Typically, they complain that any increase in the money supply must always lead to a rise in the price level or the inflation rate.
Here is a video of Ron Paul complaining about the Federal Reserve’s creation of money because it will lead to inflation.
It is a view that you find frequently in pro-free market, libertarian, and populist Austrian blogs or commentary.
A very general statement of the Austrian theory of inflation can be found on Wikipedia:
“The Austrian School asserts that inflation is an increase in the money supply, rising prices are merely consequences and this semantic difference is important in defining inflation. Austrian economists believe there is no material difference between the concepts of monetary inflation and general price inflation. Austrian economists measure monetary inflation by calculating the growth of new units of money that are available for immediate use in exchange, that have been created over time. This interpretation of inflation implies that inflation is always a distinct action taken by the central government or its central bank, which permits or allows an increase in the money supply. In addition to state-induced monetary expansion, the Austrian School also maintains that the effects of increasing the money supply are magnified by credit expansion, as a result of the fractional-reserve banking system employed in most economic and financial systems in the world.”So firstly the word “inflation” is defined specifically as an increase in the money supply, and contrary to the popular definition of “an average increase in the price level.” In the Austrian theory, “inflation” is not a general increase in prices, but an increase in the money supply.
The purpose of this post is to show that many people today who are sympathetic to Austrian economics or who are self-proclaimed followers of the Austrian school actually do not understand the Austrian theory of inflation and the price level.
Many people cannot distinguish Milton Friedman’s monetarist theory of the price level (based on the quantity theory of money) from the Austrian view, which is actually quite different from Friedman’s and, moreover, has changed over time.
First, it is necessary to say a word about the quantity theory of money. Contrary to what many believe, Austrians have always had an ambivalent and even critical attitude to the quantity theory of money. The quantity theory of money is the basis of Milton Friedman’s monetarism, a macroeconomic theory that became popular in the late 1970s and early 1980s. The quantity theory is also used frequently by pro-free market writers to decry expansion of the money supply under a fiat monetary system.
However, many Austrians actually have a rather sceptical view of the quantity theory.
Ludwig von Mises, for instance,
“agreed with the classical ‘quantity theory’ that an increase in the supply of dollars or gold ounces will lead to a fall in its value or ‘price’ (i.e., a rise in the prices of other goods and services); but he enormously refined this crude approach and integrated it with general economic analysis. For one thing, he showed that this movement is scarcely proportional; an increase in the supply of money will tend to lower its value, but how much it does, or even if it does at all, depends on what happens to the marginal utility of money and hence the demand of the public to keep its money in cash balances. Furthermore, Mises showed that the ‘quantity of money’ does not increase in a lump sum: the increase is injected at one point in the economic system and prices will only rise as the new money spreads in ripples throughout the economy. If the government prints new money and spends it, say, on paper clips, what happens is not a simple increase in the ‘price level,’ as non-Austrian economists would say; what happens is that first the incomes of paperclip producers and prices of paper clips increase, and then the prices of the suppliers of the paper clip industry, and so on. So that an increase in the supply of money changes relative prices at least temporarily, and may result in a permanent change in relative incomes as well” (Rothbard 2009: 15).In other words, Mises denied that a given increase in the money supply (say, 5%) would lead to a direct, proportional and mechanistic rise of 5% in the general level of prices.
The naïve monetarists believe that there is a “monocausal” explanation of inflation: money supply growth which will cause direct, proportional increases in the price level. This is ridiculous.
Friedrich August von Hayek believed that a simple form of the quantity theory was a “helpful guide,” but was nevertheless a critic of the theory, both in the version of it propounded by Irving Fischer and the restatement of it by Milton Friedman (Arena 2002). In particular, “Hayek criticized Friedman for concentrating too much on statistical relationships (between the quantity of money and the price level), claiming that matters are not quite that simple” (Garrison 2007: 3). Modern Austrians are divided on the issue of the quantity theory of Friedman. Some continue to be critical, like Jesús Huerta de Soto:
“[sc. The equation MV=PT of the quantity theory] contains an undeniable element of truth inasmuch as it reflects the notion that variations in the money supply eventually influence the purchasing power of money (i.e., the price of the monetary unit in terms of every good and service). Nevertheless its use as a supposed aid to explaining economic processes has proven highly detrimental to the progress of economic thought, since it prevents analysis of underlying microeconomic factors, forces a mechanistic interpretation of the relationship between the money supply and the general price level, and in short, masks the true microeconomic effects monetary variations exert on the real productive structure” (Huerta de Soto 2009).The Austrians think that quantity theory is inadequate because it ignores their theory that increases in the money supply distort the productive structure of an economy – a cause, they believe, of recessions.
