Money and Banking

Mainstream economists hold that the government must control monetary policy and the structure of banking through cartels, deposit insurance, and a flexible fiat currency. Austrians reject this entire paradigm, and argue that all are better controlled through private markets. In fact, to the extent that today we have serious and radical proposals for having the market play a greater role in banking and monetary policy, it is due to the Austrian School.

Deposit insurance has been on the public mind since the collapse of the S&L industry. The government guarantees deposits and loans with taxpayer money, and that makes financial institutions less careful. Government effectively does to financial institutions what a permissive parent does to a child: encourages poor behavior by eliminating the threat of punishment.

Austrians would eliminate deposit insurance, and not only allow bank runs to occur, but appreciate their potential as a necessary check. There would be no lender of last resort that is, the taxpayer in an Austrian monetary regime, to bail out bankrupt and illiquid institutions.

Much of the Austrian critique of central banking centers around the Mises-Hayek business cycle theory. Both argued that the central bank, and not the market itself, is responsible for the cyclical behavior of business activity. To demonstrate the theory, Austrians have undertaken extensive studies of many historical periods of recession and recovery to show that each was preceded by central-bank machinations.

The theory argues that central-bank efforts to lower interest rates below their natural level causes borrowers in the capital goods industry to overinvest in their projects. A lower interest rate is normally a signal that consumers’ savings are available to back up new production. That is, if a producer borrows to build a new building, there is enough savings for consumers to buy the goods and services that will be made in the building. Projects undertaken can be sustained. But artificially lowered interest rates lead businesses into undertaking unnecessary projects. This creates an artificial boom followed by a bust once it is clear that savings weren’t high enough to justify the degree of expansion.

Austrians point out that the Monetarist growth rule ignores the “injection effects” of even the smallest increase in money and credit. Such an increase will always create this business-cycle phenomenon, even if it works to maintain a relatively stable index number, as in the 1920s and 1980s.

What then should policy makers do when the economy enters recession? Mostly, nothing. It takes time to wipe out the malinvestment created by the credit boom. Projects that were undertaken have to go bankrupt, employees mistakenly hired must lose their jobs, and wages must fall. After the economy is cleansed of the bad investments induced by the central bank, growth can begin anew, based on a realistic assessment of the future behavior of consumers.

If the government wants to make the recovery process work faster if, say, there is an election coming up there are some things it can do. It can cut taxes, putting more wealth into private hands to fuel the recovery process. It can eliminate regulations, which inhibit private-sector growth. It can cut spending and reduce the demand on credit markets. It can repeal anti-dumping laws, and cut tariffs and quotas, to allow consumers to buy imported goods at cheaper prices.

Central banking also creates incentives toward inflationary monetary policies. It is not a coincidence that since the creation of the Federal Reserve System, the value of the dollar has declined 98%. The market did not make this happen. The culprit is the central bank, whose institutional logic drives it toward an inflationary policy just as a counterfeiter is driven to keep his printing press running.

Austrians would reform this in fundamental ways. Misesians advocate a return to a 100% gold coin standard, an end to fractional-reserve commercial banking, and the abolition of the central bank, while Hayekians advocate a system where consumers select currencies from a variety of alternatives.