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Monetary Central Planning and the State, Part 28: The Chicago and Austrian Economists on Money, Inflation, and the Great Depression

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In the post-World War II period, the two leading schools of free-market thinking have been the Austrian school, led by Ludwig von Mises and Friedrich A. Hayek, and the Chicago school, led by Milton Friedman and George Stigler. Together they have rigorously and lucidly analyzed and criticized the errors and dangers in socialist, Keynesian, and interventionist policies. Though their methods of analysis have often been different, both groups have reached a similar conclusion: only the free-market economy can ensure both freedom and prosperity.

Both the Austrians and Chicagoans, as we have seen, rejected Keynes’s argument that the market economy was fundamentally unstable and likely to generate extended periods of unemployment and idle resources. They both also argued that when inflations and depressions occurred, they were the result of monetary mismanagement and government interventions that reduced market flexibility in the face of changing circumstances. And both schools of thought were suspicious of discretionary monetary and fiscal policies, particularly of the Keynesian type, believing that they would only make for less stability, not more.

But the Austrian economists and the members of the Chicago school have differed on a number of crucial issues in the field of monetary theory, history, and policy. Central to those issues are their different interpretations of the causes and cures for the Great Depression of the early 1930s. Their different interpretations of that period arise from their differing conceptions of how money influences the market economy. And those differences come from their different views of how economic processes should be studied.

Friedman and most other monetary theorists in the Chicago tradition accepted the Keynesian idea of a macroeconomic or aggregative analysis. For example, in a reply to some of his critics published in 1974, in a volume entitled Milton Friedman’s Monetary Framework: A Debate with His Critics, Friedman said:

“Rereading the General Theory has … reminded me what a great economist Keynes was and how much more I sympathize with his approach and aims than with those of many of his followers…. I believe that Keynes’s theory is the right kind of theory in its simplicity, its concentration on a few key magnitudes, its potential fruitfulness. I have been led to reject it, not on these grounds, but because I believe that it has been contradicted by evidence: its predictions have not been confirmed by experience.”

The incompleteness in Keynes’s theory, according to Friedman, was in its narrow definition of people’s choices when deciding to hold money or spend it in some way. When the choices among which individuals may choose are widened, the demand for money appears more stable than Keynes thought, Friedman concluded. (See “Monetary Central Planning and the State: Part 25: Milton Friedman and the Demand for Money,” Freedom Daily, January 1999.)

While claiming to construct his framework from the decisions of individuals to hold various sums of money relative to their desires to spend that money on various goods and services, Friedman soon shifts to statistical aggregates and averages that summarize away the real individual choices and decisions that make up the activities and outcomes of the actual market process. And like Keynes, Friedman focuses on these macroeconomic aggregates: total demand for money relative to the total supply of money; the effect on total spending arising from an increase in the total supply of money; and the resulting impact on aggregate output in the short run and on the general price level in the long run.

The Austrian economists have taken a different view. They have argued that it is important not to forget that statistical averages of total output and the general price or wage levels do not exist in reality. They are the creation of the economic statistician summing and arithmetically averaging in various ways the individual prices, wages, and outputs of the multitudes of individual goods and services that are bought and sold on the market. Or as Friedrich Hayek expressed it:

“In fact, neither aggregates nor averages do act upon each other, and it will never be possible to establish necessary connections of cause and effect between them as we can between individual phenomena, individual prices, etc…. Yet we are doing nothing less than this if we try to establish direct causal connections between the total quantity of money, the general level of prices and, perhaps, also the total amount of output. For none of these magnitudes as such ever exerts an influence on the decisions of individuals.”

Focusing on general aggregate effects of changes in the quantity of money on output and prices, Friedman argues that to the extent that an increase or a change in the rate of increase in the money supply influences production and employment in the economy, the effect is “transitory” and limited in its effect. In the longer run, as wages and prices adjust to the changed amount of money in the economy, the only lasting effect will be the creation of a higher general level of prices and wages with no permanent change in the aggregate amounts of employment and production. (See “Monetary Central Planning and the State: Part 26: Milton Friedman and the Monetary ‘Rule’ for Economic Stability,” Freedom Daily, February 1999.)

