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The Essence of Libety

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Liberty knows no compromise

A Condensed Version of For a New Liberty: The Libertarian Manifesto by Murray N. Rothbard

Chapter 9: Inflation and the Business Cycle: The Collapse of the Keynesian Paradigm

Introduction

Until 1973-1974, the Keynesians' ruling economic orthodoxy held that a free-market economy is subject to swings and the function of the government to compensate for this market defect. The theory was that, by manipulating its spending, government could "fine-tune" the economy so as to insure full employment without inflation.

Then, in 1973-1974 the Keynesians were forced to realize that forty-odd years of fine-tuning had not eliminated chronic inflation. In fact it had escalated it into double-digits. Not only that, but the uS had plunged into its deepest and longest recession since the 1930s. This was not supposed to happen!

As early as the recession of 1958, consumer goods prices rose in the midst of a recession. Then it happened again in the recession of 1966. These were mild recessions that did not arouse much concern. But, the recession of 1969-1971 was sharp. But then a steep recession began in the midst of the double-digit inflation during 1973-1974. Had fine-tuning failed?

Several things needed to be explained. For example: Why chronic and accelerating inflation, even during deep depressions? Why the business cycle at all?

The “ Austrian School” of economics could have provided the answers. In fact, only Austrian business cycle theory offers a satisfactory explanation for the Great Depression of the 1930s. But, Keynes's General Theory swept the boards after 1936. However, it did not win out by carefully debating and refuting the Austrian position. It simply became the new fashion. The Austrian theory was never refuted, only ignored and forgotten. But fortunately, it was kept alive for four decades by Mises (at NYU), Hayek (at Chicago ) and a few of their followers.

It is no accident that the renaissance of Austrian economics coincided with the phenomenon of stagflation and its consequent shattering of the Keynesian paradigm.

Money and Inflation

According to Austrian theory, inflation is not unavoidably built into the economy, nor is it a prerequisite for economic growth. In fact, falling prices do not, in any way, damper economic prosperity. Instead they are the normal functioning of a growing market economy.

Inflation as a peacetime norm only arrived after World War II. Since then, prices have gone up continuously. Why?

The favorite explanation is that greedy businessmen raise prices in order to increase their profits. First, it is absurd to suggest that businessmen suddenly became "greedy" after 1941. Furthermore, if they are so eager to raise prices, why do they wait? Why don't they double or triple prices immediately?

The explanation that unions insist on higher wage rates which in turn causes businessmen to pass the wage increase on in the form of higher prices has a similar flaw. First, inflation appeared long before unions. Further, there is no evidence that union wages go up faster than nonunion or that prices of unionized products rise faster than those of non-unionized. But beyond that, if businesses have the ability to pass along such increases, why don't they just go ahead raise their prices anyway?

So, what is it then that prevents businesses (or unions) from demanding still higher prices? Simple, consumers won't pay them. If the price of any given product (say coffee) increases drastically, consumer demand will shift to lower-priced substitutes (like tea). So, this pushes the question backward a step. What allows consumer demand to continuously increase and yet keeps it from going up any further than it does? Well let's see.

The “price” of any given product is the amount of money the buyer must spend on it. Furthermore, there are two sides to any exchange. On the one side there is the consumer-buyer (with money to sell) and on the other is the seller (who wishes to buy money). And, according to the law of supply and demand, an increase in supply lowers price while increased demand raises it, and vice versa. Thus, we have uncovered the key element that limits consumer demand (and therefore price)— the amount (supply) of money held by consumers.

Supplies of goods are going up year after year in our growing economy. So, according to the law of supply and demand, prices should be falling—e.g. we should be experiencing "deflation." If inflation were due to the supply side, then the supply of goods should be falling in order for prices to be rising. This is obviously not the case. So the source of inflation can only be the demand side. As we saw above, the dominant factor on the demand side is the supply of money. And this is supported by historical data. Since World War II, the increase in the money supply has been much faster than the increase in the supply of goods. And that is the explanation for the chronic inflation we have experienced during that time.

