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9.13 Policy and Reform

The political attractiveness of the policy prescriptions based on the Keynesian

theory (spending programmes, tax cuts, deficit finance and monetary expansion)

and the absence of a comparable list of politically attractive policy

prescriptions associated with the Austrian theory go a long way in accounting

for the decisive victory in the 1930s of Keynesianism over Austrianism. Over

the following decades, however, the cumulative effects of the excesses of

Keynesian policy (debt monetization and double-digit inflation) eventually

caused monetarism to be seen as the more responsible alternative. Endorsing

monetarism – though not actually institutionalizing the monetary rule – became

politically viable.

Although credit expansion was curtailed in the 1980s, there was never a

sustained period of steady monetary growth at a pre-announced low rate.

Further, monetary reforms enacted in that same period blurred the distinction

between money and other highly liquid assets, making the implementation of

the monetary rule all but impossible. The very definition of money became

problematic, and the once-stable demand for money (as tracked by ‘velocity’

in the equation of exchange) itself became unstable. By default, the Federal

Reserve reverted to managing interest rates, expanding credit to whatever

extent was necessary to achieve its chosen target rate. With a pro-active

central bank dominating credit markets, the natural rate of interest is a strictly

non-observable rate, but to the extent that the central bank is sensitive to

political considerations, the managed rate is more often than not below the

natural rate.

The Austrians’ policy advice to the central bank consists of prevention

rather than cure: do not engage in credit expansion – not even if ongoing

economic growth is causing some index of output prices to fall. Abiding by

this imperative is not only politically difficult but also technically difficult,

because the central bank cannot know what the natural rate of interest is and

how it might be changing. The difficulties (both political and technical) of the

central bank’s avoiding a credit-induced boom suggest that what is needed is

fundamental reform rather than policy prescription. Late in his career, Hayek

recommended the Denationalisation of Money (1976). Subsequent writings

by contemporary Austrians – Lawrence H. White (1989) and George Selgin

(1988) – have made the case that a thoroughly decentralized banking system,

one in which the market rate of interest is an unbiased approximation of the

natural rate, may be the ultimate solution to the problem of boom and bust.