According to Hayek and the Austrians a RELATIVE INFLATION Characterised the American Boom of the 1920s, Especially after 1927

The distinction between Hayek’s emphasis on relative prices and the preoccupation of the ‘stabilisation theorists’ with the price level is brought out most clearly when considering a steadily progressive economy. Here, unlike the stationary economy, the output (of consumers’ goods) is growing over time, in the simplest case due to technical progress that steadily increases the total productivity of the factors of production. Then a constant circulation of money makes the price level decline inversely to the rate of productivity growth. In fact, advocacy of such a ‘productivity norm’ for price-level behaviour was not novel. As pointed out by Robbins, such was “not the esoteric creed of a handful of ‘sadistic deflationists’”, but the opinion of many economists of repute like Marshall, Edgeworth, Taussig, Hawtrey, Robertson, and Pigou. Yet, it was Hayek’s major and novel contribution to argue for this norm as a requirement of neutrality and thus as a means to prevent the trade cycle, whereas the older economists often had rested their case on considerations of equity. 

Looking at the market for loanable funds, in order to keep prices stable in the face of growing output money must be injected into the circulation. In particular, when money is injected by credit creation this constitutes an additional supply of credit beyond that of voluntary saving, and for this additional supply to be absorbed by demand, the interest rate must fall below its equilibrium level. Yet, this is just the situation that will give rise to an unsustainable boom, and thus to the trade cycle. In the terminology of Haberler’s study this case is one of ‘relative inflation’. According to Hayek and the Austrians such a relative inflation characterised the American boom of the 1920s, especially after 1927, and consequently the stabilisation of the price level in the face of buoyant growth in productivity was to blame for causing the crisis of 1929 and eventually the Great Depression.

—Hansjoerg Klausinger, ed., editor’s introduction to The Collected Works of F. A. Hayek, vol. 7, Business Cycles, Part I, by F. A. Hayek (Carmel, IN: Liberty Fund, 2017), 35-36.

The Cherished Economic Theories Adopted and Applied Since the 1930s Are Tragically and Fundamentally Incorrect

 The current inflationary depression [1974-1975] has revealed starkly to the nation’s economists that their cherished theories—adopted and applied since the 1930s—are tragically and fundamentally incorrect. For forty years we have been told, in the textbooks, the economic journals, and the pronouncements of our government’s economic advisors, that the government has the tools with which it can easily abolish inflation or recession. We have been told that by juggling fiscal and monetary policy, the government can “fine-tune” the economy to abolish the business cycle and insure permanent prosperity without inflation. Essentially—and stripped of the jargon, the equations, and the graphs—the economic Establishment held all during this period that if the economy is seen to be sliding into recession, the government need only step on the fiscal and monetary gas—to pump in money and spending into the economy—in order to eliminate recession. And, on the contrary, if the economy was becoming inflationary, all the government need do is to step on the fiscal and monetary brake—take money and spending out of the economy—in order to eliminate inflation. In this way, the government’s economic planners would be able to steer the economy on a precise and careful course between the opposing evils of unemployment and recession on the one hand, and inflation on the other. But what can the government do, what does conventional economic theory tell us, if the economy is suffering a severe inflation and depression at the same time? Now can our self-appointed driver, Big Government, step on the gas and on the brake at one and the same time?

—Murray N. Rothbard, introduction to the 3nd edition of America’s Great Depression, 5th ed. (Auburn, AL: Ludwig von Mises Institute, 2008), xxv-xxvi.

While Monetarists and Austrians Both Focus on the Role of Money in the Great Depression, the Causal Emphases and Policy Conclusions Are Diametrically OPPOSED

 Furthermore, as in the case of Fisher and Hawtrey, the current monetarists uphold as an ethical and economic ideal the maintenance of a stable, constant price level. The essence of the cycle is supposed to be the rise and fall—the movements—of the price level. Since this level is determined by monetary forces, the monetarists hold that if the price level is kept constant by government policy, the business cycle will disappear. Friedman, for example, in his A Monetary History of the United States, 1867-1960 (1963), emulates his mentors in lauding Benjamin Strong for keeping the wholesale price level stable during the 1920s. To the monetarists, the inflation of money and bank credit engineered by Strong led to no ill effects, no cycle of boom and bust; on the contrary, the Great Depression was caused by the tight money policy that ensued after Strong’s death. Thus, while the Fisher-Chicago monetarists and the Austrians both focus on the vital role of money in the Great Depression as in other business cycles, the causal emphases and policy conclusions are diametrically opposed. 

To the Austrians, the monetary inflation of the 1920s set the stage inevitably for the depression, a depression which was further aggravated (and unsound investments maintained) by the Federal Reserve efforts to inflate further during the 1930s. The Chicagoans, on the other hand, seeing no causal factors at work generating recession out of preceding boom, hail the policy of the 1920s in keeping the price level stable and believe that the depression could have been quickly cured if only the Federal Reserve had inflated far more intensively during the depression.

—Murray N. Rothbard, introduction to the 2nd edition of America’s Great Depression, 5th ed. (Auburn, AL: Ludwig von Mises Institute, 2008), xxxiii-xxxiv.

