The global financial system is awash with credit and money, a direct result of the \u201clow interest rate policy\u201c\u009d pursued by governments\u2019 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 \u2013 such as, for instance, stocks, real estate and housing \u2013 have been inflating substantially.<\/p>\n
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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 \u2013 1973) deserve particular attention. Taking recourse to the insights of Knut Wicksell (1851 \u2013 1926), Mises maintained that government owned central banks would \u2013 for ideological and political reasons \u2013 lower the market interest rate<\/em> below the economy\u2019s neutral interest rate<\/em>.<\/p>\n 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.<\/p>\n An unfolding economic crisis provokes public calls for even lower interest rates and a further increase in credit and money supply \u2013 as people believe that such measures are a solution to, rather than the cause of, the calamity. Mises wrote: \u201cIn 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.\u201c\u009d [Mises, L. v. (1996), Human Action, 4th Edition, Fox & Wilkes, San Francisco, pp. 576.]<\/p>\n 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 \u2013 and also aggravate \u2013 existing disequilibria.<\/p>\n 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 \u2013 but doesn\u2019t avoid \u2013 the final disaster: The debt pyramid rises further before it comes crashing down. It doesn\u2019t take much to expect that a fall of the \u201ctower of debt\u201c\u009d would create a political environment in which people see inflation as much more desirable than deflation.<\/p>\n Mises saw that the recurrence of a monetary policy induced boom-and-bust would play into the hands of the \u201canti-capitalist mentality\u201c\u009d. 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.<\/p>\n It seems paradoxical, but it is the \u201cprice level stability\u201c\u009d objective (or better: \u201cinflation targeting\u201c\u009d) 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 \u201cindex regime\u201c\u009d, 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.<\/p>\n 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\u2019s production structure and rising debt-to-GDP ratios. In other words: monetary policy sows the seeds of the monetary crisis.<\/p>\n To escape the disaster inherent in today\u2019s monetary orders, Mises argued for ending the government money supply monopoly and returning to free market money \u2013 which would, as Austrians claim, lead towards a gold standard. Mises was aware of the criticism his proposal provokes: \u201cCynics 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.\u201c\u009d [Mises, L. v. (1981), The Theory of Money and Credit, Liberty Fund, Indianapolis, pp. 499.]<\/p>\n Given the current state of affairs, how could the obvious risks of a collapse of the monetary order \u2013 and the ensuing danger to societal freedom \u2013 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 \u2013 in line with the famous \u201ck-percent rule\u201c\u009d as proposed by Milton Friedman (1912 \u2013 2006).<\/p>\n Under a constant credit and money supply growth rule, central banks could no longer \u2013 for ideological and\/or political reasons \u2013 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.<\/p>\n Higher output and employment gains should bolster public support for the free market order. In that sense, the implementation of Friedman\u2019s k-percent rule might be seen as an intermediate step, ultimately paving the way towards implementing Mises\u2019 vision: spreading the intellectual insight that free market money is the only monetary regime that is compatible with preserving the free societal order \u2013 and that the latter is in the best interest of the people.<\/p>\n