Monetarism or the Austrian School: Which Is More Effective?

At a most appropriate time, Sukrit asks:

What is the difference between the Austrian business cycle theory and monetarism, and which one do you think is a more accurate description of how the economy works?

The first part is fairly easily explained, since much material is written on both. The second part is much more difficult and subjective.

By way of background, the Austrian school is generally based on the economic theories of Ludwig von Mises (1881-1973) and Friedrich A. von Hayek (1899-1992). The latter received the Nobel Prize for economics in 1974.

Monetarism, on the other hand, is primarily based on the seminal works of Dr. Milton Friedman (1912-2006) in the Chicago school who received his Nobel Prize in 1976.

All three economists were avid defenders of freedom and capitalism.

In brief, the Austrian schools’ business cycle theory describes fluctuations in an economy based principally on intervention in the country’s money supply, resulting in inflation or deflation. In turn, this occasions recession or growth. Interference in the money supply is reflected in the level of interest rates and directly affects the level of borrowing in the economy. That level of borrowing reflects “rational economics.” Rather than relying on inductive reasoning, the Austrian school depends on deductive thought and a continuous cycle of business. The cycle, however, is not steadily predictable.

Both schools view monetary theory in the maintenance of full employment, inflation, growth and stability.

However, Milton Friedman elaborated further and suggested that money growth should be limited to a relatively stable increase of roughly three to five percent per annum. This directly contradicts the Keynesian assumption that monetary policy should be demand driven, therefore insinuating a direct political solution.

The quantity of money, then, can reasonably predict the growth of production or inflation in an economy according to Friedman. He did not, however, stipulate the Federal Reserve, often opining that central banks err regularly in their attempts to control money supplies.

The key difference between the two schools is that the Austrian school believes in cycles of business and prefers to adjust its monetary policy accordingly. Friedman, on the hand, believes that adherence to steady monetary growth without constant adjustment creates better results on a macroeconomic basis.

Unfortunately, during the last two decades – and especially during the current crisis – the U.S. Federal Reserve failed to follow Dr. Friedman’s theory of monetary aggregates. Instead of following his prescription of stable growth in the neighborhood of three to five percent per year, money was allowed to fluctuate throughout the period. It reached as much as 19% earlier this year, then slowed rapidly to two percent.

The results were pre-ordained and inevitable. Yet responsibility cannot simply be laid at any one individual’s feet.

Alan Greenspan served as chairman of the Fed from 1987 – 2006. Despite his popularity under four successive presidents, from Reagan to George W.Bush, Greenspan – and now successor Ben Bernanke – is largely blamed for the current worldwide liquidity crisis.

Certainly low cost of money and credit fueled both growth and speculation under his chairmanship. However, unforeseen circumstances like the Savings & Loan crisis, the Enron and WorldCom scandals, the World Trade Center attacks, and finally an administration that fostered the wars in Iraq and Afghanistan were destabilizing influences on Fed policy and contributed heavily to the eventual burst of speculative “bubbles.” Greed and fear were as responsible as government policies.

The main fault of Greenspan’s administration of monetary policy was to focus more on growth and inflation rather than on stability. Instead of bowing to the federal and private sector’s headiness for growth and “easy money,” a strict adherence to Friedman’s guidelines might not have led to the spectacular growth achieved. On the other hand, it might have avoided the excessive borrowing or speculation underlying today’s liquidity crisis.

It is hard to envision the Austrian school’s reliance on business cycles as performing any better than simple adherence to Friedman’s monetary policy recommendation. Even with a hard-asset economic base such as gold, speculation and suspension of convertibility during times of war can result in similar dislocations. See a fuller discussion of potential modern gold standard applications in the analysis by Cato Institute’s Lawrence White.

The trouble with both systems – and with economics in general – is that the theories for stability, growth, inflation, currencies, not to mention social issues, assume a fairly strict adherence to established guidelines and principles.

More honored in the breach rather than the observance, those guidelines or principles of an economic theory all too soon fall prey to the vagaries and convenience of politicians and the public will.

Politicians, of course, are generally more concerned with votes than with the correctness of an applied theory.

This election year is no different. The international liquidity crisis makes it a more difficult one, especially with uninformed, acrimonious candidates and an electorate bathed in ignorance and fear. The class division engendered by the euphemisms of “Main Street” versus “Wall Street” would cause a devout Communist to smile with delight! Unfortunately, it reluctantly calls into question the very principle of freedom and democracy, its costs, and its responsibilities.

Stephan is a former department chair for economics and taught at various colleges and universities at both graduate and undergraduate levels. Read his full bio at and submit your economics-related questions to his post “Got an Economics Question?”

13 comments to Monetarism or the Austrian School: Which Is More Effective?

