Milton Friedman did much to further the cause for political freedom during the 20th century, and helped to dispel many popular economic fallacies. However, although Friedman was mostly in favour of the free market where political policy is concerned, he most certainly did not think these free market principles could be extended to the banking sector and he was essentially a socialist where monetary policy is concerned. Friedman was a Monetarist.

Let me quote from the opening paragraph of Hoisington Investment Management Company’s Quarterly Review and Outlook – Fourth Quarter 2008 :

“The late Nobel Laureate, Milton Friedman, noted in his 1963 book, Monetary History of the United States (coauthored with Anna Swartz), that the money stock decreased by a massive 31% in the Great Depression. The turnover of that money, called velocity, fell 21%. Nominal GDP equals money multiplied by velocity. Consequently, from 1929 to 1933 the breakdown of both measures resulted in a contraction in nominal GDP of approximately 50%. However, Friedman postulated that if the Fed had not let money shrink, velocity would have been steady and the Great Depression would have been averted, i.e., nominal GDP would not have collapsed.”

This betrays the completely opposite ways in which Monetarist economists and Austrian economists view the economy.  Where Friedman and Swartz view the a recession as a monetary problem that can be fixed by monetary policy, the Austrians view a recession as having been caused by monetary policy but very much a real problem which can only be fixed by allowing real changes in the economy occur. This perhaps requires some clarification so let me elaborate on the two different points of view.

The Monetarist Perspective

Friedman believed that changes in the money supply could bring about changes in real productive output and, more particularly, that a contracting money supply would cause a corresponding contraction in the real productive output of the economy. 

It can certainly be argued that significant and unexpected changes in the money supply (either upward or downward) will cause widespread miscalculation as to the real profits and costs of lending and borrowing and so to this extent, severe and unanticipated deflation or inflation of the monetary unit might certainly undermine its effectiveness as a common unit of account or as a medium of exchange… and probably most of the Austrians would agree that an unstable currency could lead to real miscalculation and real losses in the economy.

However the monetarist theory does not stop there – monetarists do not merely advocate stable currencies… for if they did then they would advocate target inflation rates of 0% rather than target interest rates. They would advocate a monetary policy that concerned itself entirely with preventing any form of aggregate inflation or deflation, rather than a monetary policy that tried to balance “growth against inflation”. The real view of the monetarists is that money, in the economy, can speed and slow real economic growth like the accelerator and break pedals in a car. Monetarists believe, in the bottom of their hearts, that by expanding the money supply by smallish amounts (say 5%) they can bring about real economic growth and that similar minor changes in the downward direction (for example deflation of 5%) would be the cause, and not the effect, of a real loss of wealth.

The Austrian Perspective

Monetary inflation may create an illusion of wealth that tricks some people into genuinely producing more (real goods) than they would have if the money supply was stable. Those living in an inflationary environment may, temporarily, be tricked into working somewhat harder than they otherwise would have when they receive a nominal pay rise that is actually a real pay cut or merely a sustaining of their real pay (once inflation is taken into account), however in the long run people eventually start to see what’s going on and come to factor inflation into their behavior. Unions come to demand pay rises “to keep up with inflation”, lenders subtract inflation from the interest rates they charge in order to calculate real rates of return and companies do the same with their profits. As such, inflation could only ever have the effect of stimulating real economic growth if it is unanticipated and people have not already altered their behaviour to account for it. Even then, it could easily be alleged that these “real” stimulatory effects of inflation are likely to be only minor and most certainly only temporary.

In any event, if inflation or deflation are unexpected then they will certainly, as we have already mentioned, cause various actors in the economy to miscalculate the rates of return that they might expect from lending or to miscalculate the true costs of borrowing. This may cause people to mistake nominal profits for real profits and overconsume, which may result in a temporary spike in the GDP figure that so concerns the monetarists, however this consumption is effectively fuelled by the cannibalization of capital as opposed to any productive increases brought about by a significant or prolonged increase in the real output. A perfect example of this is that of home owners in the USA and around the world recently increasing their consumption based on the belief that they were becoming ever and ever richer because of increasing real estate prices.