The Chicago Approach to the Business Cycle Is No More Than a Recrudescence of the Fisher-Hawtrey Purely Monetary Theory of the 1910s and 1920s

Along with the renewed emphasis on business cycles, the late 1960s saw the emergence of the  “monetarist” Chicago School, headed by Milton Friedman, as a significant competitor to the Keynesian emphasis on compensatory fiscal policy. While the Chicago approach provides a welcome return to the pre-Keynesian emphasis on the crucial role of money in business cycles, it is essentially no more than a recrudescence of the “purely monetary” theory of Irving Fisher and Sir Ralph Hawtrey during the 1910s and 1920s. Following the manner of the English classical economists of the nineteenth century, the monetarists rigidly separate the “price level” from the movement of individual prices; monetary forces supposedly determine the former while supply and demand for particular goods determine the latter. Hence, for the monetarists, monetary forces have no significant or systematic effect on the behavior of relative prices or in distorting the structure of production. Thus, while the monetarists see that a rise in the supply of money and credit will tend to raise the level of general prices, they ignore the fact that a recession is then required to eliminate the distortions and unsound investments of the preceding boom. Consequently, the monetarists have no causal theory of the business cycle; each stage of the cycle becomes an event unrelated to the following stage.

—Murray N. Rothbard, introduction to the 2nd edition of America’s Great Depression, 5th ed. (Auburn, AL: Ludwig von Mises Institute, 2008), xxxii-xxxiii.

The Currency Is VIRTUALLY FIAT in Both the Gold Bullion and the Gold Exchange Standards (the Standards Used in the 1920s)

The nobility of the American aim to help Europe return to the gold standard becomes even more questionable when we realize that Europe never did return to a full gold standard. Instead, it adopted a “gold bullion” standard, which prohibited gold coinage, thus restricting gold convertibility to heavy bars suitable only for large international transactions. Often it chose a “gold exchange” standard, under which a nation keeps its reserves not in gold but in a “hard” currency like dollars. It then redeems its units only in the other country’s harder currency. Clearly, this system permits an international “pyramiding” of inflation on the world’s given stock of gold. In both the gold bullion and the gold exchange standards, the currency is virtually fiat, since the people are de facto prohibited from using gold as their medium of exchange. The use of the term “gold standard” by foreign governments in the 1920s, then, was more of a deception than anything else. It was an attempt to draw to the government the prestige of being on the gold standard, while actually failing to abide by the limitations and requirements of that standard. Great Britain, in the late 1920s, was on a gold bullion standard, and most other “gold standard countries” were on the gold exchange standard, keeping their titles to gold in London or New York. The British position, in turn, depended on American resources and lines of credit, since only America was on a true gold standard.

—Murray N. Rothbard, America’s Great Depression, 5th ed. (Auburn, AL: Ludwig von Mises Institute, 2008), 148-149.

The Boom CANNOT Continue Indefinitely; The Public Awakens to the Policy of Permanent Inflation and Flees from Money into Goods

It might be objected that depression only began when credit expansion ceased. Why shouldn’t the government continue credit expansion indefinitely? In the first place, the longer the inflationary boom continues, the more painful and severe will be the necessary adjustment process. Second, the boom cannot continue indefinitely, because eventually the public awakens to the governmental policy of permanent inflation, and flees from money into goods, making its purchases while the dollar is worth more than it will be in future. The result will be a “runaway” or hyperinflation, so familiar to history, and particularly to the modern world. Hyperinflation, on any count, is far worse than any depression: it destroys the currency—the lifeblood of the economy; it ruins and shatters the middle class and all “fixed income groups”; it wreaks havoc unbounded. And furthermore, it leads finally to unemployment and lower living standards, since there is little point in working when earned income depreciates by the hour. More time is spent hunting goods to buy. To avoid such a calamity, then, credit expansion must stop sometime, and this will bring a depression into being.

—Murray N. Rothbard, America’s Great Depression, 5th ed. (Auburn, AL: Ludwig von Mises Institute, 2008), 23.

One Can NEVER Understand the Operation of a Private Property Society IF One Thinks in Terms of the TOTALITY of a Society’s Economy

The old tendency, taken over from the Cameralists, to base the analysis of economic problems of the “national economy,” on the “totality” and not on the acting human subjects, seems hard to eradicate. In spite of all the warnings of the subjective economists, we continue to observe relapses. It is one of the lesser evils that ethical judgments regarding phenomena are presented under the guise of scientific objectivity. For example, productive activity (i.e., activity carried out in an imagined socialist community led by the critic) is contrasted with profit-seeking activity (i.e., the activity of individuals in a society based on private property in the means of production). The former will be viewed as the “just” and the latter as the “unjust” mode of production. Much more important is the fact that if one thinks in terms of the totality of a society’s economy, one can never understand the operation of a society based on private property in the means of production. It is erroneous to maintain that the necessity for the collectivist method can be proved by showing that actions of the individuals can only be understood within the framework of that individual’s environment. This is so because economic analysis does not depend on the psychological understanding of the motives of action, but only an understanding of action itself. It is unimportant for catallactics why bread, clothes, books, cannons or religious items are desired on the market; it is only important that a certain demand does exist. The mechanism of the market and, therefore, the laws of the capitalistic economy can only be grasped if one begins with the forces operating on the market. But on the market there are only individuals acting as buyers and sellers, never the “totality.” In economic theory, the totality can be taken only in the sense of an economic collective where the means of production are entirely outside the orbit of exchange and, therefore, cannot be sold for money. Here there is neither room for price theory nor a theory of money. But if we wish to grasp the value problems of a collective economy, we can  — ironically — only use that method of analysis which has come to be known as the “individualistic method.”

