Thursday, April 15, 2010

The Austrian Theory of Inflation: Myths and Reality

Many libertarians, advocates of free market economics or supporters of Austrian economics complain repeatedly about fiat money and increases in the money supply.

Typically, they complain that any increase in the money supply must always lead to a rise in the price level or the inflation rate.

Here is a video of Ron Paul complaining about the Federal Reserve’s creation of money because it will lead to inflation.

It is a view that you find frequently in pro-free market, libertarian, and populist Austrian blogs or commentary.

A very general statement of the Austrian theory of inflation can be found on Wikipedia:
“The Austrian School asserts that inflation is an increase in the money supply, rising prices are merely consequences and this semantic difference is important in defining inflation. Austrian economists believe there is no material difference between the concepts of monetary inflation and general price inflation. Austrian economists measure monetary inflation by calculating the growth of new units of money that are available for immediate use in exchange, that have been created over time. This interpretation of inflation implies that inflation is always a distinct action taken by the central government or its central bank, which permits or allows an increase in the money supply. In addition to state-induced monetary expansion, the Austrian School also maintains that the effects of increasing the money supply are magnified by credit expansion, as a result of the fractional-reserve banking system employed in most economic and financial systems in the world.”
So firstly the word “inflation” is defined specifically as an increase in the money supply, and contrary to the popular definition of “an average increase in the price level.” In the Austrian theory, “inflation” is not a general increase in prices, but an increase in the money supply.

The purpose of this post is to show that many people today who are sympathetic to Austrian economics or who are self-proclaimed followers of the Austrian school actually do not understand the Austrian theory of inflation and the price level.

Many people cannot distinguish Milton Friedman’s monetarist theory of the price level (based on the quantity theory of money) from the Austrian view, which is actually quite different from Friedman’s and, moreover, has changed over time.

First, it is necessary to say a word about the quantity theory of money. Contrary to what many believe, Austrians have always had an ambivalent and even critical attitude to the quantity theory of money. The quantity theory of money is the basis of Milton Friedman’s monetarism, a macroeconomic theory that became popular in the late 1970s and early 1980s. The quantity theory is also used frequently by pro-free market writers to decry expansion of the money supply under a fiat monetary system.

However, many Austrians actually have a rather sceptical view of the quantity theory.

Ludwig von Mises, for instance,
“agreed with the classical ‘quantity theory’ that an increase in the supply of dollars or gold ounces will lead to a fall in its value or ‘price’ (i.e., a rise in the prices of other goods and services); but he enormously refined this crude approach and integrated it with general economic analysis. For one thing, he showed that this movement is scarcely proportional; an increase in the supply of money will tend to lower its value, but how much it does, or even if it does at all, depends on what happens to the marginal utility of money and hence the demand of the public to keep its money in cash balances. Furthermore, Mises showed that the ‘quantity of money’ does not increase in a lump sum: the increase is injected at one point in the economic system and prices will only rise as the new money spreads in ripples throughout the economy. If the government prints new money and spends it, say, on paper clips, what happens is not a simple increase in the ‘price level,’ as non-Austrian economists would say; what happens is that first the incomes of paperclip producers and prices of paper clips increase, and then the prices of the suppliers of the paper clip industry, and so on. So that an increase in the supply of money changes relative prices at least temporarily, and may result in a permanent change in relative incomes as well” (Rothbard 2009: 15).
In other words, Mises denied that a given increase in the money supply (say, 5%) would lead to a direct, proportional and mechanistic rise of 5% in the general level of prices.

The naïve monetarists believe that there is a “monocausal” explanation of inflation: money supply growth which will cause direct, proportional increases in the price level. This is ridiculous.