Who, or what, controls the money supply? To answer that we must first consider how money arises in a market economy. First individuals choose one (or more) useful commodities to act as money. Over the centuries, various markets have chosen a large number of commodities as money, but two have always won out—gold and silver. Every modern currency unit originated as units of weight of either gold or silver. For example, the "dollar" was originally a one-ounce silver (Bohemian) coin. Later, it was defined as one-twentieth of an ounce of gold with the supply of gold being determined by market forces.

From the beginning the State has moved to seize control of the money-supply function from the market and turn it over to the people in charge of the State apparatus. The reason why is clear. It provides an alternative to taxation, which is always considered onerous by its victims.

After this seizure of control, the ruling class has been able to create their own money. It has been particularly easy since the discovery of the art of printing. After that, the State could change the definition of “money” from units of gold or silver into simply names for pieces of paper and print them virtually without cost. It took centuries but now the issuance of money all over the world is totally in the hands of central government.

All over the world governments have “granted” a regional monopoly to counterfeit to themselves. Just as governments call their monopoly power over legalized kidnapping conscription, and their monopoly over legalized robbery taxation , they call their monopoly power to counterfeit, increasing the money supply .

Due to the natural fact that the interest of a counterfeiter is to print as much money as he can get away with, government control of the money supply is inherently inflationary.

The Federal Reserve and Fractional Reserve Banking

Inflating by printing money is too visible. Instead, governments have devised a much more complex and sophisticated (and less visible) way to provide themselves with more money to spend and to subsidize their favored political groups. Instead of printing money, the idea is to retain the basic money (the "legal tender"), and then pyramid ”checkbook” money on top of that. By design, no one (except central bankers and a few economists) understands how this complex system really works.

The commercial banking system is under total control of the central government. The Federal Reserve ("the Fed") permits commercial banks to pyramid their demand deposits ("checkbook money") by a multiple of about 6:1. In other words, if bank reserves at the Fed increase by $1 billion, the banks pyramid their deposits by $6 billion—e.g. they can (and do) create $6 billion worth of new money.

Demand deposits (personal and business checking accounts) compose the major part of the money supply. They involve a promise by the banks that they can be redeemed in cash (Federal Reserve Notes) anytime the depositor wishes. But, the problem is that the banks cannot do that simply because they don't have that much money—they owe six times their reserves, which are composed of their own checking accounts at the Fed.

The Fed can then control the rate of monetary inflation by adjusting the multiple (6:1) of bank money creation. Meantime, the public is kept ignorant of the process.

Banks create new deposits by lending them out in the process of creation. To illustrate, suppose banks receive the $1 billion of new reserves. They will lend out $6 billion and create new demand deposits when they make these new loans. In other words, they are not necessarily re-lending existing money that the public has laboriously saved—as that same public has been led to believe.

Furthermore, the pyramid scam is compounded by the fact that the Fed actually lends reserves to the banks at an artificially cheap rate (called the "rediscount rate").

But, by far the most important mechanism for increasing bank reserves is known as "open market activities." The Fed goes into the open market and buys an asset. It doesn't matter what kind. Let's say it is a pocket calculator for $20. The seller gets a check for $20 from the Federal Reserve, which he deposits in his own commercial bank. So, at the end of this initial phase, the money supply has gone up by $20, which the Fed created out of thin air by simply writing a check on itself. The commercial bank then deposits the $20 in its reserve account with the Fed. Now, with a reserve requirement of, say 6:1, the bank can create more demand deposits in the form of loans until the total increase in checkbook money becomes $120.

This simple little example demonstrates how the process works. But, in practice, the Fed makes huge purchases of uS government bonds. This is beneficial for the Fed because the bond market is huge and highly liquid, and it does not have to get into the political conflicts that would be involved in the purchase of private stocks or bonds. For the government, it props up the price of their bonds.