—Ludwig von Mises, “The Position of Money among Economic Goods,” in Money, Method, and the Market Process: Essays by Ludwig von Mises, ed. Richard M. Ebeling (Norwell, MA: Kluwer Academic Publishers, 1990), 60-61.

The Austrian Theory of the Business Cycle Is a MICROECONOMIC PROCESS as the Price of Time Is Severed from the Preferences that Underlie It

It is the unobservability of the natural rate that is central to understanding the Austrian theory of the business cycle. Because the natural rate of interest is a theoretical construct and not a phenomenon observable on any real market, we cannot know with certainty that any given market rate of interest is accurately reflecting the underlying natural rate. It is in this sense that the Austrian theory of the business cycle is ultimately a microeconomic process; the problem begins with a price that becomes severed from the preferences that are supposed to underlie it. The whole theory elaborates the microeconomic results of that mistaken price signal. Because the price in question is the price of time, and all economic production involves time, the effects of that erroneous price are much more pervasive than those of any other price. It is that pervasiveness that makes the Austrian cycle theory ‘macroeconomic.’ It is not, however, macroeconomic in the sense of explaining some relationship among aggregates. This confusion arises with some frequency, especially when the theory is referred to as an overinvestment theory. The problem is not that there is too much investment (per se) but that the wrong kind of investment is taking place. That distinction is not readily visible through the eyes of modern macroeconomics since Keynes, which has understood investment only in terms of some aggregate measure rather than as part of an interconnected capital structure where the composition of investment is just as important as its overall level.

—Steven Horwitz, Microfoundations and Macroeconomics: An Austrian Perspective, Foundations of the Market Economy (London: Taylor & Francis e-Library, 2003), 126.

IS-LM Analysis Is Unable to Handle the EX ANTE Situation with Investment NOT Equal to Savings

The fundamental problem with the IS curve is that the equilibrium condition that defines the curve ignores the crucial difference between ex ante and ex post savings and investment. Ex post investment always equals savings, i.e., if investment is taking place, the savings must have come from somewhere. However, investment and savings need not be equal ex ante, and this is the point that IS-LM analysis is unable to handle. If the market rate of interest is inconsistent with the underlying preferences of savers and investors, then ex ante savings and investment may not be equal, triggering system-wide changes in prices and resource allocation, including labor. The whole Wicksellian / monetary equilibrium tradition we shall explore is centered around the way that market forces attempt to correct ex ante disequilibria, and the patterns of discoordination that such attempts can engender. For Wicksellians, it is ex ante disequilibria in the loanable funds market that explain movements in the price level and the resulting economic discoordination. However, by not addressing the possibility of ex ante disequilibrium, the IS-LM mechanism, and Keynes of The General Theory, overlook the entire set of problems that interest a post-Wicksellian, and to that extent Austrian, macroeconomist. 

—Steven Horwitz, introduction to Microfoundations and Macroeconomics: An Austrian Perspective, Foundations of the Market Economy (London: Taylor & Francis e-Library, 2003), 8-9.

Forced Saving Occurs When Investment Expenditure Is Financed by Monetary Expansion

 According to Keynes, fiscal expansion would increase the price of ‘wage goods’ (that is, consumer goods) as a result of diminishing returns. This would simultaneously reduce real wages and increase profitability. Yet the concept of ‘forced saving’ was denied. Forced saving occurs when investment expenditure is financed by monetary expansion: as resources are reallocated to the production of capital goods, fewer commodities are available to consumers, and so forced saving takes place. Forced saving provided a key element in the Loanable Funds theory of interest rate determination. Later attempts to reconcile the Loanable Funds theory with Keynes’s Liquidity Preference theory are critically examined, and the latter is judged to be an unwarranted generalisation based upon very special circumstances.

—G. R. Steele, introduction to Monetarism and the Demise of Keynesian Economics (New York: St. Martin’s Press, 1989), 4.

The Interest Rate Is a Function of the Supply and Demand for Loanable Funds

The business cycle is caused by the changes in the money supply that affect relative prices, and most importantly, the interest rate. One might consider why investors do not perceive these misleading price signals, and the reason is that individuals are not in a good position to separate out changes in prices due to changes in underlying supply and demand conditions from changes in prices due to monetary factors. In addition to the inevitable uncertainty about the future that has already been noted, as economic progress occurs, people may change their time preference. Increasing incomes can lead individuals to defer some consumption until later, saving more and consuming less in the present. This would increase the supply of loanable funds and lower the interest rate as a result of real changes in preferences rather than changes induced by monetary factors. Savers and investors can respond to market signals, but do not have a good way of separating interest rate changes caused by changes in time preference from changes due to monetary fluctuations. 

Garrison (2001) discusses changes in the interest rate that might be due to technological advances. If a new technology is developed for producing consumer goods, that technology might require investment in the short term to produce the goods that are anticipated to be profitable in the long run. An increase in investment demand will cause the interest rate to rise in the short run, but that short run might be a period of years before the technology is finally in place and able to deliver the consumer goods. This is an example with the larger point being that the interest rate is a function of the supply and demand for loanable funds. Many factors influence the supply and demand for loanable funds, and the effect of monetary expansion and contraction on the supply of loanable funds is only one factor. Entrepreneurs will, of course, try to discern and separate monetary causes for fluctuations in the interest rate from other causes, but in a complex economy nobody can do this perfectly. Market participants can see the actual market rate but can only conjecture about the importance of various factors that cause that rate to be at its current level. 