Friedrich August von Hayek believed that a simple form of the quantity theory was a “helpful guide,” but was nevertheless a critic of the theory, both in the version of it propounded by Irving Fischer and the restatement of it by Milton Friedman (Arena 2002). In particular, “Hayek criticized Friedman for concentrating too much on statistical relationships (between the quantity of money and the price level), claiming that matters are not quite that simple” (Garrison 2007: 3). Modern Austrians are divided on the issue of the quantity theory of Friedman. Some continue to be critical, like Jesús Huerta de Soto:
“[sc. The equation MV=PT of the quantity theory] contains an undeniable element of truth inasmuch as it reflects the notion that variations in the money supply eventually influence the purchasing power of money (i.e., the price of the monetary unit in terms of every good and service). Nevertheless its use as a supposed aid to explaining economic processes has proven highly detrimental to the progress of economic thought, since it prevents analysis of underlying microeconomic factors, forces a mechanistic interpretation of the relationship between the money supply and the general price level, and in short, masks the true microeconomic effects monetary variations exert on the real productive structure” (Huerta de Soto 2009).
The Austrians think that quantity theory is inadequate because it ignores their theory that increases in the money supply distort the productive structure of an economy – a cause, they believe, of recessions.

These Austrian views of the quantity theory are frequently ignored or simply unknown to many who hold a crude, vague or confused Austrian view of economics.

Austrians, in essence, have two objections to inflation. The visible effect (if output does not rise) is rising prices. This could be rising prices in goods and services (not necessarily uniformly), but also in the prices of financial and real assets. Austrians quite reasonably include asset price inflation in the overall price level (note that the prices of stocks, bonds, other financial assets, real estate, and commercial property are not normally included in consumer prices indices). But their further complaint is that there is also an invisible effect: the increasing money supply stops the money stock from remaining stable and hence it prevents deflation, which would increase the purchasing power of money. A rising money stock, therefore, does not allow money’s purchasing power to increase through price deflation.

With respect to asset price inflation, the Austrian view ignores the fact that effective financial regulation can prevent bubbles, especially in real assets like housing and real estate. The US, for instance, had stable housing prices from about 1950 until the mid-1970s, and the same was true in many other countries, because of regulation.

The Austrian claim that money supply increases cause the invisible effect of preventing deflation ignores the fact that, although price deflation increases money’s purchasing power, deflation can have devastating effects on economic activity. Debts, for instance, are fixed in nominal terms and, when deflation causes wage and price falls, debtors face a greater burden in repaying debt. The Austrians argue that the gold standard should be restored, but this would leave the level of the money supply subject to external factors like discoveries of gold and the current account balance. In fact, the gold standard was no guarantee of zero inflation: the UK was on the gold standard and had persistent inflation between 1897 and 1912, partly because of the influx of gold from new discoveries.

Furthermore, when we examine articles on the Austrian theory of inflation at the Ludwig von Mises Institute by more academic Austrian scholars, we even find a more balanced argument:
“the essence of inflation is not a general rise in prices but an increase in the supply of money, which in turns sets in motion a general increase in the prices of goods and services .... While increases in money supply (i.e., inflation) are likely to be revealed in general price increases, this need not always be the case. Prices are determined by real and monetary factors. Consequently, it can occur that if the real factors are pulling things in an opposite direction to monetary factors, no visible change in prices might take place. In other words, while money growth is buoyant – i.e., inflation is high – prices might display low increases.”

Frank Shostak, “Defining Inflation,” Mises Daily, March 6, 2002.
Shostak also believes that increasing the money supply leads to a misallocation of resources. This is indeed possible, especially in an unregulated financial system, but it is by no means necessary or inevitable. Credit has to be given to the Austrians for their business cycle theory, because at the time when they first produced it (in the 1920s and 1930s) it was an improvement over the neoclassical view that business cycles caused by a failure of aggregate demand could not occur in capitalism because of Say’s law, and also because the Austrians (like the post Keynesians) correctly saw that money is not “neutral”. However, Austrian business cycle theory still has major flaws and it cannot be accepted, though that is a topic for another essay.

