of fiat-money regimes around the world has become unmistakable.
They can only be kept alive by central banks creating ever-greater
amounts of base money and governments underwriting commercial banks’
The US Federal
Reserve, for instance, increased the stock of the monetary base
– which includes banks’ demand deposits held with the Fed,
plus coins and notes in circulation – from $870.9 billion in
August 2008 to $1735.3 billion in January 2009.
reserves” – banks’ base-money holdings minus required reserves
– rose from $1.9 billion to $798.2 billion. These excess reserves
allow the banking sector, which operates under fractional reserves,
to increase the credit and money supply manifold.
base expands when the central bank takes over the troubled assets
of commercial banks in order to extend new credit to those banks.
This process is gaining momentum: on March 18, 2009, the Federal
Open Market Committee (FOMC) announced that it will increase base
money by purchasing another $1,150 billion of securities. It is
also considering increasing base money by extending credit to private
households and small businesses.
What the Fed
does is produce inflation – and this is a truth that
stands in sharp contrast to what mainstream economists say, namely
that the rise in base money will just increase the liquidity
in the interbank market and will not affect the money holdings in
the hands of consumers, firms, and the government, which –
they admit – could then inflate consumer prices.
Austrian economists stress that inflation is a result of
a rise in the stock of money. This viewpoint rests on sound economics,
firmly rooted in the notion that, first and foremost, value is a
subjective concept. Money is a good, like any other, and it is therefore
subject to the law of diminishing marginal utility.
A rise in the
money stock necessarily reduces the marginal utility of a money
unit – and therefore its value – from the viewpoint of
the individual; likewise, the marginal utility of a money unit –
and therefore its value – would increase if the money stock
the value individuals assign to a money unit are reflected in prices
for vendible items. For instance, if the money stock in the hands
of an individual rises, he may wish to increase his holdings of
other goods. As he exchanges money against vendible items, the prices
of the latter are bid up.
In that sense,
the change in the money stock is what must be called inflation,
while changes in the prices for goods and services are just symptoms
of the underlying cause, which is the change in the stock of money.
What the rise
in base money has done so far is prevent prices of banks’ security
holdings from declining to free-market levels. In other words, the
money injection helps to keep asset prices at artificially elevated
levels, thereby preventing prices in financial markets, credit markets
in particular, from adjusting.
Toward Ever-Higher Inflation
controlled fiat-money regime is highly inflationary, as it allows
for an increase in the stock of money mostly through bank credit
in excess of real savings (circulation credit). The rising
money stock pushes up prices – be it consumer or asset prices
(such as stocks, housing, etc.).
money stock through circulation credit sets into motion an illusionary
boom, leading to malinvestment. However, the latter does
not come to the surface as long as the credit and money supply keeps
If money supply
growth slows down all of a sudden, however, investor expectations
are disappointed, and investment projects, which were – in
a world of ever more money and rising prices – considered economically
viable, become unprofitable.
down of money growth reveals that the production structure does
not comply with actual demand, thereby unmasking the squandering
of scarce resources. And so the artificial boom, induced by new
money injections, turns into bust.
A policy of
holding up the artificial boom would require ever-greater increases
in money. Ludwig von Mises saw that this would lead to disaster:
no means of avoiding the final collapse of a boom brought about
by credit expansion. The alternative is only whether the crisis
should come sooner as the result of a voluntary abandonment
of further credit expansion, or later as a final and total catastrophe
of the currency system involved.
for Producing Inflation
In an attempt
to keep credit and money supply from slowing down and the economies
from going into recession, monetary policies around the world are
about to push short-term interest rates towards zero and expand
the stock of base money, and thereby banks’ excess reserves, drastically.
banks can be expected to put their excess reserves to use, because
base-money balances do not yield any interest: banks need to generate
income to be in a position to pay interest on their liabilities
(demand, time and savings deposits, and debentures).
is one option. However, in an economic environment of financially
overstretched borrowers, banks might be hesitant to increase their
loan exposure vis-à-vis households and firms. In fact, it might
be increasingly difficult for banks to do so given that equity capital
has become increasingly scarce and costly.
banks may wish to monetize government debt, as the latter does not
require putting equity capital to use. The government
then spends the additionally created money stock on politically
expedient projects (unemployment benefits, infrastructure, defense,
etc.), and the money stock in the hands of households and firms
however, commercial banks decide to refrain from additional lending,
and even call in loans falling due, the government may decide –
as another drastic, but logically consequential step of interventionism
– to nationalize the banking industry (or at least a great
part of it). By doing so, it can make the banks increase the credit
and money supply.
the central bank could print additional money, distributing it to
households and firms as a transfer payment.