  • Raymond

    Mr Z

    I think the monetarists believed government intervention (in the banking system) as necessary while the Austrians believe it is the root cause of economic malaise.
    That is a fundamental difference that needs elaboration.

    Here is an article that may help answer your readers question—–

    The very idea that the capitalist market economy is flawed and that government intervention is necessary to correct it goes all the way back to Karl Marx.

    He saw the recurring economic boom and bust that accompanied the Industrial Revolution in the late eighteenth century. He believed that this flaw lies deep within the market system, and that massive government intervention was needed to correct it. He didn’t recognize the influence of another institution that arrived on the scene: Banking.

    Is it at all possible that this ideology might have spawned the socialist economies of the old Soviet Union and China?
    Yet this same socialist ideology was embedded in the American political consciousness of the time, so we also adopted it for our use. We created our own institutions to execute a socialist ideology and they are here with us today.

    Government management of the economy is today an article of faith that is unquestioned. Just read a paper, or turn the TV on. Go to a university?

  • Raymond

    Make that link

    Mr Z

    I do have a nagging question on my mind about the concept of “price stability” —

    Market prices naturally fluctuate because they convey the underlying supply and demand for something, correct?

    If so, how could the Central Bank achieve “price stability”?


  • J.D. Seagraves

    The Austrian school does not believe in monetary manipulation at all. Furthermore, Austrians believe that the quantity of money is unimportant.

  • Stephan Zimmermann

    Ray – Similar to most ecnomists, Austrian School adherents have been divided on many outlooks from the beginning. (Schumpeter vs VonMises for example) That division, to me, rests on different outlooks on their essential trust and faith in mankind, on political systems, and, of course, on the role of gold and the role of a central bank (i.e., the Fed, Bank of England, etc.) in fiat money creation.

    If one denies the effectiveness of mathematically analytical (econometric) proofs, then any dicussion between the two schools of thoughts is effectively moot.

    If one denies the desirability of fractional banking, a logical discussion of alternatives becomes simply an academic one, returning at once to my fundamental recurring assumptions on the nature of mankind.

    A more important question: in today’s pragmatic world how could one actually institute the return to a metal standard (gold) with the very finite world-wide supply of the metal?

    What would be the effects of a return to the gold standard on convertibility and immediate impact on gold prices? How would it effect existing financial infrastructure? What dislocations of people in general might occur? What might be the consequences on political systems?

    Who would control inflows and outflows of gold? How would heightened demand for gold during times of war affect the country or countries in question?

    The questions are endles, and in too many cases purely academic.

    You might even find that many of the answers would severley impact the very existence of political systems as we know them.

    Your second question raises almost as many.

    Go back to your thoughts on fractional banking system… then decide whether or not you suscribe to the theory of a Fed, charged with money creation …

    How do you react to the theoretical control of a bank’s creation of money in a given economy … will you accept tangible or only theoretical proof?

    Friedman sugests that a monetary system would be able to achieve theoretical price stability in an economy by simply keeping fixed the rate of monetary growth. Whether or not this would effectively maintain stability again depends on people, rather than theoretical economic systems…. and people, it has been argued by many, do not do well in following a virtually automatic system such as a 100% gold standard or relatively siimple growth in money supply.

    My basic answer returns to my simple question: what is the naature of mankind in both short and long run.

  • Stephan Zimmermann

    J.D. – The Austrian school made several assumptions between “money” and “gold.” Money did not, of itself, have any “value,” as opposed to gold, considered as “capital.” While it is true thaat the school did not advocate a control of money, there was a very real impact and regulation of the supply of gold in an economy, largely through government’s fostering various wars and conflicts., right?

    You’d have to correct me, but it seems to me that Von Mises, especially, accepted the theory of the quantity theory, even after the Friedman elements were introduced.

  • Thanks for the answer! From my amateur readings however, I thought there were more significant differences between the two schools? There seems to be much animosity – at an intellectual level – between the Austrians and monetarists.

    For example, if we take Congressman Ron Paul as a spokesman for Austrian economics – even though he’s not an economist – the Austrians seem to be more “radical” and in the present financial crisis would have advised the government to “do nothing” as far as monetary policy goes. Let the banks fail. Let the adjustments/corrections happen. That way we’ll have a severe recession for a year, but it won’t lengthen into a depression.

    Whereas the monetarists would have advised the central bank to increase liquidity by lowering the interest rate. But Austrians would argue that this is worsening the problem by creating more malinvestment in the future. They would prefer tax cuts instead, as the least harmful way to stimulate the economy.

    Overall, Austrians seem to be more distrustful of fiat money, and want it to be “backed” by gold (to prevent rampant inflation) or, alternatively, they want free banking, where there’s no government central bank and private banks are responsible for issuing money.