The important point, however, is that Shostak is careful to qualify his statement quoted above. He says that increasing the money supply will always cause an increase in the level of prices, but then concedes that prices are also “determined by real and monetary factors. Consequently, it can occur that if the real factors are pulling things in an opposite direction to monetary factors, no visible change in prices might take place.”

This is a very important qualification. He is right that the inflation rate (the rate of increase in a price index like the CPI) and changes in the level of prices also depend very much on real factors, as well as monetary ones. For example, the following factors could tend to decrease the level of prices:
2. an appreciating exchange rate;
3. a rise in cheaper imports into a country;
5. changes in the velocity of circulation of money;
6. higher unemployment (= less demand for goods and services), and
7. a fall in extension of bank credit.
In reality, all or some of these factors listed above could operate to cause either a zero inflation rate (which Japan actually had in 1996 and 2004) or a fall in average prices (deflation), even when the money supply is still actually increasing.

We can take a real world example. In the late 19th century, the UK experienced sustained price deflation from 1873–1896. However, the actual broad money stock was rising in these years: between 1873–1896 the money stock grew by about 1.3% a year, or over the entire period by about 33%. Yet between 1873–1896 wholesale prices fell by 39%. What happened was that in this period the money supply was rising, but not as fast as demand for money, and also steep falls in the prices of agricultural commodities contributed to the fall in overall prices (Capie and Wood 1997: 287–289).

Now Shostak’s slightly more balanced Austrian view that an increasing money supply does not always necessarily lead to a rise in the price level is hardly ever considered by popular proponents of Austrian school economics.

Instead, we hear endless rants about how increasing the money supply always and automatically devalues or reduces money’s purchasing power.

This simply ignores the fact that the mechanism that reduces the purchasing power of money is an average increase in the price level.

Once it is conceded that (1) the relationship between a rising money stock and rising price level is not automatic, necessary or inevitable and (2) the Austrian business cycle theory is wrong, most of the popular and crude objections to an increasing money supply collapse.

But there is more to be said. If we go right back to the work of Ludwig von Mises in The Theory of Money and Credit (1912), we actually find another definition of inflation:
This definition of inflation is hardly ever used by popular followers of Austrian school economics.

The fundamental fact is that Mises did not define an increase in the money supply accompanied by a corresponding demand for money as inflation.

As interpreted by a modern Austrian scholar:
“Mises …. suggests inflation [is] … ‘an increase in the quantity of money above the market demand of money.’ Note that, under Mises’ suggested definition, not every increase in the quantity of money is inflation, only increases that exceed market demand …. [Mises] saves the term inflation for cases where the quantity of money is increasing above the market demand for money” (Cachanosky 2009: 5).
That means that the money supply can continuously rise in proportion to the demand for money, and that this is presumably not objectionable in Mises’ theory.

This is a far cry from some modern advocates of a crude Austrian or quantity theory of money, who complain that any increase in the money supply is bad and will cause a rise in prices.

In addition, if you reject Austrian business cycle theory, this passage quite obviously raises the question of why a rise in fiat money in response to the demand for it in an economy with effective financial regulation that channels credit to productive investments (rather than asset bubbles or speculation) would be a bad thing.


Arena, R., 2002, “Monetary Policy and Business Cycles: Hayek as an Opponent to the Quantity Theory Tradition,” in J. Birner, P. Garrouste, T. Aimar (eds), F. A. Hayek as a Political Economist: Economic Analysis and Values, Routledge, London.

Cachanosky, N., 2009, “The Definition of Inflation According to Mises: Implications for the Debate on Free Banking,” Libertarian Papers Vol. 1, Art. No. 43.

Capie F. H. and G. H. Wood, 1997, “Great Depression of 1873-1896,” in D. Glasner et al. (eds), Business Cycles and Depressions: An Encyclopedia, Garland Pub., New York, 287–289.