Now, suppose that some bank (or banks) had to cash in some of its checking account reserves in order to acquire hard currency. Wouldn't the Fed be forced to go bankrupt? No, because it has the monopoly on printing cash. All it would have to do is print whatever amount it needed.

So, the real key to inflation is a continually expanding money supply through Fed purchases of government securities.

The Federal Reserve was created in 1913 and it permitted inflation to pay for World War I. Then in 1933, the government took the country off the gold standard. Dollars were no longer redeemable in gold. Before then, Federal Reserve Notes were payable in gold. This was an important shackle upon the Fed's ability to inflate by expanding the money supply.

Government cannot create new gold at will. But it (or its surrogate, the Fed) can issue Federal Reserve Notes at will and at virtually no cost. This is what paved the way for price inflation during and after World War II.

But, at the time, there was still one restraint. The uS government was still pledged to redeem any dollars held by foreign governments in gold. Due to inflation during the 1950s and 1960s, dollars piled up in the hands of European governments. Then, in August of 1971, the uS declared national bankruptcy by repudiating its solemn contractual obligations and "closing the gold window." It was not a coincidence that double-digit inflation followed during 1973-1974.

Bank Credit and the Business Cycle

The business cycle arrived late in the 18 th century. There seemed to be no explainable reason for this cyclical pattern of regularly recurring booms and busts.

In fact, before the late 18 th century, it was just the opposite. The economy generally went along smoothly until some sort of sudden interruption occurred—a famine, war or other easily identifiable, one-shot cause or specific blow to trade.

The cycle occurred in the economically advanced areas—the port cities and other areas engaged in trade with the most advanced centers of world production. Two important phenomena began to emerge–industrialization and commercial banking, specifically "fractional reserve" banking. Therefore, two theories emerged to explain the phenomenon—those blaming industry and those blaming the banking system. The former believed the responsibility was within the free-market economy and called either for its abolition (e.g., Karl Marx) or for drastic control (e.g., Lord Keynes). On the other hand, those who saw the fault to be in fractional reserve banking naturally placed the blame on money and banking.

The English classical economist, David Ricardo was the first to develop a cycle theory centering on money and banking. His theory went something like this:

• Fractional-reserve banks expand credit
• the money supply expands
• this raises prices and sets the inflationary boom into motion
• domestic prices increase more than the prices of imported goods, so
• imports increase and exports decline, which causes
• a deficit in the balance of payments which has to be paid for by gold flowing out of the country, so
• banks find themselves in danger of bankruptcy, stop their expansion and contract bank loans and checkbook money
• this reverses the economic picture and bust quickly follows
• the fall in the supply of money leads to a fall in prices ("deflation")
• goods again become more competitive with foreign products
• the balance of payments reverses itself
• Gold flows into the country
• the condition of the banks becomes sounder and
• recovery gets under way

The Ricardian theory recognized that the inflationary boom was caused by government intervention and that recession was the necessary adjustment process by which the market throws off the distortions.

But why the business cycle? The short answer is motivation. Banks profit by expanding credit, so they are naturally inclined to do so. Therefore, when they recover from a bust, they simply resume that natural tendency. Further, government always wants to inflate in order to increase its own revenue as well as to subsidize favored groups. So, Ricardian theory explained the continuing recurrence of the business cycle.

But it did not explain two things. First is the massive cluster of error that businessmen suddenly seen to have made when bust follows boom. Second is the reason that both booms and busts are more severe in the "capital goods industries" than in consumer goods.

The Austrian theory of the business cycle (promulgated by Ludwig von Mises) built on the Ricardian to develop its own "monetary malinvestment" theory as an explanation for the cluster of errors and the greater intensity of the business cycle in the capital goods industries—and, the modern phenomenon of stagflation.

The theory begins like the Ricardian: government and the central bank stimulate credit expansion and thereby expand the money supply, which drives up prices (causes inflation). But not only that, in the process, it artificially lowers the interest rate. This, in turn, sends misleading signals to businessmen and causes them to make unsound investments.