  • J.D. Seagraves

    What I mean to say is that Mises and other Austrians reject the notion that there is an “optimum” quantity of money. Any amount will do. But the supply should be free of manipulation and determined by the market.

    The Austrian theory of the business cycle is that it is government manipulation of the money supply that causes booms and busts. The business cycle is unnatural and the result of government intervention. The Austrian view is much more hardline laissez-faire than the Friedmanite view.

  • raymond

    Theoretical control of a bank’s creation of money in a given economy? Sir all of your answers are vague or nonexistent yet your question demands the specific.

    And no, I don’t think one question is more important than the other to ask with all due respect.

    Your money is your private property. Taking away its purchasing power is theft. That’s not theory. I believe that.

    When the US government took away Americans money (gold) and hoarded it at Fort Knox to move us to a fiat monetary system, I doubt if they sat down and addressed
    its consequences.

    I may be off here, but I think the Austrians believe that if the stock of money in circulation remains constant relative to the economies increasing output, money will simply buy more goods. And increasing the stock of money circulating will simply produce the opposite. Do I have this right? Thanks.

  • Stephan Zimmermann

    Ray – I was not being specifically vague in response to your question, I have found throughout my years of teching, though, that it is far better to ask my students more questions to stimulate their thinking than by issuing sound-bytes as if they were the “truth.”

    “Theoretical control of a bank’s creation of money in a given economy?” applies in general to any central bank. The Fed tries to accomplish its purpose in the macroeconomic sector as does the European Union, the Banco de Mexico, the Saudii Arabian Monetary Agency and many more. You can check on which one you are most specifically interested, and then see their policies, etc. The overall purpose may be the same – stability, ggrowth, inflation, employment – yet the means to achieve those may be very different.

    Whether “Your money is your private property. Taking away its purchasing power is theft.” is certainly a normative question, rather than an objective one, that could be discussed endlessly. It depends on so many different variables, including law, ethics, religion, etc., ultimately depending on your own outlook rather than objective proof.

    Different governmental systems would have different ideas on the rights of citizens to their money and the responsibility of that government.

    The issue of the use of gold in the U.S. was (and in some circles, remains) a major issue in history. Look back over William Jennings Bryan and his famous “Cross of Gold” speech of 1896 and read about the various issues that surrounded it.

    Go back even further to Alexander Hamilton and the origin of the first central bank of the U.S. to provide you with a fascinating insight to the history of money and banking, not simply in the United States, but throughout the world.

  • J.D. Seagraves

    “the Austrians believe that if the stock of money in circulation remains constant relative to the economies increasing output, money will simply buy more goods. And increasing the stock of money circulating will simply produce the opposite. Do I have this right?”

    Yes, that is right. But Austrians are also interested in the redistributive element of inflationary monetary expansion — something the Chicago School and monetarists largely (or entirely) ignore.

  • Raymond

    Thanks Mr Z

    I do like reading economic history to look for the—-


    I find it goes straight to the motives of a particular group or individual whenever they want to advance some idea, cause or laws.

    It’s like reading the list of beneficiaries from a life insurance policy.

    Kings used to shave off their treasuries gold coins in ancient times and the result was rising prices in the realm.
    The practice of debasement is ancient and not so hard to understand even though creating money out of thin air today
    is nothing more than a blip at the NY Feds trading desk.

    But the question—– who benefits?

    I dug up something about William Jennings Bryan written by William L. Anderson —–

    William Jennings Bryan and Woodrow Wilson pushed for the income tax, inflation trough debasement of the money supply and the internal protectionist device known as Jim Crow laws which attempted to shield white workers from competition from blacks.

    Is this the person?

    To be fair, Anderson also wrote that the Republicans and Democrats vied with each other to see who could more thoroughly expand the state. Republicans led by Theodore Roosevelt and Senator LaFollette of Wisconsin, pushed for high tariffs, government ownership of natural resources, anti trust regulation and imperialistic adventures abroad.

    And we call Karl Marx a socialist.

    Thank Mr Z

  • J.D. Seagraves

    LaFollette was an anti-imperialist. He was bad on economics but very good on foreign policy. He was NOT in line with Theodore Roosevelt at all on war and peace.

  • J.D. Seagraves

    Also: Although Bryan was an inflationist (and a racist) he was also an anti-imperialist. I’d say that LaFollette and Bryan were the “good” versions (comparatively) of T.R. and Wilson, respectively… Or that T.R. and Wilson were their evil twins.

    And even though Bryan was an inflationist, he, like virtually all inflationists of his day, at least still wanted money to be backed by precious metal! They wanted silver in addition to gold (bad idea), but just think how far we’ve come when even the inflationists of old are radical anti-inflationists by today’s standards.

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