Garrison, R., 2007, “Hayek and Friedman: Head to Head”

Huerta de Soto, J., 2009, “A Critique of the Mechanistic Monetarist Version of the Quantity Theory of Money,”


Quiggin, J., 2009, “Austrian Business Cycle Theory,” May 3rd


Shostak, F., 2002, “Defining Inflation,” Mises Daily, March 6

Friday, April 2, 2010

Japan’s Quantitative Easing (QE), the Yen Carry Trade and QE in the US

I have recently seen two short essays comparing QE in Japan with that in the US:
"Quantitative easing in US and Japan".

Paul Krugman, “Way off Base”.
The monetary base in Japan rose by 70% from 2001–2006 and by 140% in the US from 2008–2010.

The Bank of Japan increased the base money from about 65 trillion yen in March 2001 to 110 trillion yen by 2006.

In the article above, Paul Krugman points out that, just because the monetary base rises rapidly, this does not necessarily mean that higher inflation must occur or is likely to occur – and Japan’s case proves it, as Japan continued to experience deflation down to 2006 despite its QE.

Needless to say, when QE was adopted in the UK and the US in 2009, we had many predicting hyperinflation for 2009 or the near future.

To take one example, the investment analyst and entrepreneur Marc Faber was interviewed by Glenn Beck on 28th May, 2009, and predicted that hyperinflation would happen in the US and that this was 100% certain.

It is obvious that there was no hyperinflation in 2009 and no signs of it now.
Many have correctly pointed out that Japan engaged in QE in the early 2000s, and no hyperinflation ever resulted. One response to this is that much of the money created by the Bank of Japan during QE was simply lent out for the yen carry trade.

The blogger Cynicus Economicus, for example, has argued that Japan did not experience high inflation because the printed money (that is, the excess bank reserves) went to the West via the carry trade (See “Getting carried away…” Trade & Forfaiting Review, 3 Dec 2009; "Easy money?" Trade & Forfaiting Review, 9 April 2009).

However, the view that all or most of the excess reserves created by Japan's QE were simply lent out in the carry trade is actually false.

First, the initial phase of the yen carry trade occurred from 1995 to October 1998 – before Japanese QE even began.

In addition, the second phase of the yen carry trade went from 1999 (again before Japanese QE began) to 2008:
despite the carry trade’s importance, no one knows for sure how large it really is. Mr. Kanno [an economist for JPMorgan Securities] estimates that about 7 trillion yen, or about $58.39 billion, flowed overseas last year [2006] alone. Another way to measure the trade is by the amount of assets now held overseas by all those involved in the trade since it began in 1999, when the Bank of Japan first cut rates to near zero. Mr. Kanno estimates those holdings are worth about 40 trillion yen, or around $330 billion …. Policy makers also seem aware that the carry trade is mostly driven by Japanese individuals trying to improve the return on their savings. Mr. Kanno of JPMorgan estimates that these individuals’ holdings overseas have grown to about 30 trillion yen since 1999, making up about three-quarters of all carry-trade-related investments. Most of the rest is held by foreign investors, he said.
Martin Fackler, “Bank of Japan Raises Short-Term Interest Rates,” New York Times, February 22, 2007.
So in fact that vast majority of all yen carry trade investors were Japanese savers, who were investing their own money that they had saved, not newly created money from QE.

Furthermore, the Bank of Japan rapidly drained the excess reserves and ended QE in March 2006, yet the yen carry trade continued. With the end of QE the Bank of Japan also ended its zero-interest-rate policy, and lifted interest rates slightly, though again the yen carry trade simply continued.