Any effects on relative prices, the allocation of resources, or the distribution of income during a period of monetary inflation will be mostly temporary and of secondary importance, Friedman argues. They are simply “first-round” effects that will be of little significance from the longer-run perspective. Or as Friedman expressed it in that same reply to his critics, “One way to characterize the quantity-theory [of money] approach is to say that it gives almost no importance to first-round effects.”

Friedman reaches his conclusion by analyzing changes in the money supply in the following way: Imagine that a helicopter randomly drops money down on a population; the people of the society pick up the money and proceed to spend it until prices have risen to a level high enough to once again balance the demand for money with the increased supply.

On the other hand, the Austrians have argued that while it is true that in the long run, increases in the money supply do result, other things held unchanged, in a rise in prices in general, it is necessary to analyze the process by which changes in the money supply enter the economy and the particular ways they influence individual demands and supplies and individual prices and production plans. Or as Austrian economist Oskar Morgenstern put it:

If no account is given where this additional money originates from, where it is injected, with what different magnitudes and how it penetrates (through which paths and channels, and with what speed), into the body economic, very little information is given. The same total addition will have very different consequences if it is injected via consumers’ loans, or via producers’ borrowings, via the Defense Department, or via unemployment subsidies, etc. Depending on the existing condition of the economy, each point of injection will produce different consequences for the same aggregate amount of money, so that the monetary analysis will have to be combined with an equally detailed analysis of changing flows of commodities and services.

The Austrians have considered this more detailed analysis of the inevitable non-neutral influence of money as essential to any complete understanding of inflation’s full effects on the market economy. (See “Monetary Central Planning and the State, Part 6: Ludwig von Mises and the Non-Neutrality of Money,” Freedom Daily, June 1997.)

Given their different perspectives on how best to analyze money and inflationary processes in the market economy, it is not surprising they have viewed the causes and cures for the Great Depression differently, as well. Friedman, for example, looks at the 1920s and concludes that Federal Reserve policy at that time was not inflationary at all, with the general wholesale price level fairly stable during that decade. If there are criticisms of Fed policy to be made, Friedman argues, it should be that in the early 1930s, the American central bank did not do more to increase the money supply, after it had contracted by about one-third, to lift the U.S. economy out of the Depression.

The Austrians, looking beneath the stable price level of the 1920s, have argued that if not for the expansion of the money supply during that decade, prices would have slowly fallen to reflect the significant increase in productivity and output due to technological innovations and capital formation. Instead, Fed monetary expansion kept prices higher than otherwise would have been the case, which created the illusion of economic stability through a stable price level and brought about an unsustainable misdirection of capital investment as well as labor and resource misallocation. The imbalances Fed policy produced finally became visible after 1929.

When the Depression began, the solution should have been a writing down of malinvested capital and a lowering of wages and prices to reflect the downturn in economic activity and the decrease in the money supply caused by bank failures due to bad loans and depositors’ wanting to withdraw money from their accounts. Instead, first the Hoover administration and then Roosevelt’s New Deal did everything possible to prevent the necessary and healthy market corrections. That was the real reason for the depth and the duration of the Great Depression. (See “Monetary Central Planning and the State, Part 12: The Austrian Analysis and Solution for the Great Depression,” Freedom Daily, December 1997.)

Yet, at the end of the day, both the Austrians and the Chicagoans reach one essential, common conclusion: monetary central planning has created more instability in the 20th century than there would have been if money and the banking system had been left outside of government control.

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    Richard M. Ebeling is a professor of economics at Northwood University. He was formerly president of The Foundation for Economic Education (2003–2008), was the Ludwig von Mises Professor of Economics at Hillsdale College (1988–2003) in Hillsdale, Michigan, and served as vice president of academic affairs for The Future of Freedom Foundation (1989–2003).