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 . . . → Read More: 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?”