The link between ‘fiat money’ and boom-and-bust cycles

The online edition of the Handelsblatt, a major German business newspaper, recently featured an op-ed blaming government-created ’fiat money’ for the current financial crisis.

It recommends privately-issued, commodity-backed currencies as an alternative. To the best of my knowledge, this is the first time that a mainstream German newspaper has covered such a radically different interpretation of the crisis.

The author’s analysis is clearly rooted in the business cycle theory of the Austrian School of economics. According to this perspective, interest rates ought to reflect society’s ‘time preference’, the degree to which people are willing to forego consumption today in exchange for (greater) consumption tomorrow.

This rate determines the ‘time structure’ of an economy – the allocation of resources between consumption and investment purposes. It also affects the distribution of investment funds between projects that pay off after a short time and those that require a longer period.

In the Austrian interpretation, the interest rate is the key parameter in the coordination of economic activities. Manipulating it can upset the whole balance of the economy.

If the central bank injects more money into the economy by pushing interest rates below the ‘natural rate’, market actors are lured into believing that people have become more ‘patient’. Hence, additional investment projects are started, especially ones with a long-term horizon.

But these projects are castles built in the sky, because no additional funds for investment have been made available. People’s time preference has not changed. Eventually, the shortage of capital must come to light, interest rates must rise again, and a lot of projects fail. In the Austrian view, the ‘bust’ really means that the time structure of the economy is brought back into line with society’s preferences.

The author of the Handelsblatt article advocates abandoning the system of government-provided money. In a first step, he wants to return to a gold standard system, administered by the central bank. In the long run, he wants to abolish central banking altogether and see it replaced by a system of free banking.

Although many will disagree with this radical conclusion, it is important that Austrian ideas are more widely understood. Hopefully their exposition in the German press will not be a one-off. Austrian School disciples around the world have spent years translating the works of Mises and Hayek into various different languages. It would be ironic if these writings continued to be ignored in a place where people could read them in the original!

The British government’s policy of reducing nominal interest rates could only be justified if deflation were expected (leaving ‘real’ interest rates still significantly positive). Since the Chancellor of the Exchequer has just explicitly denied this possibility the policy seems mistaken. Not only does it penalise ‘blameless’ savers in favour of improvident borrowers, but it seems to attach far too much weight to interest rates as a decisive factor in investment decisions by businesses.

And as we speak, a minor diplomatic clash takes place because Peer Steinbrück criticises Gordon Brown for “carelessly throwing tons of money around”. Uh? I remember how in the late 90s, the majority of SPD members considered the Labour Party as half-way Thatcherites and traitors to the common cause. Gerhard Schröder invited Tony Blair to an SPD party convention in 1999, and was then pressurised to withdraw the invitation, to pass it on to Lionel Jospin of the French Parti Socialiste instead.

I don’t think I agree with D R Myddelton. Interest rates should be set at the rate which ensures the inflation target is met. If that penalises savers with negative real interest rates that is just unfortunate. If economic and monetary conditions are such that real interest rates have to be negative to meet the inflation target then there is little that can be done about it. Also, it is not the Chancellor’s view of whether we will get deflation that matters (fortunately) but the Central Bank’s.

Recent financial troubles lend credence to several features of the Austrian view. The particular theoretical obsession with defining the ‘length of the production process’ and its relationship to the rate of interest absorbed massive intellectual effort for little return. But the basic insight that severe economic dislocation and malinvestment is the result of monetary disturbances originating in the banking system does seem to apply persuasively to the present crisis.

Surely all ‘money’ is ‘fiat money’? Everybody can print their own notes – it’s called an ‘IOU’ or a ‘cheque’ or ’signing a delivery note’. I just don’t like this expression ‘fiat money’. The key to this must be that the government – oops, the Bank of England – stops interfering with interest rates, overtly, covertly, directly or indirectly (all distortions are bad distortions) and just acts as LOLR on a commercial basis, hopefully making a profit for the taxpayer while it’s at it.

I agree with Martin. There are so many features of the boom that have Austrian characteristics. However, the problems ORIGINATE in central banks rather than in the banking system as such even if private banks are an important conduit of the low interest rate signals set by the central bank.

@Mark:
IOUs and cheques are not new money. They are (temporary) money substitutes.

Hi…
I agree with u,here are so many features of the boom that have Austrian characteristics.

The British government’s policy of reducing nominal interest rates could only be justified if deflation were expected (leaving ‘real’ interest rates still significantly positive). Since the Chancellor of the Exchequer has just explicitly denied this possibility the policy seems mistaken. Not only does it penalise ‘blameless’ savers in favour of improvident borrowers, but it seems to attach far too much weight to interest rates as a decisive factor in investment decisions by businesses.

And as we speak, a minor diplomatic clash takes place because Peer Steinbrück criticises Gordon Brown for “carelessly throwing tons of money around”. Uh? I remember how in the late 90s, the majority of SPD members considered the Labour Party as half-way Thatcherites and traitors to the common cause. Gerhard Schröder invited Tony Blair to an SPD party convention in 1999, and was then pressurised to withdraw the invitation, to pass it on to Lionel Jospin of the French Parti Socialiste instead.

I don’t think I agree with D R Myddelton. Interest rates should be set at the rate which ensures the inflation target is met. If that penalises savers with negative real interest rates that is just unfortunate. If economic and monetary conditions are such that real interest rates have to be negative to meet the inflation target then there is little that can be done about it. Also, it is not the Chancellor’s view of whether we will get deflation that matters (fortunately) but the Central Bank’s.

Recent financial troubles lend credence to several features of the Austrian view. The particular theoretical obsession with defining the ‘length of the production process’ and its relationship to the rate of interest absorbed massive intellectual effort for little return. But the basic insight that severe economic dislocation and malinvestment is the result of monetary disturbances originating in the banking system does seem to apply persuasively to the present crisis.

Surely all ‘money’ is ‘fiat money’? Everybody can print their own notes – it’s called an ‘IOU’ or a ‘cheque’ or ’signing a delivery note’. I just don’t like this expression ‘fiat money’. The key to this must be that the government – oops, the Bank of England – stops interfering with interest rates, overtly, covertly, directly or indirectly (all distortions are bad distortions) and just acts as LOLR on a commercial basis, hopefully making a profit for the taxpayer while it’s at it.

I agree with Martin. There are so many features of the boom that have Austrian characteristics. However, the problems ORIGINATE in central banks rather than in the banking system as such even if private banks are an important conduit of the low interest rate signals set by the central bank.

@Mark:
IOUs and cheques are not new money. They are (temporary) money substitutes.

Hi…
I agree with u,here are so many features of the boom that have Austrian characteristics.

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