[Originally published February 2007.]
It is hard to think of a slogan that nurtures anti–free market sentiment as strongly as the term “stabilization policy.” To Ludwig von Mises, stabilization policy was a direct consequence of the failure of government’s interventionism in the field of monetary affairs:
Shortcomings in the governments’ handling of monetary matters and the disastrous consequences of policies aimed at lowering the rate of interest and at encouraging business activities through credit expansion gave birth to the ideas which finally generated the slogan “stabilization.”1
However, stabilizing the purchasing power of money is exactly what today’s central banks, the agencies of government-held money supply monopolies, are trying to deliver. Following Irving Fisher’s index regime,2 monetary policies around the world have been assigned the mandate of preserving “price stability.” The latter is usually defined as a (consumer) price index to be held constant over time, e.g., allowed to increase only at a small and pre-determined percentage over time.
To Mises, a monetary policy aiming at preserving price stability did not stem from attempts to improve economic calculation but to fight the concept of the free market:
The idea of rendering purchasing power stable did not originate from endeavors to make economic calculation more correct. Its source is the wish to create a sphere withdrawn from the ceaseless flux of human affairs, a realm which the historical process does not affect.3
For economists of the Austrian school, the monetary policy objective of price stability is a recipe for bringing about disastrous results, namely recurrent economic crises, which in turn ultimately lead to a destruction of economic and political freedom. With price stability having become so widely favored, it is important to outline the Austrian School’s thinking in some more detail.
Impossibility of Money Stability
The starting point for Austrian economists is the observation that human action in a free society is characterized by ongoing, perpetual change. In a market economy, people continually choose among alternatives, leading to ever-changing valuations of goods and services bought and sold. Searching for absolute stability of vendible items’ exchange ratios would therefore be an erroneous and futile undertaking. This insight applies also to the exchange ratio of money.
Money is a means of exchange. As such it is subject to peoples’ actions and valuations in the same way that all other economic goods and services are. As a result, money’s subjective and objective exchange values continually fluctuate, and there is no such a thing as the stability of the exchange ratio of money vis-à-vis other goods and services; in a free-market economy there aren’t fixed exchange ratios.
What about economic calculation, for which money is an indispensable tool? Before governments took full control of monetary affairs, agents in free markets had decided to use precious and relatively scarce commodities — such as gold and silver — as media of exchange. Their quantities in circulation tended to change relatively slowly and predictably over time. Changes in money’s purchasing power could thus be largely disregarded. In this sense, money based on scarce commodities provided “accounting stability.”
Indeed, when measured on the basis of consumer price indices, money prices in, for instance, the United States and United Kingdom, were de facto constant during the 1800s and early 1900s, the era of the commodity/gold standard (see graphs below). As a result, inflation, as represented by the annual change in the price indices, was zero on average, even though it tended to fluctuate widely in the short-term.
After the start of the First World War in 1914, which is widely seen as marking the transition to the era of government controlled paper money standards, price indices started drifting upwards. The trend of ever-higher money prices — and thus constantly positive inflation — was only temporarily interrupted from the early 1920s to the middle of the 1930s (including the period of the Great Depression).
Increasing Money Supply Leads to Inflation
From the Austrians’ viewpoint, any change in money supply influences money’s exchange ratio, irrespective of whether a commodity or fiat money standard is in place. Take, for instance, a gold standard regime, in which money supply increases due to, say, a rise in gold supply hitting the market. Additional money is spent on particular goods in specific sectors of the economy. The first users of the newly created money spend it on goods and services given prevailing market prices.
As more and more market agents get hold of additional money, the marginal utility of money in their personal valuation scales declines, while the marginal utility of non-monetary goods and services increases. In an attempt to restore their portfolio equilibrium, people offer more money against goods and services. Money prices rise as each money unit can buy fewer goods and services when compared with the situation before the stock of money increased.
From this viewpoint it is straightforward to define inflation, as Mises did, as an increase in money supply — and deflation as a decline in money. Mises’s definition of inflation and deflation stands in stark contrast to today’s interpretation of these terms: “What many people today call inflation or deflation is no longer the great increase or decrease in the supply of money, but its inexorable consequences, the general tendency towards a rise or a fall in commodity prices and wage rates.”4
Money Is Not Neutral
Mises made the point that any increase or decrease in money supply would produce uneven price effects through time. To him, money is not “neutral.” For instance, an increase in money supply drives up, in a first step, certain money prices while leaving those of other goods and services unchanged. The injection of additional money leads to changes in relative prices. The latter, in turn, influence market agents’ investment and consumption plans.
When governments took full control of monetary affairs, the commodity standard was replaced by fiat money. In contrast to free-market money, a government-run, fiat-money regime does not set any limits to increasing credit and money supply, and market interest rates can be artificially lowered — a measure that is widely believed to be economically necessary and beneficial. However, manipulating the interest rate invites trouble.