—Randall G. Holcombe, Advanced Introduction to the Austrian School of Economics, Elgar Advanced Introductions (Cheltenham, UK: Edward Elgar Publishing, 2014), 80-81. 

Non-Austrian Views of the Business Cycle View a Booming Economy as a Healthy One

Rothbard (1963), taking an Austrian school approach, describes the cause of the Great Depression as the result of malinvestment that occurred during the 1920s. Monetary expansion during the 1920s led to the boom period described by Mises and Hayek. The Keynesian explanation for the Depression is that aggregate demand declined, largely due to the volatility of investment demand that suffered a substantial reduction after the stock market crash of 1929. The monetarist explanation was that because of problems with the banking system, the money supply declined precipitously following the 1929 stock market crash, and that monetary contraction turned what would have been a much less severe recession into the Great Depression. 

The Austrian explanation distinguishes itself by tracing the causal factors back to malinvestment during the upturn in the cycle. The problems leading to the business cycle occur during the upturn, and the downturn is the recovery phase, during which dislocations occur as people reallocate their resources away from unsustainable uses, as Horwitz (2000) notes. The significance of malinvestment as a cause of the downturn naturally focuses attention on the importance of recognizing the heterogeneity of capital. The Keynesian, monetarist and more recent general equilibrium models of the business cycle do not see the causes as being created by malinvestment prior to the downturn because those models do not account for the heterogeneity of capital. Non-Austrian views of the business cycle view a booming economy as a healthy one, whereas the Austrian school sees the downturn as the inevitable consequence of malinvestment during the boom phase.

—Randall G. Holcombe, Advanced Introduction to the Austrian School of Economics, Elgar Advanced Introductions (Cheltenham, UK: Edward Elgar Publishing, 2014), 80. 

Coase’s Transaction-Cost Theory of the Firm Can Be Interpreted as Attempting to Strengthen the Argument for Market Socialism

 Instead, however, Coase chooses a very different approach, in which the market’s resource allocation, in accordance with Salter’s and Plant’s teachings, is efficient but in which it appears costly to use the price mechanism. Doing this, Coase formulates an argument that seems intended to undermine Mises’s case for free-market resource allocation by showing that the cost of using the price mechanism makes it imperfect (costly) for coordinating production. While the allocative result of the price mechanism may be superior (even with transaction costs), this is insufficient, since the assumption often made in economic theory—that prices are known—“is clearly not true of the real world.” This identification is well in line with Coase’s lifelong contribution to economic research, which has been dedicated to “the study of the working of the real world economic system.”

The ‘costly market’ approach plays well into the market socialists’ argumentation for the possibility of socialism, as discussed above, and their proposed schemes to overcome Mises’s calculation problem by providing socialism with centrally regulated, advertised (therefore easily known) list prices. Coase's transaction-cost theory of the firm can, in this sense, be interpreted as attempting to undermine the theory of capitalism and, at the same time, strengthen the argument for market socialism.

Really, Coase’s argument essentially echoes that of Taylor (1929): socialism (or the firm) can be as efficient as capitalism, yet have the benefit of being less costly. Coase’s concurrent work on accounting appears to strengthen this interpretation.

—Per L. Bylund, “Ronald Coase’s ‘Nature of the Firm’ and the Argument for Economic Planning,” Journal of the History of Economic Thought 36, no. 3 (September 2014): 320-321.

Although Taken for Granted, the Business Firm as an Economic Phenomenon Is One of the Most Complicated to Explain

 It may not be much of an exaggeration to claim that many of science’s great achievements have been of one of two kinds: it has shown that what was believed to be impossibly complex is in fact the result of a rather simple mechanism or process; and it has shown that what was thought of as simple or taken for granted was in fact quite complicated or even beyond our ability to explain. In line with the latter, it indeed seems often to be the case that what appears to be most glaringly obvious may sometimes be the very hardest to explain. The business firm as an economic phenomenon clearly falls in this category. 

To the non-academic, the firm presents little problem. Perhaps this is the reason why it was taken for granted for so long also in the study of economics. While the firm has often been present in different forms of analyses and theorising, it has far less often been subject to scrutiny. Adam Smith famously discusses the division of labour exemplified by work with a pin factory and Karl Marx similarly discusses the use and exploitation of labour within factories, to mention only two noteworthy examples. Yet neither of them ask the fundamental question of why there are firms. This, in fact, is almost exclusively the case for economists and social theorists for all but the last century. If the modern account of the recent history of economics is to be trusted, this question remained unasked until a very young Ronald H. Coase posed it in his Nobel-winning article ‘The Nature of the Firm’ published in 1937. Coase’s article was not the first to study firms, but it is generally regarded as the beginning of the modern theory of the firm literature — the tradition that asks why there are firms.

—Per L. Bylund, introduction to The Problem of Production: A New Theory of the Firm, Routledge Advances in Heterodox Economics 27 (London: Routledge Taylor and Francis Group, 2016), 1.

The Ergodic Presumption Is the Essential Foundation of Classical Efficient Market Theory

To grasp Keynes’s theory, one must first consider the contrasting framework, accepted down to our day by most economists, which Keynes rejected. In that view, everything is fine as long as prices and wages are flexible. If prices can adjust to changes in business expectations, why should there ever be a serious problem? Davidson contends that this way of thinking rests on a flawed assumption. Advocates of the standard model imagine that accurate markets exist, not only for present transactions, but for future contracts as well.