On the free market, the interest rate is determined by the aggregate of individual "time preferences." The essence of any loan is that a "present good" is being exchanged for a "future good." Since people prefer to have money now, present goods always command a premium over future goods. That premium is the interest rate.

Time preference also determines what proportion of their income people will save and invest as compared to how much they will consume now.

A decline in time preference means that people's preference for the future increase relative to their preference for the present. Thus, they will consume less and save and invest more. This represents an increase in the supply of investment funds, which, in turn, causes the interest rate to fall.

But what happens when the interest rate falls artificially (due to intervention) instead of naturally (from changes in the time preferences of consumers)? Well, businessmen react as they always do to lower interest rates—they invest more in capital goods. Investments that previously looked unprofitable now seem profitable because of the lower interest expense.

Businesses are glad to borrow the expanded bank money at cheaper rates and invest in capital goods. Eventually this money gets paid out in higher wages and bids up labor costs.

The problems begin to reveal themselves when workers begin to spend the new bank money. The public's time preferences have not really gotten lower. They don't want to save more so they consume most of their new income. This redirects spending back to the consumer goods industries and means that they don't save and invest enough to buy the newly produced capital equipment and raw materials. This reveals itself as a sudden, sharp depression in the capital goods industries indicating that business has invested too much in capital goods and not enough in consumer goods (hence the term "mal-investment "). Then, the "depression" that follows is the necessary and healthy period in which the market sloughs off and liquidates the unsound investments of the boom.

Put another way, inflationary credit expansion will raise all prices; but prices and wages in the capital goods industries will go up faster than those in the consumer goods industries. Thus, the boom will be more intense in the capital goods industries. On the other hand, the depression will lower prices and wages in the capital goods industries relative to consumer goods. All prices will fall but prices and wages in capital goods will fall more sharply. In other words, both the boom and the bust will be more intense in the capital than in the consumer goods industries.

How is it that booms go on for so long? Why does it take so long for the depression adjustment to begin? The answer is that booms would be very short-lived if the bank credit expansion were just a one-shot deal. But it is not. Somewhat like the repeated doping of a horse, it proceeds on and on, never allowing the rise in cost in the capital goods industries to catch up to the inflationary rise in prices. But, when credit expansion finally stops, the piper must be paid—the longer the boom, the greater the mal-investment, the more harrowing the readjustment.

Thus, the Austrian theory explains the cluster of error (mal-investment) in the capital goods industries and, consequently, the greater intensity of boom and bust in those industries versus in consumer goods. It also explains the recurrence of the cycle—once the bust plays itself out and the banks begin to recover, they simply return to their natural tendency of credit expansion and the process starts anew.

But how does it explain stagflation—which is recession with rising prices (particularly for consumer goods)? This is the worst of both worlds for the consumer—high unemployment and increases in the cost of living.

In the old-fashioned (pre Keynesian) boom-bust cycle, prices generally went up during the boom phase, but by more for capital goods than for consumer goods. So, relative to each other , capital goods prices rose and consumer prices fell. Then, in the bust, the opposite occurred—the money supply went down, prices generally fell, but the prices of capital goods fell by more than consumer goods. So, relative to each other , capital goods prices fell and consumer prices rose .

This is still taking place. However, the difference is that the gold standard has been eliminated. This has enabled the Fed to increase the money supply at its whelm. And it does— all the time. With Keynesian “fine-tuning,” the money supply always increases whether it is during boom or recession. It is never allowed to fall. This means that consumer goods prices (the cost of living) go up (along with unemployment) during recession—indeed, the worst of both worlds for the consumer.

What are the policy implications of this Austrian analysis of the business cycle? By its nature (state bureaucrats and politicians are subject to the same motivations as all men), the State will always like to inflate and to interfere in the economy. So, the only solution is the absolute separation of money and banking from the State. Specifically, this means abolishing the Federal Reserve System and the returning to a commodity money.

Continue to the next chapter...

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