Tadashi Nakamae, in a 2007 article in the International Economy magazine, explains what happened:
The Bank of Japan undertook drastic steps to lower interest rates to save domestic banks and non-financial companies after Japan’s bubble burst. Easing the interest payment burdens of [banks] … was the most effective measure to rescue them. The victim of this policy was the household sector. Their interest income was wiped out. After peaking in 1991 at 39 trillion yen in returns from 600 trillion yen in interest-bearing financial assets (mostly bank deposits), households’ interest income has nose-dived to less than 5 trillion yen from 860 trillion yen in interest-bearing assets …. Zero interest rates also triggered a significant change among Japanese savers. An increasing number, who had traditionally favoured domestic bank deposits, are now looking abroad for better returns …. Japanese households have some 1,500 trillion yen—triple the size of Japan’s GDP—in financial assets (including the 860 trillion in interest-bearing instruments). The 15 trillion yen flowing overseas is just 1 percent of the total.

Tadashi Nakamae, “Weak Yen Conundrum: Why Japanese households love foreign financial assets,” International Economy, Winter 2007.
Thus there was more than enough money in Japanese household savings to fund most of the yen carry trade (and in 2010 Japanese savers still have about $15 trillion US in savings).

Even foreign investors probably could have borrowed yen for their carry trade operations from the Japanese money markets and the banks' own deposit base rather than massively drawing on excess reserves.

As an aside, the carry trade also caused significant depreciation in the exchange rate of the yen, as you can see in this graph of the trade weighted value of the yen (1980–2009). The fall was very steep.

It is likely that the fall in the yen’s value had a major role in the recovery of Japan’s economy in the 2000s by making its exports much cheaper on international markets. This factor was no doubt important, given that Japan is an export-led growth economy (Lok Sang Ho, “The Moral of Japan's Lost Decade”).

So the yen depreciation was actually beneficial.

With respect to the carry trade and the fall in the yen's value, the relevant policy instrument was the interest rate, which was driven down to zero by the Bank of Japan through QE. The expanding monetary base did this, but those reserves were not all suddenly lent out. When QE ended in 2006, the short term interest rate rose from nearly 0% to 0.25% – which was still a very low rate.

But, during the time of QE, the monetary base had been increased to 110 trillion yen by 2006, so the banks had more than enough money to lend into Japan’s domestic economy if they wanted to, yet domestic Japanese bank loans actually fell during most of the time in which QE was conducted and the broad money supply growth was slow.

The claim that the yen carry trade prevented the injection of the newly created bank reserves into Japan’s economy is obviously false. There were other factors that prevented a rise in bank loans.

Hyperinflation never resulted because bank lending is determined not simply by reserves, but by the number of creditworthy businesses and individuals and the willingness of banks to lend. In the uncertain environment of the lost decade and the slow recovery that followed it, Japanese business confidence was not that high, so borrowing and lending was not either.

Much the same thing has happened in the US. As of February 2010, the US banks were still not lending much:
David Rosenberg from Gluskin Sheff said lending has fallen by over $100bn (£63.8bn) since January, plummeting at an annual rate of 16pc. "Since the credit crisis began, $740bn of bank credit has evaporated. This is a record 10pc decline," he said ... The M3 broad money supply – watched by monetarists as a leading indicator of trouble a year ahead – has been contracting at a rate of 5.6pc over the last three months. This signals future deflation.

Ambrose Evans-Pritchard, “US bank lending falls at fastest rate in history,” The Telegraph, 17 February 2010.
In other words, the situation is similar to what happened in Japan during their experiment with QE.

You can get excellent graphs of the various US money supply measures and growth rates at (Monetary Base and Money Supply).

These confirm that the broadest US money supply measure (M3) is falling.

The most recent data from suggest that “for the three weeks between Feb. 24 and March 10, outstanding loan balances were flat. That represents the first three-week period without a decline since early 2008.”

But this doesn’t mean that lending will significantly increase any time soon, as there is still a lack of creditworthy borrowers and non-performing loans are a serious issue, as pointed out in the Forbes article.

One can also point out that even in an upturn banks are likely to return to conservative lending principles – and even if they did increase lending greatly they still only have a limited demand for credit from over-indebted borrowers, not enough to cause hyperinflation.