short, if workers do not save all additional income ($1,000) and spend even a small portion of it, then consumer-goods prices will rise relative to capital-goods prices. This relative increase in consumer-goods prices is one trigger of the recession in Austrian business cycle theory (Huerta de Soto 2012). Only if all newly created fiduciary media are saved will this equal a fall in time preference and make the new projects viable. Thus, at best, real bill credit expansion could be an anticipator of a fall in time preference if workers save all their additional income.

One could think that in maturity mismatching something similar happens. In maturity mismatching, the intermediary anticipates the amount of future savings that will be available, and in real bill credit expansion the intermediary would do the very same.

Yet there are important differences. First, there are the legal differences mentioned above in this section. Maturity mismatching is unproblematic from a legal point of view, while fractional reserve credit expansion violates traditional legal principles. Second, the intermediary that engages successfully in maturity mismatching does not have to assume a decrease in time preference, because with constant time preferences the (gross) amount of available savings remains ceteris paribus the same. However, the fractional reserve bank must assume a sudden fall in time preference at the moment it expands credit. Furthermore, the bank must take into account that other fractional reserve banks might expand credit at the same time, thereby increasing the necessity of a fall in time preference. Howden (2014) argues that there is an important knowledge problem involved because the more distant a bank is from the initial credit expansion, the more difficult it is for actors to know whether loans are backed by real savings or by unbacked credit expansion.

Third, once the 3-month loan is repaid in our example, the amount of fiduciary media is reduced. When the bank now expands credit again, all newly created fiduciary media have to be saved again, which implies the need for a continued fall in time preference to make the financed projects sustainable. And there is an incentive to renew the loan, as it enlarges profits relative to other banks. Banks that do not renew loans and refrain from credit expansion will sacrifice profits (Huerta de Soto 2012, 667; Carilli and Dempster 2001).

Fourth, fractional reserve banks can indeed increase profits by cooperating and expanding credit in rhythm during the boom (Bagus and Howden 2011a). In the case of maturity mismatching, financial intermediaries do not profit from cooperation and from excessively mismatching maturities. If there is excessive maturity mismatching and short-term savings are not correctly anticipated, cooperating intermediaries suffer losses.

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On the concept of dynamic efficiency, see Huerta de Soto (2009).

For a similar Robinsonian example, see Bagus and Howden (2010a).

Instead of issuing a loan, the bank could issue shares that first are bought by A, who after 3 months sells the shares to B, who 3 months later sells to C, who finally sells to D. Shares can fall in price, of course. So if A is only able to sell the shares at a lower price, he cannot increase his consumption in the amount of his initial sacrifice, and B’s sacrifice is accordingly smaller.

As Machlup (1940, 33) puts it, “It is the main advantage of the security system of financing real capital that it allows temporary savings put by for future requirements (that is, temporarily postponed consumption) to be used for the formation of fixed capital.” Similarly, Machlup (1932, 283) states, “The short-term saving is liquid in so far as a new saver takes the place of the liquidating one. The substitution of one saver or investor for another can be expected in normal times. There is a continuous prolongation and turnover of short-term loans and short-term investments. The individual owners, creditors, and debtors change but the volume of capital is not reduced” (emphasis in original).

As Machlup (1940, 225) puts it:

For even though the individual savings are only saved for a temporary period, collectively they may in large part be looked upon as long-term savings of the economic system. In most cases the temporary saver who withdraws his funds in order to make the purchase that he had previously postponed has a successor who is just saving part of his income for later use. The probability that the new savings will be sufficient to cover withdrawals of old savings is what makes it possible to invest these short-term funds in production.

Full Reserve Banking