The assumption of accurate futures markets in turn rests on a hypothesis, which Davidson deems the crucial principle of neoclassical economics.

Since drawing a sample from the future is not possible, efficient market theorists presume that probabilities calculated from already existing past and current market data are equivalent to drawing a sample from markets that will exist in the future . . . the presumption that data samples from the past are equivalent to data samples from the future is called the ergodic axiom. Those who invoke this ergodic assertion argue that economics can be a “hard science” like physics or astronomy only if the ergodic axiom is part of the economist’s model. . . . The ergodic presumption is the essential foundation of classical efficient market theory.

Readers will not be surprised to learn that Samuelson, who evidently ranks high on the list of Davidson ’s villains, fervently endorses the ergodic axiom. 

Keynes saw the fallacy in this assumption. The future is in fact radically uncertain.

The classical ergodic axiom, which assumes that the future is known and can be calculated as the statistical shadow of the past, was one of the most important classical assumptions that Keynes rejected. . . . For decisions that involved potential large spending outflows or possible large income inflows that span a significant length of time, [Keynes argued that] people “know” that they do not know what the future will be. They do know that for these important decisions, making a mistake about the future can be very costly . . . 

Keynes, the author of A Treatise on Probability, was well equipped to make this fundamental point. 

Davidson is right that Keynes has here scored heavily against neoclassical economics. But the uncertainty of the future hardly suffices to establish the validity of the Keynesian system. For one thing, Austrian economics also emphasizes the uncertainty of the future. It is constantly stressed by Mises, who goes so far as to claim that the uncertainty of the future is a praxeological law, deduced from the action axiom. Davidson never so much as mentions the Austrian School in this book. For him, only the efficient-market economists, with their false ergodic assumption, and their Keynesian rivals count.  

—David Gordon, review of The Keynes Solution: The Path to Global Economic Prosperity, by Paul Davidson, The Mises Review 15, no. 3 (Fall 2009), under “The Discussion of Chapter 19 of the General Theory,” https://mises.org/library/keynes-solution-path-global-economic-prosperity-paul-davidson (accessed May 12, 2021).

Hayek Attempts to Resolve the Dilemma between Equilibrium Theory and the Disequilibrium Associated with Business Cycles

In Monetary Theory and the Trade Cycle, Hayek draws attention to the deficiency of equilibrium theory to explain “why a general disproportionality between supply and demand should arise.” The solution to this problem, Hayek notes, is not to be found by changes originating within the equilibrium construct nor by the methods of equilibrium analysis since “the essential means of explanation in static theory . . . is the assumption that prices supply an automatic mechanism for equilibrating supply and demand.” In resolving the dilemma between equilibrium theory and the disequilibrium associated with business cycles, Hayek argues that it is only the introduction of money that can provide a “new determining cause” capable of explaining “the difference between the course of events described by static theory . . . and the actual course of events.” The introduction of money, Hayek tells us, “does away with the rigid interdependence and self-sufficiency of the ‘closed’ system of equilibrium and makes possible movements which would be excluded from the latter.” . . . 

My remarks perhaps come in somewhat sharper relief if we examine Hayek’s discussion of neutral money in the Appendix to Lecture IV of Prices and Production. In general, neutral money is employed by Hayek to describe a monetary economy that has achieved a constellation of relative prices as if money were not present; it would involve an economy fully specifiable by equilibrium theory. In reflecting on the suitability of the neutral money concept as an objective of monetary policy, Hayek says:

. . . the term points, of course, only to a problem, and does not represent a solution. . . . The necessary starting point for any attempt to answer the theoretical problem seems to me to be the recognition of the fact that the identity of demand and supply, which must necessarily exist in the case of barter, ceases to exist as soon as money becomes the intermediary of the exchange transaction. The problem then becomes one of isolating the one-sided effects of money . . . which will appear when, after the division of the barter transaction into separate transactions, one of these takes place without the other complementary transaction. In this sense, demand without corresponding supply, and supply without a corresponding demand, evidently seem to occur. . . . 

—William N. Butos, “Hayek and General Equilibrium Analysis,” Southern Economic Journal 52, no. 2 (October 1985): 338.

Philosophically, Friedmanism Would Destroy Money Itself and Reduce Us to the Chaos and Primitivism of the Barter System

There is no question about the fact that the present international monetary system is an irrational and abortive monstrosity, and needs drastic reform. But Friedman’s proposed reform, of cutting all ties with gold, would make matters far worse, for it would leave everyone at the complete mercy of his own fiat-issuing state. We need to move precisely in the opposite direction: to an international gold standard that would restore commodity money everywhere and get all the money-manipulating states off the backs of the peoples of the world. 

Furthermore, gold, or some other commodity, is vital for providing an international money—a basic money in which all nations can trade and settle their accounts. The philosophical absurdity of the Friedmanite plan of each government providing its own fiat money, cut loose from all others, can be seen clearly if we consider what would happen if every region, every province, every state, nay every borough, county, town village, block, house, or individual would issue its own money, and we then had, as Friedman envisions, freely fluctuating exchange rates between all these millions of currencies. The ensuing chaos would stem from the destruction of the very concept of money—the entity that serves as a general medium for all exchanges on the market. Philosophically, Friedmanism would destroy money itself, and reduce us to the chaos and primitivism of the barter system. 

