The Long FAQ on Liberalism
A Critique of the Austrian School of Economics:
THE GOLD STANDARD AND BUSINESS CYCLE
Austrians believe in the gold standard, whereas mainstream
economists favor the current system of fiat money. Before exploring
why, we should note that virtually all economists agree that the
total amount or value of money in a system should closely match
its level of economic activity. If there is too much money, then
inflation rises. If there is too little money, then unemployment
rises. Under the current system, the government fights inflation
by contracting the money supply, and fights unemployment by expanding
it. This achieves the optimum level of money, and minimizes our
Austrians call for a 100-percent gold standard (that is, without
even fractional reserve banking) because it would get the government
out of the business of controlling the money supply. Under a gold
standard, the total amount or value of money would be fixed, determined
only by the size of the nation's gold reserves. Sure, unemployment
and inflation may rise, but eventually prices will readjust themselves
through natural inflation or deflation and solve the problem.
Austrians believe that this readjustment, painful or prolonged
though it may be, is a self-cleansing exercise that rids the economy
of malinvestment. That is, it eliminates weak firms that shouldn't
have been created in the first place.
Another essay on this site rebuts the
gold standard in detail. But the following quick review highlights
the most important of the gold standard's many weaknesses:
First, it would make nearly inflexible the total amount of the
nation's money supply. Gold bugs claim the value of that money
would adjust itself to the level of market activity through inflation
or deflation. But although money inflates easily, it suffers from
"price stickiness" when trying to deflate. Often, deflation
barely occurs, and the result is high unemployment, recession
or even depression instead. In other words, money doesn't adjust
itself to the level of economic activity; the level of economic
activity adjusts itself to the money. History bears this out:
the U.S. suffered eight depressions while on commodity money;
in the 60s years since, it has suffered none.
Second, gold standards based on a fractional reserve allow the
phenomenon of bank panics or bank runs, which leave depositors
holding worthless money. This only exacerbates recessions and
depressions. The solution to this would be to adopt a pure gold
standard. But there is not enough gold in the world to cover the
phenomenal amount of economic activity currently in it, without
an equally phenomenal revaluation of gold. Furthermore, industry
is making increasing demands on gold; a change in dentistry or
electronics could deflate an entire economy.
The Austrian's beliefs on the gold standard set up the argument
that government is the cause of the business cycle (the economy's
recurring pattern of recession and recovery). When the government
expands the money supply -- usually by easing credit restrictions
and lending rates -- this artificially increases investment. Much
of this is malinvestment, on projects that wouldn't have been
started otherwise. When the malinvestment reaches sufficient proportions,
the result is a recession. Should the government do anything to
ease the pain? Austrians say no. Weak firms must be allowed to
go bankrupt, unjustified jobs must be eliminated, artificially
high wages must fall. Only then can the economy start anew on
a healthier course of growth.
The theory that the Fed's monetary expansion and easing of credit
restrictions results in "malinvestment" is an unsupported
claim. It is backed up only by the Austrian's faith and deductive
"logic" that such malinvestment occurs.
It is true that the Fed's actions allow investments to occur that
were otherwise waiting to happen. But the real question is: should
they? In a depression, a lot of good investment is undoubtedly
being held back by lack of money. Whether it proceeds through
expanding the money supply or allowing the currency to deflate
What the Austrians are really doing is moving the goal posts.
The sound investment waiting to happen in a recession gets branded
as "malinvestment" when the Fed takes steps to let it
proceed. Whether or not you believe this investment would have
been sounder under a deflating currency depends on whether or
not you wish to believe a negative.
Austrians often repeat that since the Federal Reserve System was
created in 1913, our currency has devalued 98 percent, due to
the printing of money. But this
is a meaningless statistic. Suppose you need $2,000 a month to
buy the necessities of life, but you earn $2,000 a month as well.
You're making ends meet. Now suppose that your bills climb to
$10,000 a month -- but so does your income. Has anything real
changed? Of course not.
At low levels, inflation under fiat money is relatively harmless.
However, the deflation caused by the gold standard is truly
destructive. If dollars have inflated to 2 percent
of their original value, and the price of gold has risen 20 times,
then maintaining the gold standard would have deflated the dollar
to 2.5 times its original value. That's a lot of
No, the real question is not how much money has inflated, but
whether or not your absolute standard of living has risen.
And in this regard, the current system of fiat money has been
a clear success. Between the end of World War II and the early
70s, the U.S. standard of living (adjusted for inflation) doubled
-- the fastest rate of prolonged growth in U.S. history. The U.S.
became a middle class nation for the first time, with the share
of families owning their own homes climbing from 44 to 63 percent.
Families owning their own cars rose even more dramatically, from
54 to almost 100 percent. (1) Poverty, which had been 56 percent
in 1900, fell to an all-time low of 11 percent in 1973. (2) And, of course, there
has not been a single depression since World War II, not in this
or any other country following Keynesian monetary policies. Those
who would claim that fiat money has been a disaster for our economy
are simply indulging in scare-mongering and demagoguery.
Next Section: History of the Austrian School
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1. Paul Krugman, Peddling Prosperity (New York: W.W. Norton
& Company, 1994), p. 57.
2. Stanley Lebergott, The American Economy: Income, Wealth
and Want, (Princeton: Princeton University Press, 1976), p.
statistic refers to the proportion of husband-wife families with
low incomes, not including aid-in-kind.)