Under a fiat-money regime, this can be done at any time and without
limit, as Federal Reserve Chairman Ben S. Bernanke made unmistakably
clear in a notorious speech in 2002:
government has a technology, called a printing press (or, today,
its electronic equivalent), that allows it to produce as many
U.S. dollars as it wishes at essentially no cost. By increasing
the number of U.S. dollars in circulation, or even by credibly
threatening to do so, the U.S. government can also reduce the
value of a dollar in terms of goods and services, which is equivalent
to raising the prices in dollars of those goods and services.
We conclude that, under a paper-money system, a determined government
can always generate higher spending and hence positive inflation.
fiat money is fraudulent money. It is money that is created out
of thin air, in violation of property rights: fiat-money production
doesn’t require any of the wealth-producing activities characteristic
of the free market. It is and will always be, by construction, fraudulent
What is more,
fiat money created through bank credit expansion necessarily causes
boom-and-bust cycles, inducing governments to push back free-market
forces to prop up the economy and keep the fiat-money regime afloat;
in fact, fiat money will increasingly undermine the free-market
Mises was well
aware of the final consequences of a monetary regime that rests
on ever-greater increases in the money stock produced by banks’
expanding circulation credit. It would, at some point,
lead to bankruptcies on the grandest scale, resulting in a contraction
of the credit and money supply (deflation).
Or it would
end in hyperinflation:
once public opinion is convinced that the increase in the quantity
of money will continue and never come to an end, and that consequently
the prices of all commodities and services will not cease to
rise, everybody becomes eager to buy as much as possible and
to restrict his cash holding to a minimum size. For under these
circumstances the regular costs incurred by holding cash are
increased by the losses caused by the progressive fall in purchasing
power. The advantages of holding cash must be paid for by sacrifices
which are deemed unreasonably burdensome. This phenomenon was,
in the great European inflations of the ‘twenties, called flight
into real goods (Flucht in die Sachwerte) or crack-up
very well what he was referring to. He had lived through the period
of great inflation that started in Europe in 1914 with World War
I. This finally led to hyperinflation and a complete destruction
of Germany’s Reichsmark in 1923. On a technical level, Germany’s
hyperinflation was the result of the German Reichsbank monetizing
the growing government debt, issued for financing social benefits,
subsidies, and reparation payments.
of Inflation (1979), reviewing Germany’s hyperinflation
from a political-economic viewpoint, Hans F. Sennholz asked, “Who
would inflict on a great nation such evil which had ominous economic,
social, and political ramifications not only for Germany but for
the whole world?”
His sobering answer was that
mark was printed by Germans and issued by a central bank that
was governed by Germans under a government that was purely German.
It was German political parties, such as the Socialists, the
Catholic Centre Party, and the Democrats, forming various coalition
governments that were solely responsible for the policies they
conducted. Of course, admission of responsibility for any calamity
cannot be expected from any political party.
the German hyperinflation was the result of a policy that considered
the financing of government debt by an accelerating increase in
the money stock as the politically least unfavorable method. It
seems that the state of opinion hasn’t actually changed much. Today,
there is great public support when it comes to expanding the base-money
stock for financing ailing banks, insurance companies and, most
important, rising government debt.
and theories that led to the German monetary destruction have since
then caused destruction in many other countries. In fact, they may
be at work right now all over the western world.”
Austrian economics would rightly maintain that current fiat-money
polices have become increasingly inflationary – and they should
have little doubt that the forces and instruments that can pave
the way towards hyperinflation are already in place and gaining
strength by the day.
to a destruction of the currency is the return to sound money
– free-market money – as outlined by Mises and further
developed by Murray N. Rothbard. It would presumably, at least in
the initial stage, result in gold-backed money under 100% reserves.
The edging up of the gold price seems to support the view that people
consider gold as the ultimate means of payment –
a status that will become increasingly obvious once people fear
that the exchange value of fiat money will be eroded substantially.
audio version of this article, read by Floy Lilley, is available
for free download.
Mises, Ludwig von. Human Action: A Treatise on Economics,
4th ed. (San Francisco: Fox & Wilkes, 1996), p. 572.
In this context, see an overview of the Fed’s blueprint for making
inflation: Johnson, K., D. Small, and R. Tryon. (1999) “Monetary
Policy and Price Stability.”
Mises, Human Action, p. 427.
Sennholz, H. S. Age of Inflation. (Belmont, Mass.: Western
Islands, 1979), p. 80.
first appeared on Mises.org.
Polleit [send him mail]
is Honorary Professor at the Frankfurt School of Finance & Management.