One of Friedman’s crucial errors in his plan of turning all monetary power over to the State is that he fails to understand that this scheme would be inherently inflationary. For the State would then have in its complete power the issuance of as great a supply of money as it desired. Friedman’s advice to restrict this power to an expansion of 3–4% per year ignores the crucial fact that any group, coming into the possession of the absolute power to “print money,” will tend to . . . print it!

 —Murray N. Rothbard, “Milton Friedman Unraveled,” Journal of Libertarian Studies 16, no. 4 (Fall 2002): 50.

“The Business Cycle Largely a ‘Dance of the Dollar’” (1923) Set the Model for the “Purely Monetary” Theory of the Business Cycle

In keeping with this outlook, Irving Fisher wrote a famous article in 1923, “The Business Cycle Largely a ‘Dance of the Dollar’”—recently cited favorably by Friedman—which set the model for the Chicagoite “purely monetary” theory of the business cycle. In this simplistic view, the business cycle is supposed to be merely a “dance,” in other words, an essentially random and causally unconnected series of ups and downs in the “price level.” The business cycle, in short, is random and needless variations in the aggregate level of prices. Therefore, since the free market gives rise to this random “dance,” the cure for the business cycle is for the government to take measures to stabilize the price level, to keep that level constant. This became the aim of the Chicago School of the 1930s, and remains Milton Friedman’s goal as well. 

Why is a stable price level supposed to be an ethical idea, to be attained even by the use of governmental coercion? The Friedmanites simply take the goal as self-evident and scarcely in need of reasoned argument. But Fisher’s original groundwork was a total misunderstanding of the nature of money, and of the names of various currency units. In reality, as most nineteenth century economists knew full well, these names (dollar, pound, franc, etc.) were not somehow realities in themselves, but were simply names for units of weight of gold or silver. It was these commodities, arising in the free market, that were the genuine moneys; the names, and the paper money and bank money, were simply claims for payment in gold or silver. But Irving Fisher refused to recognize the true nature of money, or the proper function of the gold standard, or the name of a currency as a unit of weight in gold. Inst4ead, he held these names of paper money substitutes issued by the various governments to be absolute, to be money. The function of this “money” was to “measure” values. Therefore, Fisher deemed it necessary to keep the purchasing power of currency, or the price level, constant. 

This quixotic goal of a stable price level contrasts with the nineteenth-century economic view—and with the subsequent Austrian School. They hailed the results of the unhampered market, of laissez faire capitalism, in invariably bringing about a steadily falling price level. For without the intervention of government, productivity and the supply of goods tends always to increase, causing a decline in prices. Thus, in the first half of the nineteenth century—the “Industrial Revolution”—prices tended to fall steadily, thus raising the real wage rates even without an increase of wages in money terms. We can see this steady price decline bringing the benefits of higher living standards to all consumers, in such examples as TV sets falling from $2000 when first put on the market to about $100 for a far better set. And this in a period of galloping inflation. 

—Murray N. Rothbard, “Milton Friedman Unraveled,” Journal of Libertarian Studies 16, no. 4 (Fall 2002): 46-47.

The Key Problem with Friedman’s Fisherine Approach Is the Same Orthodox Separation of the Micro and Macro Spheres

The third major feature of the New Deal program was proto-Keynesian: the planning of the “macro” sphere by the government in order to iron out the business cycle. In his approach to the entire area of money and the business cycle—an area on which unfortunately Friedman has concentrated most of his efforts—Friedman harks back not only to the Chicagoans, but, like them, to Yale economist Irving Fisher, who was the Establishment economist from the 1900s through the 1920s. Friedman, indeed, has openly hailed Fisher as the “greatest economist of the twentieth century,” and when one reads Friedman’s writings, one often gets the impression of reading Fisher all over again, dressed up, of course, in a good deal more mathematical and statistical mumbo-jumbo. Economists and the press, for example, have been hailing Friedman’s recent “discovery” that interest rates tend to rise as prices rise, adding an inflation premium to keep the “real” rate of interest the same; this ignores the fact that Fisher had pointed this out at the turn of the twentieth century. 

But the key problem with Friedman’s Fisherine approach is the same orthodox separation of the micro and macro spheres that played havoc with his views on taxation. For Fisher believed, again, that on the one hand there is a world of individual prices determined by supply and demand, but on the other hand there is an aggregate “price level” determined by the supply of money and its velocity of turnover, and never the twain do meet. The aggregate, macro, sphere is supposed to be the fit subject of government planning and manipulation, again supposedly without affecting or interfering with the micro area of individual prices.

—Murray N. Rothbard, “Milton Friedman Unraveled,” Journal of Libertarian Studies 16, no. 4 (Fall 2002): 45-46.

Friedman and Schwartz’s Case That the Demand for Money (the Inverse of Velocity) Is Constant Is Statistical Legerdemain (a Sleight of Hand)

For many years I [Joseph T. Salerno]—and other Austrians—have had to endure charges by monetarists that Murray Rothbard fudged the data to increase monetary growth rates during the 1920s in order to portray it as an inflationary decade. As I argued in an exchange with eminent monetary historian Richard Timberlake these allegations are baseless. So, now it is with delicious irony that I draw your attention to an explosive article by three econometricians thoroughly debunking the empirical claim made by Milton Friedman and Anna Schwartz that the velocity of money in the U.S. has exhibited long-run stability for more than a century leading up to 1975. 

