The Long FAQ on Liberalism
A Critique of the Austrian School of Economics:


Gold Standard

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 economic problems.

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.

Business Cycle

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 is irrelevant.

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 unemployment.

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.

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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. 508. This statistic refers to the proportion of husband-wife families with low incomes, not including aid-in-kind.)