The government-made increase in credit and money supply seems to suspend, at least temporarily, the law of scarcity, encouraging market agents to pursue investment projects for which the economy simply does not have the required resources. Sooner or later, however, it becomes obvious that businesses, who happily borrowed at cheap lending rates, invested too heavily (or better: malinvested) in capital goods and underinvested in consumption goods.
The misallocation of scarce resources is brought into the open when consumers start returning to their previous consumption-investment preferences. Demand declines, the boom turns into bust and the crisis unfolds. To Austrians, the building up of the boom, which must collapse as it is fuelled by an inflationary credit and money expansion, would occur even if the central bank kept a price index stable: a stabilized price index does not prevent the building up of distortions in relative prices and the economy’s production structure.
The Call for Free-market Money
Austrians advocate ending governments’ money supply monopolies and returning to free-market money. They don’t think the latter would be free of inflation, but they hold the view that inflation would be much better contained under free-market money when compared with a government-controlled, fiat money. Under a freely chosen commodity-based money regime, such as the gold standard, money supply would tend to increase relatively predictably and in relatively small quantities over time — compared with random, arbitrary, and usually dramatic increases in paper money supply.
The Austrians’ great concern is that a government-dominated money-supply regime would ultimately lead to economic and therefore political disaster; the objective of price stability would not alter such a dismal prediction. Even if a central bank succeeds in stabilizing a targeted price index, it would — by an ideologically motivated increase in credit and money supply — generously increase credit and money supply. It thereby distorts the economy’s price mechanism, promotes malinvestment and initiates subsequent economic downturns. And it is actually the latter with which the trouble really starts.
To Mises, government interventionism — the artificial lowering of the interest rate through expanding bank credit and money supply — causes cyclical swings of the economy, inflation, stock market crashes, and subsequent losses in output and employment. This in turn would provoke the public calling upon the government to solve the crisis. Additional government action, rather than market forces, is usually seen as the solution to economic hardship. What follows are more interventions, leading further and further away from the ideal of the free society.
Public Opinion and Anticapitalist Mentality
With an economic crisis unfolding, people become dispirited and lose their confidence in the concept of the free market. They look for a quick bail-out, and fail, or simply do not want, to identify government interventionism as the actual cause of the crisis. An anticapitalist mentality would be particularly receptive to diagnoses of market failure rather than to ascribing the causes of the crisis to government interventionism.
To escape the consequences of a self-made monetary crisis, brought about by an ideologically motivated increase in credit and money expansion, the society opts for the policy that has actually brought about the malaise. In the words of Mises: “In the opinion of the public, more inflation and more credit expansion are the only remedy against the evils which inflation and credit expansion have brought about.”5
If public opinion is looking for government action to end the crisis, hopefully reversing it into a boom, political quarters can be expected to capitalize on such a desire. Politicians usually rise to prominence by advocating government measures that are supposed to restore the economy back to health. An “easy monetary policy” is usually seen as the appropriate policy measure.
Central banks, even if politically independent, would hardly be in a position to stem the tide. As government-owned institutions, they cannot pursue a policy that is out of line with public opinion. In fact, if a central bank’s monetary policy does not meet the electorate’s preference, it wouldn’t take long for people — instructed by the anti–free market propaganda — to favor ending the bank’s political independence and bringing it back under direct parliamentary control — thereby speeding up the demise of the currency.
Return to the Sound Money Principle
Austrians voice great concern that any government-controlled money supply will necessarily be prone to crisis, whether or not central banks can keep a price index number stable. As a consequence, they propose a return to free-market money, which would be compatible with the “sound money principle,” as Mises put it.
The sound money principle not only allows reaping the full benefits of property rights, the division of labor, and free trade, thereby improving the general standard of living; it also represents a conditio sine qua non for the free society:
It is impossible to grasp the meaning of the idea of sound money if one does not realize that it was devised as an instrument for the protection of civil liberties against despotic inroads on the part of governments. Ideologically it belongs in the same class with political constitutions and bills of right.6
To Mises, the sound money principle has two aspects: “It is affirmative in approving the market’s choice of a commonly used medium of exchange. It is negative in obstructing the government’s propensity to meddle with the currency system.”7
Against this backdrop, today’s government controlled paper money standards could not have moved further away from what the Austrians consider a money regime compatible with the ideal of a free society. Such a worrying assessment is supported by the fact that there is rather little, if any, public debate about the Austrian School of Economic thinking regarding the remoter consequences that the very objective of today’s monetary policies might entail.
However, such a debate has become indispensable for preserving the concept of the free society. Central banks’ monetary policies have opened the floodgates of credit and money supply. They have set the economies on a path where the options appear to be either increasing inflation further — in a futile attempt to temporarily escape the final collapse — or allowing deflation restoring the economies back to equilibrium.
Needless to say that both outcomes — which are the direct results from the fateful wish for money stability — would play into the hands of anti-free market forces. A return to free market money would prevent these developments.