Neil Ericsson, David Hendry, and Stedman Hood argue that dubious “data adjustment” in Friedman and Schwartz’s empirical models “dramatically reduced apparent movement of the velocity of circulation of money and . . . adversely affected the constancy and fit of his estimated money demand models.” In other words, Friedman and Schwartz’s empirical case that the demand for money (the inverse of velocity) is constant, which Friedman and Schwartz painstakingly elaborated in three statistical tomes published from 1963 to 1982 and which is the linchpin of monetarism, has been exposed as statistical legerdemain. 

Friedman and Schwartz adjusted the raw data to account for: 1. the sudden onset of rapid developments of financial instruments and institutions in the U.S. economy compared to the U.K. economy; and 2. short-run fluctuations in velocity associated with business cycles. In adjusting for “changing financial sophistication,” Ericsson et al. point out, Friedman and Schwartz added a linear trend of 2.5% on money supply observations prior to 1903, but made no trend adjustment at all to the data after that year. In the process, they “adjusted” the money stock for 1867 from its raw or unadjusted value of $1.28 billion to $3.15 billion. This is a phantom increase of 246% on the observed money stock! The result of this trend adjustment was to substantially suppress the effect of the precipitous decline in observed velocity of more than 50% from the early 1870s to 1903 on its variability over the entire period studied (1867-1975). Thus although the adjustment applies to only 30% of the period studied, it accounts for almost 75% of the total variance of velocity.

—Joseph T. Salerno, “Milton Friedman Debunked—by Econometricians,” Mises Wire, entry posted May 12, 2017, https://mises.org/wire/milton-friedman-debunked-econometricians (accessed April 16, 2021).

The Parallels between the Myth of the Laissez-Faire Hoover and the Myth of the Do-Nothing Fed Are Striking

In addition to the myth of the laissez-faire Herbert Hoover, another popular theory of the Great Depression blames the do-nothing Federal Reserve. Ironically, this interpretation comes, not from Big Government critics of the free market, but instead from none other than Milton Friedman and his monetarist followers. Just as modern-day Keynesians urge the government to “avoid the mistakes of Hoover” by running up massive deficits, so too do modern monetarists urge the Fed to “avoid the mistakes of the Depression” by injecting massive amounts of reserves into the banking system. 

The parallels between the myth of the laissez-faire Hoover and the myth of the do-nothing Fed are striking. Just as Hoover engaged in unprecedented “stimulus” through his fiscal policies, so too did the Fed—starting immediately after the stock market crash in 1929—engage in unprecedented “easy money” policies. Because the massive budget deficits eventually forced Hoover to reverse course and raise taxes (in 1932), modern Keynesians say Hoover didn’t borrow-and-spend enough. Similarly, because a gold outflow from the country eventually forced the Fed to reverse course and tighten the money supply (in late 1931), the monetarists say the Fed didn’t inflate enough. But in both cases, the question remains: If budget deficits and cheap money were the right medicine, why was the Depression still getting worse, two years into these unprecedented fiscal and monetary remedies?

—Robert P. Murphy, “Did the Tightwad Fed’s Deflation Cause the Great Depression?” in The Politically Incorrect Guide to the Great Depression and the New Deal (Washington, DC: Regnery Publishing, 2009), 63-64.

New Keynesian Views on Monetary Theory and Policy Are More Fallacious Than Those of Their Predecessors

The essential fallacy of John Maynard Keynes and his early disciples was to cultivate the monetary equivalent of alchemy. They believed that paper money was a suitable means to alleviate the fundamental economic problem of scarcity. The printing press was, at any rate under certain plausible conditions of duress, a substitute for hard work and savings and cutting prices. 

The self-styled new Keynesians have not at all abandoned this fallacy and they therefore do not differ in any essential respect from the old Keynesians, in spite of the pains they take to distinguish themselves from the latter. The new Keynesian recommendation for monetary policy is to “stabilize the growth of aggregate demand.” In plain language this means that the monetary authorities should never stop flooding the economy with paper money. Recognizably, this is the core tenet of the old Keynesian monetary program, which in itself had been nothing but even older fallacies clothed in the new language of aggregate analysis. 

In many respects, new Keynesian views on monetary theory and policy seem to be even more fallacious than those of their predecessors. Whereas Keynes and his immediate followers were still trained in the old-fashioned art of economic reasoning, the new Keynesians are macro economic purebreds. Their expertise lies more or less exclusively in the field of modeling. As with the macroeconomics profession in general, they are devoted to a positivistic methodology, putting all their energies into modeling quantitative relationships among things that are the result of human action, rather than into the analysis of human action itself. Not surprisingly, therefore, their “science” of the economy resembles a hotchpotch of educated guesswork, conventions, and fictions, all designed to make the problems under consideration amenable to mathematical treatment. 

—Jörg Guido Hülsmann, “New Keynesian Monetary Views: A Comment,” Quarterly Journal of Austrian Economics 6, no. 4 (Winter 2003): 73.

The Textbook Rendition of the Short-Run Phillips Curve Dynamics Clashes with the Empirical Record and with a Fundamental Proposition of Monetarism

Textbook writers and even many self-identified monetarists have taken this short-run/long-run Phillips curve analysis to be the monetarists’ account of the market mechanisms that cause a money-induced boom to go bust. Much more plausibly, however, Friedman’s presidential address was intended only as immanent criticism of the views held by his Keynesian-oriented contemporaries. Many saw the Keynes-inspired downward-sloping Phillips curve as an enduring trade-off between inflation and unemployment, a virtual menu of policy choice for left-leaning politicians willing to put up with inflation in order to reduce unemployment and for right-leaning politicians willing to put up with unemployment in order to reduce inflation. Friedman’s message was simply that there is no long-run trade-off. 

