“Hayek, like Keynes, hoped to prevent a slump from developing by preventing the credit cycle from starting. But his method was very different. It was to forbid the banks to create credit, something which could be best achieved by adherence to a full gold standard. He was quite pessimistic, though, about this being practical politics, so his conclusion, like Keynes’s, was that a credit-money capitalist system is violently unstable – only with this difference, that nothing could be done about it. One can understand why Hayek’s doctrines attracted a certain kind of socialist: they seemed to reach Marx’s conclusions by a different route. Because of the Austrian school’s close attention to the institutional and political setting of a credit-money economy, Hayek’s picture of the capitalist system in action was altogether more sombre than that of conventional Anglo-Saxon economics, with its story of easy adjustments to ‘shocks.’” (Skidelsky 1992: 457).Skidelsky is actually right: the Austrian trade cycle theory requires that real world capitalism has been severely flawed for over two centuries, and serious entertainment of the theory also leads to the conclusion that the history of modern capitalism has been nothing but an endless series of unsustainable cycles. Far from being a defence of real world modern capitalism, Austrian theory is radical rejection of and attack on it. When Hayek lectured at the London School of Economics, he was working at an institution that had been founded in 1895 by the Fabian socialists Sidney Webb, Beatrice Webb and George Bernard Shaw. Socialists listening to his lectures might very well have concluded that his theory of the trade cycle was yet another nail in the coffin of capitalism, while rejecting his policy advice of doing nothing.
The Austrian school nevertheless touts itself as the purest of pure defenders of capitalism. But the actual “free markets” and alternative “capitalism” imagined by, say, Rothbardian anarcho-capitalists is a fantasy, Alice-in-Wonderland construct that has never existed in the real world. The Rothbardian vision of capitalism is one where fractional reserve banking, fiduciary media and government would be completely abolished.
But, frankly, one of the secrets of capitalism was its fractional reserve banking (FRB) system, able to expand the money supply endogenously in accordance with demand for credit, and capable of using idle resources. Fiduciary media (or money substitutes) have traditionally been bills of exchange, cheques, demand deposits, and private bank notes. Even cheques and banknotes were used increasingly in the 18th century as the use of actual gold declined. It is estimated that, in some capitalist countries by the beginning of 19th century, bills of exchange were 70% of money in circulation, and the other 30% was paper money and commodity money (Suntum 2004: 74). By contrast, Triffin (1985: 152) estimates that in 1800 bank money or credit money probably constituted less than 33% of the money supply. But by 1913 paper currency and bank deposits accounted for 90% of overall currency circulation in the world, and actual gold itself for not much more than 10%. If this is correct, gold rapidly declined to less than 50% of the money supply in the course of the 19th century. If a bill of exchange was issued and then a bank note issued based on the same gold in a demand deposit, new money was created. Gold came to function merely as a monetary base.
FRB increased commerce, trade and investment very significantly in the 19th century. The intelligent defenders of capitalism (like George Selgin) celebrate FRB, rather than condemn it. Joseph Schumpeter, for example, also realised the genius of the modern credit system:
“In this sense, therefore, we define the kernel of the credit phenomenon in the following manner: credit is essentially the creation of purchasing power for the purpose of transferring it to the entrepreneur, but not simply the transfer of existing purchasing power. The creation of purchasing power characterises, in principle, the method by which development is carried out in a system with private property and division of labour. By credit, entrepreneurs are given access to the social stream of goods before they have acquired the normal claim to it. It temporarily substitutes, as it were, a fiction of this claim for the claim itself. Granting credit in this sense operates as an order on the economic system to accommodate itself to the purposes of the entrepreneur, as an order on the goods which he needs: it means entrusting him with productive forces. It is only thus that economic development could arise from the mere circular flow in perfect equilibrium. And this function constitutes the keystone of the modern credit structure” (Schumpeter 1983 : 107).But FRB has both a positive and negative side: when credit is used to fuel asset bubbles and feverish speculation on financial or real asset markets, this in all known cases ends in the collapse of bubbles, and leads frequently to debt deflation, financial system instability, and depression or recession.
The Austrians are in fact divided into two irrational ideological extremes: on the one hand, the anti-FRB Rothbardians condemn the FRB system as immoral and blame it for all business cycles, and, on the other hand, the free banking Austrians defend FRB and labour tirelessly trying to absolve it of all charges that it creates instability. Both are false and ridiculous views.
There is no contradiction is saying that FRB has both great benefits for economic development under some circumstances, but disastrous consequences in other circumstances. The best analogy would be modern drugs: they have marvellous therapeutic value, but when used incorrectly many can kill you.
The solution to the problem of the potential instability of FRB is not to abolish it, but to regulate it, abolish commodity money and provide a lender of last resort in the form of a central bank. Far from being a perversion or distortion of capitalism, these developments were a natural and logical development of the capitalist system to a more efficient and superior form. That is why, I suspect, the mainstream neoclassicals (who are also vehement defenders of capitalism) mostly have no problems with central banking and fiat money.
Schumpeter, J. A. 1983 . The Theory of Economic Development: An Inquiry into Profits, Capital, Credit, Interest, and the Business Cycle, Transaction Books, New Brunswick, N.J. and London.
Skidelsky, R. J. A. 1992. John Maynard Keynes: The Economist as Saviour, 1920–1937 (vol. 2), Macmillan, London.
Suntum, U. van. 2004. The Invisible Hand: Economic Thought Yesterday and Today (trans. Caroline Hemingway), Springer, Berlin and New York.
Triffin, R. 1985. “Myth and Realities of the Gold Standard,” in B. Eichengreen and M. Flandreau (eds), The Gold Standard in Theory and History, Routledge, London and New York. 140–161.