These Austrian views of the quantity theory are frequently ignored or simply unknown to many who hold a crude, vague or confused Austrian view of economics.
Austrians, in essence, have two objections to inflation. The visible effect (if output does not rise) is rising prices. This could be rising prices in goods and services (not necessarily uniformly), but also in the prices of financial and real assets. Austrians quite reasonably include asset price inflation in the overall price level (note that the prices of stocks, bonds, other financial assets, real estate, and commercial property are not normally included in consumer prices indices). But their further complaint is that there is also an invisible effect: the increasing money supply stops the money stock from remaining stable and hence it prevents deflation, which would increase the purchasing power of money. A rising money stock, therefore, does not allow money’s purchasing power to increase through price deflation.
With respect to asset price inflation, the Austrian view ignores the fact that effective financial regulation can prevent bubbles, especially in real assets like housing and real estate. The US, for instance, had stable housing prices from about 1950 until the mid-1970s, and the same was true in many other countries, because of regulation.
The Austrian claim that money supply increases cause the invisible effect of preventing deflation ignores the fact that, although price deflation increases money’s purchasing power, deflation can have devastating effects on economic activity. Debts, for instance, are fixed in nominal terms and, when deflation causes wage and price falls, debtors face a greater burden in repaying debt. The Austrians argue that the gold standard should be restored, but this would leave the level of the money supply subject to external factors like discoveries of gold and the current account balance. In fact, the gold standard was no guarantee of zero inflation: the UK was on the gold standard and had persistent inflation between 1897 and 1912, partly because of the influx of gold from new discoveries.
Furthermore, when we examine articles on the Austrian theory of inflation at the Ludwig von Mises Institute by more academic Austrian scholars, we even find a more balanced argument:
“the essence of inflation is not a general rise in prices but an increase in the supply of money, which in turns sets in motion a general increase in the prices of goods and services .... While increases in money supply (i.e., inflation) are likely to be revealed in general price increases, this need not always be the case. Prices are determined by real and monetary factors. Consequently, it can occur that if the real factors are pulling things in an opposite direction to monetary factors, no visible change in prices might take place. In other words, while money growth is buoyant – i.e., inflation is high – prices might display low increases.”Shostak also believes that increasing the money supply leads to a misallocation of resources. This is indeed possible, especially in an unregulated financial system, but it is by no means necessary or inevitable. Credit has to be given to the Austrians for their business cycle theory, because at the time when they first produced it (in the 1920s and 1930s) it was an improvement over the neoclassical view that business cycles caused by a failure of aggregate demand could not occur in capitalism because of Say’s law, and also because the Austrians (like the post Keynesians) correctly saw that money is not “neutral”. However, Austrian business cycle theory still has major flaws and it cannot be accepted, though that is a topic for another essay.
Frank Shostak, “Defining Inflation,” Mises Daily, March 6, 2002.
The important point, however, is that Shostak is careful to qualify his statement quoted above. He says that increasing the money supply will always cause an increase in the level of prices, but then concedes that prices are also “determined by real and monetary factors. Consequently, it can occur that if the real factors are pulling things in an opposite direction to monetary factors, no visible change in prices might take place.”
This is a very important qualification. He is right that the inflation rate (the rate of increase in a price index like the CPI) and changes in the level of prices also depend very much on real factors, as well as monetary ones. For example, the following factors could tend to decrease the level of prices:
1. the falling prices of specific goods through increasing productivity or output;In reality, all or some of these factors listed above could operate to cause either a zero inflation rate (which Japan actually had in 1996 and 2004) or a fall in average prices (deflation), even when the money supply is still actually increasing.
2. an appreciating exchange rate;
3. a rise in cheaper imports into a country;
4. falls in the prices of imported basic commodities that are factor inputs;
5. changes in the velocity of circulation of money;
6. higher unemployment (= less demand for goods and services), and
7. a fall in extension of bank credit.