The common textbook rendition of the short-run Phillips curve dynamics actually clashes both with the empirical record and with a fundamental proposition of monetarism. The low unemployment rate during the boom depends on wage rates lagging behind rising output prices. This sequence would mean that real wage rates are relatively low during the boom. But the notion of low real wages during credit-induced booms has no empirical support. (In the Austrian view, the artificially cheap credit increases investment, increases the demand for labor, and hence increases the real wage rate. In fact, the higher real wages are in large part responsible for the political popularity of credit-induced booms). 

Not long after Friedman offered his criticism of the Phillips curve as a menu of choice, he set out ten fundamental propositions of monetarism, which included the proposition that a monetary expansion causes quantities (output and, as a virtual prerequisite, employment) to increase first and prices only later. With this sequence, of course, it cannot be the rising prices that, being differentially perceived by employers and employees, are responsible for increased employment and output. Friedman actually finessed the issue of “quantities then prices” versus “prices then quantities” in his presidential address, portraying the latter as an extra boost during a later phase of the adjustment process. But it was exclusively the “prices then quantities” sequence that became the standard textbook version, formalized by Robert E. Lucas Jr. as a monetary misperception theory of the business cycle. In any case, the “quantities then prices” understanding, which Friedman favored, is evidently not strong enough to show up in his highly aggregative monetarist framework as an empirically verifiable boom-bust sequence.

—Roger W. Garrison, review of Alchemists of Loss: How Modern Finance and Government Regulation Crashed the Financial System, by Kevin Dowd and Martin Hutchinson, The Independent Review: A Journal of Political Economy 16, no. 3 (Winter 2011/2012): 444-445.

Irresponsible Monetary Policy Eventually Leads to an Increase in the Natural Rate of Unemployment

As Bellante and Garrison (1988) remind us, Friedman acknowledges that irresponsible monetary policy would eventually lead to an increase in the natural rate of unemployment. Two of Friedman’s papers (1976 and 1977) suggested the potential existence of a positively sloped Phillips curve. But in neither case did Friedman reconsider his model of dynamic monetary theory in light of his empirical work. 

In his Nobel lecture, Friedman acknowledged that additional research was needed to resolve the inconsistency between the monetarist Phillips curve and empirical data. He anticipated that this “third stage” of the research into the relationship between inflation and unemployment would only be successful if a way was found to incorporate political factors:

In recent years, higher inflation has often been accompanied by higher not lower unemployment, especially for periods of several years in length. A simple statistical Phillips curve for such periods seems to be positively sloped, not vertical. The third stage is directed at accommodating this apparent empirical phenomenon. To do so, I suspect that it will have to include in the analysis the interdependence of economic experience and political developments. It will have to treat at least some political phenomena not as independent variables—as exogenous variables in econometric jargon—but as themselves determined by economic events—as endogenous variables [. . .]. The third stage will, I believe, be greatly influenced by a third major development—the application of economic analysis to political behavior, a field in which pioneering work has also been done by Stigler and Becker as well as by Kenneth Arrow, Duncan Black, Anthony Downs, James Buchanan, Gordon Tullock, and others. (1977, p. 470)

In my doctoral thesis (Ravier, 2010), I called this “Friedman’s dilemma” because Friedman observed an empirical reality his own analytical framework was unable to explain. Friedman observes a positively sloped Phillips curve and a long-term effect of monetary stimulus which is not neutral in real terms. Both are inconsistent with his own theories. Instead he provides evidence confirming the work of Robert Lucas (1973) and, more recently, William Niskanen (2002). Robert Mulligan (2011) has demonstrated the connection between Niskanen’s article and Austrian business cycle theory.

—Adrián O. Ravier, “Dynamic Monetary Theory and the Phillips Curve with a Positive Slope,” Quarterly Journal of Austrian Economics 16, no. 2 (Summer 2013): 172-173.

The Method Used to Develop the Phillips Curve Is More Akin to That of the German Historical School

The Phillips curve is named after the British economist A. W. Phillips (1958), who in a pathbreaking article investigated the statistical relationship in the UK between the annual rate of change of money wages and the annual rate of unemployment. Later versions of the Phillips curve examined the relationship between unemployment or the rate of growth of output and, alternatively, the rate of change of product prices, and the deviation between actual and ‘expected’ inflation. 

Inasmuch as the Phillips curve is an important component of mainstream economics, its development remains a curious paradox. Logical positivism is the conventional methodology of the neoclassical mainstream and this methodological doctrine has been severely criticized by economists working within the Austrian methodological perspective. Logical positivism involves the construction of theory that is tested by empirical evidence. The resulting empirical evidence may lead to modification of the theory and further testing, but the initial theory construction always precedes empirical testing. The Phillips curve developed purely as an empirical relationship with only ad hoc theoretical rationalizations provided. Only later were attempts made to develop a theory that would ‘explain’ the statistical relationship. This method is more akin to that of the German historical school, of which criticism by the Austrian school has been much more severe. The series of currently recognized policy errors that followed from attempts to exploit the Phillips curve serves as an excellent but unfortunate example of the problems associated with ‘letting the facts speak for themselves.’

—Don Bellante, “The Phillips Curve,” in The Elgar Companion to Austrian Economics, ed. Peter J. Boettke (Aldershot, UK: Edward Elgar Publishing, 1994), 372.