This is not to say that the Austrians view inflation as irrelevant and nor are the above comments the main objections that Austrians have to inflationary monetary policy. Primarily the Austrians view increases in the money supply as a transfer of wealth and control over labour/capital from those who have cash and savings to those doing the lending (in the first instance), to those who receive the money at “favourable” interest rates (in the second instance) and  to the suppliers of the industries where that borrowed money is spent (in the 3rd, 4th and nth instances). Its primary effect is not to increase the aggregate output of the economy but to tax savers and subsidise lenders. For every extra real unit of goods that is commanded by the borrowers of the new loans (which are bringing about the monetary expansion) one real unit of goods less is commanded by those people in the economy who had cash in their hands or balances in their checking accounts before the monetary expansion took place. No extra buying power is created and no extra goods will be produced – all that changes is what kind of goods are produced. As such the Austrians hold that monetary expansion distorts the structure of production by funnelling money away from genuinely profitable activities into unprofitable ones

A full explanation of Austrian Business Cycle Theory is beyond the scope of this article. However for our purposes it is sufficient to recognize that during an inflationary boom many of the goods that are being produced are subsidized by newly created money (i.e. by inflation) and were it not for the subsidies then the production of these goods would not be profitable… as such, many of the industries that develop during an inflationary boom are not really profitable either, and the existence of these industries is only made possible by forcing money from savers and lending it to these industries at subsidized interest rates. The ventures that are invested in during inflationary booms are not ventures that produce those things that people want most urgently and, left to their own devices, people would have chosen to invest their resources more wisely in things they felt a more pressing need for (and which consequently brought better returns – sufficient returns to pay the going rate of interest rather than merely a subsidized rate).

This funnelling of money from profitable activities to unprofitable ones is the equivalent of dismantling your house in the city (which you need so that you can go to work), transporting all the bricks, roofing tiles, wood and nails out to the beach and constructing a beach house, which is certainly very flash and would be nice to have but which you don’t really need (and certainly don’t need at the expense of your primary residence in the city). The beach house is a luxury that you cannot afford. The dismantling of your primary residence is a very real problem and not one that can be “papered over” by “revaluing the beach house” since what you cannot afford is not the “paper value” of the beach house, but the very real price that was paid for it (i.e. your primary residence).

Action and Reaction

Given their differing views as to the real effects of monetary inflation and deflation, it will hardly be surprising that the recommendations of the Austrians and Monetarists differ markedly in the face of a financial crisis. As companies start to make losses and people start to get laid off, when debts start to go bad and consequently (in the context of a monetary system based on fractional reserves) when the total quantity of money in the economy starts to shrink, the two camps have completely opposite recommendations.

Friedman, Swartz and Bernanke see the monetary contraction and they believe this is the cause of the problem. They believe that real output is the result of changes in the money supply and so all that concerns them is making sure that the monetary base does not contract. If they can do this, whilst at the same time avoiding inflation, then they believe they will be able to keep their beloved GDP intact and the problem will be solved. For a monetarist the problem is principally a mathematical problem, with perhaps a little bit of a psychological twist (the drop in GDP is sometimes blamed on the reluctance on the part of consumers to spend). It never occurs to the monetarists, by measuring and tracking broad aggregates, that there may in fact be real problems with the structure of production in the economy and that the tell tale signs of businesses collapsing all around them might reflect more fundamental problems than a simple lack of ink and paper.

And for the Keynesian Monetarists, if piling reserves into the hole that has been dug does not serve to prop up the GDP then it is argued that money should be quite simply given to those industries that need it (i.e. the industries that could only exist on the back of inflationary subsidies) or injected into the economy by government spending or both (nationalize unprofitable industries). If those industries can keep pumping out goods and if we can get money into the pockets of consumers to buy those goods then our beloved GDP will remain intact, right? It never occurs to the monetarists that the reason these industries are failing is because they are not making the goods that people really want.

The Austrians, on the other hand, view the problem rather differently. For the Austrians, the industries that rise on the back of inflation are doomed from the start. For a time, subsidized industries are able to make nominal profits quite simply because they do not accurately accounted for one of their primary costs – namely that of interest (and nor are they able to, for the market rate of interest becomes completely unknowable). But the monetarists do not view interest in the same way as the Austrians. The monetarists believe that interest rates can be set by edict rather than, as the Austrians believe, that these are a price aned therefore can only emerge naturally from the market as a result of the personal preferences of individual lenders and borrowers. Interest rates are the controls of the car that the monetarist drives – the means by which he “steers” the economy. For the Austrian nothing is more ridiculous – interest rates are the most fundamental price in the economy and can only be determined, like all prices, by supply and demand. In the case of interest rates, that supply is not ink and paper but real capital (tractors, oil, wood and human labour) and the demand is the potential uses to which that capital might be put by borrowers (to build homes and start companies).

Certainly there is some demand for the products produced by subsidized industries (citizens in the US were quite happy to have a second home – particularly those citizens who had no incomes). However life is full of choices and if you spend $100 on shoes then you can’t simultaneously spend it  on groceries… as such, people must prioritize their expenses. The new industries paid for by inflation quite simply are not a priority for people – if they were then they would not require inflationary subsidies either to spring into existence or to sustain their existence. Industries that produce things that people truly want (in light of the genuine costs of production) would be profitable even at the higher rates of interest that would have existed had the money supply not been expanding. To put it simply, although people might like to build beach houses, most people would choose not to if they knew that the real cost of building a beach house would be that they would lose their primary residence. Pretending, for a while, that they can have beach houses for free and that the cost of starting new companies is minimal to nil is just to engage in fantasy – nothing is free where economics is concerned – everything is a choice between two or more alternative possible uses for a particular resource and savings are no exception. 

