November 9, 2015

Just once I’d like to read a negative critique of “Austrian” economics from someone who actually understands it, but up until now every piece of criticism I’ve come across has contained basic misunderstandings of what this school of economics is about. The latest example is a 6th November blog post by Martin Armstrong.

According to the beliefs expressed by Mr. Armstrong in the above-linked blog post, Austrian Economics informs us that “fiat” money causes the business cycle and that the business cycle began with the Industrial Revolution. Both of these beliefs are completely wrong. Austrian Economics does not say that the business cycle is caused by fiat money and it does not say that the business cycle began with the Industrial Revolution.

Austrian Economics informs us that the business cycle is caused by large increases in the supply of money that create the impression that there are more real savings in the economy than is actually the case. Over the past few centuries the dominant cause of these large money-supply increases in the most developed economies was “fractional reserve banking”, a practice that effectively began with goldsmiths issuing more receipts for gold than they had actual gold in their vaults. However, “Austrian Business Cycle Theory” does not revolve around the specific method via which the monetary inflation occurs. A king debasing the coinage or issuing large quantities of paper money could potentially have a similar effect to goldsmiths issuing unbacked receipts for gold or an economy being flooded with gold — in the days when gold was money — due to successful foreign conquest (e.g. Spain and the Conquistadors in the 1500s) or commercial banks lending new money into existence or modern central banks implementing QE.

As to the other of Mr. Armstrong’s aforementioned beliefs, anyone who has gone to the trouble of researching Austrian Economics would know that “Austrian” economists have analysed the monetary and economic developments that occurred throughout history. As a good economic theory should, Austrian Economics works in all circumstances. It works regardless of whether we are dealing with a large modern city, a small village, a man alone on an island, a free economy, a command economy, an economy that uses paper money, an economy that uses tangible money, a robust economy, an economy immersed in depression, and so on.

Towards the end of his post Mr. Armstrong makes two assertions that aren’t specifically related to Austrian Economics, but warrant clarification.

First, he writes:

…tangible money must have a “use” other than money. Gold and silver were prized objects but had no utilitarian “use” value outside of jewelry. Gold was desirable but was not a vital commodity that served a purpose beyond its prized status like art. Therefore, numerous monetary systems have existed that were not gold based since the medium of exchange had to have a “use” value other than as money.

The fact is that many things have been used as money throughout the ages, but the more advanced economies ended up gravitating towards gold and/or silver. One reason is that for an item to become money in a large and mostly-free economy it must have a use other than money, but the non-monetary demand for the item will ideally be very small — to the point of being trivial — relative to the monetary demand. Otherwise, changes in non-monetary demand could cause large and unpredictable swings in the purchasing-power of money. That’s why if markets were free to choose they would almost certainly not choose platinum as money, even though platinum has similar physical attributes to gold.

Second, he writes:

Money is not a store of value; it is a medium of exchange. In that case, it is merely an agreed upon medium to supplant barter.

This is mostly correct. However, if an item isn’t widely perceived to be a good store of value then in a free market it won’t generally be accepted as a medium of exchange and therefore won’t be money.

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