The global financial system is awash with credit and money, a direct result of the “low interest rate policy“ pursued by governments’ central banks. In most western industrialised countries, credit and money supply growth has been exceeding real output gains in the last decades. As a result, debt-to-GDP ratios have been increasing markedly. Also, prices of many assets – such as, for instance, stocks, real estate and housing – have been inflating substantially.
These developments bear quite some resemblance to a looming crisis as described by the Austrian School of Economics, of which the contributions of Ludwig von Mises (1881 – 1973) deserve particular attention. Taking recourse to the insights of Knut Wicksell (1851 – 1926), Mises maintained that government owned central banks would – for ideological and political reasons – lower the market interest rate below the economy’s neutral interest rate.
With the cost of credit thus artificially depressed, market agents embark upon debt financed spending. Credit and money supply rises. Investment increases relative to savings, and the economy expands. Sooner or later, however, the discrepancy between the monetary induced increase in demand for and supply of resources becomes obvious. Inflation picks up; hoped-for output and employment gains fall short of expectations; investment projects, which were originally thought to be profitable, disappoint; the economy falls into recession.
An unfolding economic crisis provokes public calls for even lower interest rates and a further increase in credit and money supply – as people believe that such measures are a solution to, rather than the cause of, the calamity. Mises wrote: “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.“ [Mises, L. v. (1996), Human Action, 4th Edition, Fox & Wilkes, San Francisco, pp. 576.]
No doubt, a recession would be the economically required adjustment. In fact, it would be the very process that could change relative prices of goods and services, thereby allowing the economy to converge back towards equilibrium. However, central banks, giving in to public demands for lower interest rates and an increase in credit and money supply, perpetuate – and also aggravate – existing disequilibria.
By lowering interest rates in periods of economic crisis, central banks de facto try to heap a new monetary excess on top of the preceding monetary excess. Whereas such a tactic might postpone the collapse for a certain period of time, it increases – but doesn’t avoid – the final disaster: The debt pyramid rises further before it comes crashing down. It doesn’t take much to expect that a fall of the “tower of debt“ would create a political environment in which people see inflation as much more desirable than deflation.
Mises saw that the recurrence of a monetary policy induced boom-and-bust would play into the hands of the “anti-capitalist mentality“. Faced with output and job losses, people would become disenchanted with the free market order. They would start calling for government market interventions, even accepting totalitarian methods, hoping that it could improve production and employment.
It seems paradoxical, but it is the “price level stability“ objective (or better: “inflation targeting“) that works towards the catastrophe as predicted by the Austrians. Most monetary authorities define price level stability on the basis of a price index. Among many defects of such an “index regime“, one problem is that the indices usually ignore asset prices. This is tragic, as consumer and asset prices do not (necessarily) move in parallel. In fact, changes in consumer prices do not (necessarily) reflect what is going on in the economy in terms of price changes.
As inflationary effects of a rising credit and money supply do not show up in consumer prices (because they are, at least temporarily, confined to asset prices), many central banks ignore credit and money growth when setting interest rates. They keep expanding credit and money supply at rates which do not have any relation with real economic developments. This causes (asset price) inflation, malinvestment, distortions in the economy’s production structure and rising debt-to-GDP ratios. In other words: monetary policy sows the seeds of the monetary crisis.
To escape the disaster inherent in today’s monetary orders, Mises argued for ending the government money supply monopoly and returning to free market money – which would, as Austrians claim, lead towards a gold standard. Mises was aware of the criticism his proposal provokes: “Cynics dispose of the advocacy of a restitution of the gold standard, by calling it utopian. Yet we have only the choice between two utopians: the utopia of a market economy, not paralysed by government sabotage on the one hand, and the utopia of totalitarian all-round planning on the other hand.“ [Mises, L. v. (1981), The Theory of Money and Credit, Liberty Fund, Indianapolis, pp. 499.]
Given the current state of affairs, how could the obvious risks of a collapse of the monetary order – and the ensuing danger to societal freedom – be reduced? One viable strategy would be abandoning the concept of inflation targeting, and limiting central bank action to expanding credit and money by a constant and (rather) low rate – in line with the famous “k-percent rule“ as proposed by Milton Friedman (1912 – 2006).
Under a constant credit and money supply growth rule, central banks could no longer – for ideological and/or political reasons – manipulate interest rates. What is more, a predictable credit and money supply would work towards reducing monetary induced boom-and-bust, thereby strengthening market forces in aligning supply and demand via changes in relative prices.
Higher output and employment gains should bolster public support for the free market order. In that sense, the implementation of Friedman’s k-percent rule might be seen as an intermediate step, ultimately paving the way towards implementing Mises’ vision: spreading the intellectual insight that free market money is the only monetary regime that is compatible with preserving the free societal order – and that the latter is in the best interest of the people.
Note that the views expressed herein represent those of the author and to not necessarily correspond to those of the institutions the author is affiliated with.