The Austrian analysis, therefore, is that there is a real problem in the economy – technical recessions are not merely mathematical riddles but symptoms of very real problems that demand very real changes. The Austrians suggest that people have to stop dismantling their primary residences and stop building beach houses. Essentially the Austrians recommend something entirely obvious – that we do not continue to subsidize unprofitable industries. Certainly the removal of inflationary subsidies will cause a contraction in the industries that depended on these subsidies. Many of the companies in these industries will realize nominal losses at the new rates of interest that will be discovered in the market place and people will lose their jobs as a result. Eventually, the workers and capital having been freed from previously unprofitable uses will find new uses either rebuilding the industries that were damaged during the inflationary boom or in the construction of new and genuinely profitable industries… however the transition to this new equilibrium will certainly take time.

In any modern economy the different industries are not completely separate from one another but rather are intricately linked. Many industries depend heavily on others – for example a failure of one or more of the large automobile manufacturers would no doubt have domino effects on many of their suppliers. And no doubt the degree of specialisation in modern economies makes it difficult for employees in one industry to shift into other more profitable lines of work. As finance workers in London take jobs as teachers it may not appear to them that they are “shifting into more profitable lines of work”, given the massive nominal pay cut that they must accept in making this transition – however the sad fact is that their old jobs simply are not profitable. It may take many of these workers many years to become as efficient in new lines of work as they were in their previous posts and indeed some of them may never again have the same real salaries that they had before. This is unfortunate and no doubt it will be difficult for the individuals concerned. It is even more unfortunate that this malaise should affect so many people in the economy at the same time and some Austrians would no doubt think it appropriate for the Monetarists, who have guided monetary policy for the last century, to offer some form of apology for having provoked such a situation.

The Austrian does not disagree that these events are unfortunate, nor are they unaware that the recommendations made by the Austrian school will require sacrifices and hardship for many individuals. However the Austrian does hold that if the advice of the Austrian school is not heeded then these sacrifices will not be avoided but will merely be greater – for these are sacrifices that must be made for mistakes of the past. The question is not how we can avoid past mistakes (we cannot) but how we can avoid future mistakes.

The monetarists would have us focus not on our real standard of living and the things that we really want, but on sustaining nominal GDP – even to the point of having the government spend money on things in order that this technical goal should be attained, quite regardless of whether we need the things that government buys (and implicitly we don’t, since otherwise government wouldn’t have to take our money off us to purchase them as we’d buy them of our own free will). But if the Gross Domestic Product consists entirely of  the production of polka dot ties that no body wants, and which the government must therefore buy, of what possible relevance could the GDP actually be? Surely this is just reviving the policies of the former USSR? The GDP statistic becomes more and more irrelevant, to individuals, as an ever greater proportion of the nations production is directed by government and the central bank.

The Austrians would have us focus on root causes and addressing real problems for the man on the street, which requires adjustments in the structure of capital and that we shift our focus from building beach houses that we do not need (and cannot afford) back to the things that we really want and need.

Whether present policy is formed primarily by monetarist recommendations or primarily by Austrian recommendations will determine whether we are solving imaginary problems or real ones, and thus how many of us will know hardship tomorrow.

Standing in buckets

Government taxes mean that individuals and corporations only keep a certain portion of their gains whilst at the same time they realize 100% of their losses. As Hazlitt put it in Economics in One Lesson:

“When a corporation loses 100 cents of every dollar it loses, and is permitted to keep only 60 cents of every dollar it gains, and when it cannot offset its years of losses against its years of gains,  or cannot do so adequately, its policies are affected.”

This is a particularly pertinent point at present, since many corporations are starting to make some serious losses following a series of years in which they made bumper profits. If we were to regard the activity of these corporations over their entire lifetime then, on the balance of things, many of these corporations might actually be running at a profit, if we were to take taxes out of the equation… so they are still, even in the wake of their most recent losses, net contributors to the overall economy and perhaps were it not for taxes their shareholders would choose to continue operations. For practical reasons, however, taxes are levied annually and because these companies are unable to offset their current losses against earlier profits (which they have already paid taxes on) they are declared to be unprofitable and in many cases are driven into bankruptcy…

For example, Widgets Inc. starts up business and makes $100 in their first year of operation… on which they have to pay taxes of $40. They now have $60. In their second year of operation they make a loss of $70 and thus, unless they are able to find funding, they are technically under the water. Despite having made an effective profit of $30 over the course of the two years that they have been running, the tax burden that they have to shoulder has forced them out of business.