We can take a real world example. In the late 19th century, the UK experienced sustained price deflation from 1873–1896. However, the actual broad money stock was rising in these years: between 1873–1896 the money stock grew by about 1.3% a year, or over the entire period by about 33%. Yet between 1873–1896 wholesale prices fell by 39%. What happened was that in this period the money supply was rising, but not as fast as demand for money, and also steep falls in the prices of agricultural commodities contributed to the fall in overall prices (Capie and Wood 1997: 287–289).
Now Shostak’s slightly more balanced Austrian view that an increasing money supply does not always necessarily lead to a rise in the price level is hardly ever considered by popular proponents of Austrian school economics.
Instead, we hear endless rants about how increasing the money supply always and automatically devalues or reduces money’s purchasing power.
This simply ignores the fact that the mechanism that reduces the purchasing power of money is an average increase in the price level.
Once it is conceded that (1) the relationship between a rising money stock and rising price level is not automatic, necessary or inevitable and (2) the Austrian business cycle theory is wrong, most of the popular and crude objections to an increasing money supply collapse.
But there is more to be said. If we go right back to the work of Ludwig von Mises in The Theory of Money and Credit (1912), we actually find another definition of inflation:
“In theoretical investigation there is only one meaning that can rationally be attached to the expression Inflation: an increase in the quantity of money (in the broader sense of the term, so as to include fiduciary media as well), that is not offset by a corresponding increase in the need for money (again in the broader sense of the term), so that a fall in the objective exchange-value of money must occur. Again, Deflation (or Restriction, or Contraction) signifies: a diminution of the quantity of money (in the broader sense) which is not offset by a corresponding diminution of the demand for money (in the broader sense), so that an increase in the objective exchange-value of money must occur. If we so define these concepts, it follows that either inflation or deflation is constantly going on, for a situation in which the objective exchange-value of money did not alter could hardly ever exist for very long. The theoretical value of our definition is not in the least reduced by the fact that we are not able to measure the fluctuations in the objective exchange-value of money, or even by the fact that we are not able to discern them at all except when they are large” (Mises 1953).This definition of inflation is hardly ever used by popular followers of Austrian school economics.
The fundamental fact is that Mises did not define an increase in the money supply accompanied by a corresponding demand for money as inflation.
As interpreted by a modern Austrian scholar:
“Mises …. suggests inflation [is] … ‘an increase in the quantity of money above the market demand of money.’ Note that, under Mises’ suggested definition, not every increase in the quantity of money is inflation, only increases that exceed market demand …. [Mises] saves the term inflation for cases where the quantity of money is increasing above the market demand for money” (Cachanosky 2009: 5).That means that the money supply can continuously rise in proportion to the demand for money, and that this is presumably not objectionable in Mises’ theory.
This is a far cry from some modern advocates of a crude Austrian or quantity theory of money, who complain that any increase in the money supply is bad and will cause a rise in prices.
In addition, if you reject Austrian business cycle theory, this passage quite obviously raises the question of why a rise in fiat money in response to the demand for it in an economy with effective financial regulation that channels credit to productive investments (rather than asset bubbles or speculation) would be a bad thing.
Arena, R., 2002, “Monetary Policy and Business Cycles: Hayek as an Opponent to the Quantity Theory Tradition,” in J. Birner, P. Garrouste, T. Aimar (eds), F. A. Hayek as a Political Economist: Economic Analysis and Values, Routledge, London.
Cachanosky, N., 2009, “The Definition of Inflation According to Mises: Implications for the Debate on Free Banking,” Libertarian Papers Vol. 1, Art. No. 43.
Capie F. H. and G. H. Wood, 1997, “Great Depression of 1873-1896,” in D. Glasner et al. (eds), Business Cycles and Depressions: An Encyclopedia, Garland Pub., New York, 287–289.
Garrison, R., 2007, “Hayek and Friedman: Head to Head”
Huerta de Soto, J., 2009, “A Critique of the Mechanistic Monetarist Version of the Quantity Theory of Money,” Economicthought.net
Mises, L. von, 1953, The Theory of Money and Credit (trans. H.E. Batson), J. Cape, London.
Quiggin, J., 2009, “Austrian Business Cycle Theory,” May 3rd
Rothbard, M. N., 2009, The Essential von Mises, von Mises Institute, Auburn, Alabama.
Shostak, F., 2002, “Defining Inflation,” Mises Daily, March 6