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9.12 Inflation and Deflation in the Austrian Theory

The Austrian theory of the business cycle is an account of the credit-induced,

unsustainable boom. The ‘fundamental mechanisms’ mentioned in Hayek’s

assessment of Keynesian constructions are the market forces (time discount

and derived demand) that keep production plans aligned with intertemporal

preferences and that can malfunction when the rate of interest is falsified by

credit expansion. Artificial booms contain the seeds of their own undoing –

hence their fundamental unsustainability.

The reader may well have noticed that the Austrian theory does not feature

the general rise in prices and wages that may be experienced during a creditinduced

boom. Neither price and wage inflation nor the potential misperceptions

of the inflation rate are fundamental to the theory. The focus instead is on the

misallocation of resources during the period of artificially cheap credit.

Intertemporal discoordination can occur on an economy-wide basis, according

the Austrians, even during a period of overall price-level stability. In fact, it is

during just such periods that the conflict between producers and consumers is

likely to be hidden until market conditions in the various stages of production

eventually reveal the boom’s unsustainability. The problem that festers during

the boom is likely to go undetected, all the more so if macroeconomists – and

financial markets – take an unchanging price level to the hallmark of macroeconomic


Showing the particulars of saving-induced growth (Figure 9.8) and of

credit-induced booms (Figure 9.10) made use of the simplifying assumption

that we begin with a no-growth economy. In application, of course, we

have to allow for some ongoing economic growth – and possibly for some

fairly high real growth rate. In a rapidly growing economy, credit expansion

may be seen by policy makers as simply ‘enabling’ growth or possibly as

‘fostering’ growth. The Austrians take a different view: credit expansion

fosters a little more growth than can be supported by real saving. The

upward pressure on prices attributable to credit expansion may just offset

the downward pressure on prices attributable to the underlying real growth.

Thinking in terms of the equation of exchange, we can say that increases in

M may just about match increases in Q, such that P remains fairly constant.

While the monetarists would see this price-level stability as evidence of a

successful and commendable application of the monetarist rule, the Austrians

would see price-level constancy during a period of real economic growth

as a warning sign. The monetary rule does not rule out credit-induced

intertemporal discoordination.

The contrast here between monetarist and Austrian views sheds light on

the issue of the respective theories’ applicability. For the monetarists who

rely on Phillips curve analysis (and for new classicists who set out a monetary

misperception theory of the business cycle), booms that lead to busts

must be characterized by inflation. The differential perceptions of inflation

experienced by employers and employees (in the case of Phillips curve analysis)

and the general misperceptions of inflation (in the case of new classical

theory) have as a strict prerequisite that there must actually be some inflation

to perceive differentially or to misperceive (see Chapters 4 and 5). These

theories, then, cannot apply to the boom and bust during the interwar period

or to the more recent expansion of the 1990s. In these key cyclical episodes,

the inflation rate was nil (in the former case) and very mild (in the latter). The

inflation-dependent theories apply only to the less dramatic cyclical variations

dating from the late 1960s and extending into the late 1980s. The ability

of the Austrian theory to account for the downturns in 1929 and 2001 would

seem to add to this theory’s credibility.

The Austrian literature does contain much discussion about inflation. But

in connection with business cycle theory, the strong long-run relationship

between the quantity of money and the overall price level serves to answer a

secondary question about the sustainability of the credit-induced boom. Once

the artificial boom is under way, can the bust be avoided by further credit

expansion? The Austrian answer is that there may be some scope for postponing

the market correction, but only by worsening the root problem of

intertemporal discoordination and hence increasing the severity of the eventual

downturn. In the long run, credit is not a viable substitute for saving.

Further, attempts to prolong the boom through continued increases in credit

can fuel an asset bubble. (Think of the stock market orgy in the late 1920s

and the ‘irrational exuberance’ in the late 1990s.) And, ultimately, increasingly

dramatic injections of credit can set off an accelerating inflation

(hyperinflation) that robs money of its utility.

The Austrian school 515

Deflation, like inflation, is a secondary issue in the Austrian literature.

Growth-induced deflation, that is, the decline in some overall price index

that accompanies increases in real output, is considered a non-problem.

Price reductions occur wherever supply and demand conditions warrant.

Here, the microeconomic forces that govern individual markets are fully in


Deflation caused by a severe monetary contraction is another matter. Strong

downward pressures on prices in general put undue burdens on market mechanisms.

Unless, implausibly, all prices and wages adjust instantaneously to the

lower money supply, output levels will fall. Monetary contraction could be

the root cause of a downturn – as, for instance, it seems to have been in the

1936–7 episode in the USA. The Federal Reserve, failing to understand the

significance of the excess reserves held by commercial banks, dramatically

increased reserve requirements, causing the money supply to plummet as

banks rebuilt their cushion of free reserves. But what caused the money

supply to fall at the end of the 1920s boom? The monetarists attribute the

monetary contraction to the inherent ineptness of the central bank or to the

central bank’s (ill-conceived?) attempt to end the speculative orgy in the

stock market, an orgy that itself goes unexplained.

In the context of Austrian business cycle theory, the collapse in the money

supply is a complicating factor rather than the root cause of the downturn. In

1929, when the economy was in the final throes of a credit-induced boom, the

Federal Reserve, uncertain about just what to do and hampered by internal

conflict, allowed the money supply to collapse. The negative monetary growth

during the period 1929 to 1933 helps to account for the unprecedented depth

of the depression. But like Keynes’s focus on the loss of business confidence,

the monetarists’ focus on the collapse of the money supply diverts attention

from the underlying maladjustments in the economy that preceded – and

necessitated – the downturn.