I guess this culls off the least profitable of the profitable companies, however Hazlitt’s point can hardly be denied – Taxes Discourage Production. Essentially a nation that imposes a 40% income tax is setting a bar over which all companies must jump if they are to stay afloat. For although some years they will make losses and others they will make profits, they will not be able to adequately offset their profits against their losses (particularly in times like these) and so over the long term companies must not merely break even but they must make a certain minimum amount of profit simply in order to stay afloat, and the magnitude of that profit is necessarily dependent upon the proportion of their revenues that are spent on taxes.

We could state the above somewhat more mathematically by saying that in order for a company to remain profitable, their EBIT (Earnings Before Interest and Taxes) must be greater than both the Interest that they pay on loans and the taxes that they pay during any profitable years of operation.

EBIT > Interest + Taxes

At this point you can perhaps start to see the enormous contradiction inherent within present government policy. For at the same time as the imposing income taxes governments around the world have also established the vast apparatus of central banking that has been assigned the task of controlling interest rates. In the United States this organization (The Federal Reserve) has two mandates: that of “stimulating growth” and that of “controlling inflation”.

Setting aside their deplorable track record with regards to controlling inflation, let us focus for a moment on their other role of stimulating growth. Despite price fixing having shown itself to fail time and time again, the manner in which the central bank purports to “stimulate growth” is by artificially lowering nominal interest rates so as to tip the equation above in favor of businesses. For if one of the main costs that businesses incur is interest then why don’t we simply write laws to lower interest rates (or even better, come up with a fantastically complex system to achieve the same thing indirectly, with vastly more effort and at a vastly greater cost)? The rather warped view of those supporting the central bank is that if they can keep nominal interest rates down then entrepreneurs, with the prospect of cheaper capital, will be more inclined to start businesses.

Ignoring the numerous difficulties that the central bank must face in order to actually make capital cheaper (rather than just cause a shortage, as is what we would expect in any industry where price caps were imposed) the central bank’s attempts to make capital cheaper are in direct conflict with the policy of taxation. For as we have already described, the bar that companies must jump over is not that of interest rates but that of interest rates + taxes.

It is therefore ironic that the government should be trying to tax itself out of the current mess. For in increasing government spending the government is implicitly and unavoidably raising taxes. All government revenue, without exception, comes from taxes and so there is no way that government can increase its expenses without implicitly increasing taxes. The irony is that both the bumper profits of recent years and the sudden crisis resulting from this, in which a disproportionate number of companies all go bust at the same time, placing us squarely in the midst of a recession and falling government revenues, are a direct result of government sponsored policy to artificially lower interest rates (supposedly to lower the costs  to business and stimulate growth).

And so recent moves to raise taxes in California and guarantees of future taxation implicit in Obama’s promises to increase government expenditure are both very much a direct result of the insane efforts of government to “stimulate growth”. Like children in a bath tub they have seen the rubber ducky of Interest rates bobbing towards them and, in an effort to make it disappear through force of will, they have tried to push it under the water. Unwittingly, the very force of their hand serves to raise the overall water level of taxation and other expenditure upon which the rubber ducky floated and so now a whole bunch of other kids in the bath tub (who weren’t tall enough) are now in the process of drowning. OK, I’m maybe straining an analogy there a little bit but, quite simply, the Federal Reserve trying to push down interest rates in order to lower the bar that businesses have to jump over has resulted in their pushing up (by vastly more) taxation and has thus raised the bar that not only businesses but all of the hapless victims that participate in their monetary system must jump over just to survive.

What is the current wave of taxation to be used for? Almost without exception, attempts to prop up the various collapsing walls of the very low interest rate policy that got us where we are today: to bail out failed banks, to bail out mortgage lenders and insurers or perhaps even to bail out the borrowers themselves… or sometimes to bail out companies that would have been profitable neither with nor without taxes (such as the auto makers).


Efforts by government to “reduce the costs” to businesses by lowering nominal interest rates merely increase the costs to business by at least that degree to which government participates.

In order for businesses to survive, as a rough guide to sustainability, they must ensure EBIT > Interest + Taxes. Any attempt by government to decrease the Interest component of the equation necessarily increases the Taxes component by at least as much (and almost doubtless by more, since the bureacrats and bankers effecting this transformation of Interest into Taxes must be paid).

At times like these, I cannot help but be reminded of one of Churchill’s better quotes:

“We contend that for a nation to try to tax itself into prosperity is like a man standing in a bucket and trying to lift himself up by the handle” – Winston Churchill