Understanding the Austrian Theory of the Business Cycle

By Mark Skousen

One of the highlights of my professional career occurred recently when I had the opportunity to talk with Professor F. A. Hayek at his vacation home in the Austrian Alps. It was an unforgettable experience. Since the death of Ludwig von Mises in 1973, Professor Hayek has been the acknowledged dean of the “Austrian” school of economics, which teaches individualism, laissez-faire economics, and the gold standard. He is now 86 years old, but sharp and alert, and still working hard on a number of projects.

Professor Hayek is the oldest living member of the Austrian school, which began in Vienna with Carl Menger in the 1870s, and continued with Eugen von Böhm-Bawerk, Ludwig von Mises, and Murray N. Rothbard, among others. In 1974, Professor Hayek won the Nobel Prize in Economics for his work on the Mises-Hayek theory of the business cycle.

Of all the many contributions of the “Austrians,” their theory of the business cycle is one of the most valuable. Economists and Wall Street analysts have known for decades that the markets are highly volatile. There is a business cycle in national output, interest rates, and inflation, creating bull and bear markets in stocks, bonds, gold, and so on. And Austrian theory is the only satisfactory explanation of this business cycle.

The first thing to understand is that the principle source of economic disruption and the business cycle is irresponsible government policy. The business cycle, inflation, and high nominal interest rates are not caused by the free market, but by government’s monetary and fiscal policies.

Without government intervention, the free-market economy would reflect:

1) Stable interest rates, probably in the 2%-3% range, as in the 1950s.

2) No inflation. In fact, historically, average prices have tended to decline slightly with a free market and gold standard.

3) Low unemployment. No minimum wage laws and forced collective bargaining, which keep wages artificially high during a recession.

4) High savings rate. Contrary to standard Keynesian doctrine, high personal savings rates are good for economic growth.

5) Economic growth without recessions or depressions.

But as long as government is ubiquitous, and controls the supply of money, it will appear that “capitalism” is inherently unstable, as the Marxists say. Only the wise student of history and economic science knows that government policy, not the free market, is responsible for economic instability.

The key to understanding the economic cycle is what the Austrians call the “structure of production.” Unlike the Keynesians and Monetarists, the Austrians look at the economy not as a whole, but as a collection of individual parts—not “macroeconomics,” but “microeconomics.”

The easiest way to understand the “structure of production” is to see how the economy exists at a single moment, as if a snapshot were taken. If the whole economy were suddenly frozen, what would you see? You would see some products and services completed, such as cars coming off the assembly line ready to sell to consumers. Other products would be half finished, and still others would be just starting production.

In other words, there is an order to the production of goods and services in an economy. The “higher” order or stages of production are “capital goods,” which include tools, machinery, raw materials, trucks, and other goods necessary to produce final consumer goods, which include automobiles, food, clothing, and so on.

This distinction is very important in understanding the inflationary boom-bust cycle. As the Austrians point out, the central bank (the Federal Reserve) expands the money supply in a way that affects certain industries more than others. Historically, because the Fed expands the money supply primarily through the credit markets, the capital-goods investor has been more affected than the consumer-goods market.

There are essentially four states to the business cycle:
First, the inflationary boom. The Fed expands the money supply by purchasing Treasury securities from banks. Profits in capital-intensive industries tend to rise, and because the stock market is highly capital-intensive, the stock market goes through a bull market. However, at the later stages of the inflationary boom, consumer prices start catching up, the stock market loses its luster, and the bull market ends. Also, at the end of the inflationary cycle, gold and silver and other inflation hedges move up sharply.

Second, the credit crunch. Once consumer prices start rising sharply, and interest rates start edging up, the Fed usually puts on the brakes and causes a credit crunch. Interest rates rise rapidly as capital industries scramble for funds to escape bankruptcy.

Third, recession. Production of capital goods falls more sharply than consumer goods. Gross National Product declines, and stocks continue to fall. Interest rates start dropping as demand for credit declines. Prices for commodities and capital goods tend to fall more sharply than consumer goods, which sometimes continue to rise (“inflationary recession”).

Fourth, economic recovery. The recession in capital goods ends as the economy returns to stability. The Austrians are the only school with satisfactory answers to two questions facing economics today: 1) how it is possible to have low inflation in the face of double-digit increases in the money supply, and 2) inflationary recession.
The “low-inflation” environment continues, despite 10% annual increases in the money supply, because of the previous “malinvestments” in the capital goods industries. When companies are on their backs, it requires a greater increase in credit than the previous cycle to achieve a return to previous levels of economic prosperity. After the economy has gone through a major recession and the inflationary psychology has been broken, the government must expand the money supply at a higher rate than the previous cycle in order to achieve the same level of economic activity and price inflation. Note, however, that under President Reagan, the money supply has grown at the same rate as under President Carter, but not more—therefore, we would expect, under Austrian theory, the inflation rate to fall below the double-digit rates of the 1970s. Indeed it has.

I believe the money supply must expand at a 15% to 20% annual rate in order to rekindle double-digit price inflation this time around. So far it hasn’t happened, although lately M1 has been growing at a 14% rate. At some point, of course, price inflation will catch up, but it’s too early to tell when this will happen.
During the inflationary stage of the business cycle, production and prices for capital goods and raw commodities tend to rise much more than for final consumer goods. Only at the later stages of the inflationary boom do consumer goods (as measured by the Consumer Price Index) begin to rise.

Look, for example, at the production of automobiles. During an inflationary boom, the price of iron, steel, aluminum, and other producer goods used in building cars may increase substantially, perhaps doubling in value. But the price of an automobile in the showroom may increase only 5% to 10%.

During a recession, just the opposite occurs. Prices for producers’ goods and raw commodities drop sharply, compared to consumer goods. In the case of cars, steel may fall sharply in price. Meanwhile, the price of finished cars may fall only slightly, or, as has occurred recently, continue to rise.

Thus, consumer goods always tend to rise in a recession relative to capital goods. If you look at the statistics of any recession, you’ll note that the raw commodities price index and the wholesale price index fell by a greater amount than consumer prices. Consumer prices also tended to fall, but not by the same amount. In other words, consumer prices rose in relation to wholesale and commodity prices.

The relationship still holds even today during a recession, except that now in absolute terms, consumer prices are rising instead of falling. This is because the magnitude of monetary inflation is much greater than in past cycles. So, relative to capital goods, all recessions are “inflationary recessions.” It’s just that such a relationship didn’t become obvious until the Consumer Price Index continued to rise in the 1973-1975 recession and the 1980-1981 recession.

If you want to learn more about this aspect of Austrian economics, I recommend the following books, all available from the Institute: What Has Government Done to Our Money?, by Murray N. Rothbard ($5), America’s Great Depression also by Rothbard ($20), An Introduction to Austrian Economics by Thomas C. Taylor ($6), and The Austrian Theory of the Trade Cycle by Ludwig von Mises and others ($5); shipping charge: $2.75 with each order.

All show that the only way that we can escape from the business cycle is through the establishment of sound money (i.e., a gold standard and no central bank) and the free market. If we are ever able to do so, the Austrian school of economics will deserve the credit.

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The World Currency Crisis

By Murray N. Rothbard

I: Keynesians and FixedExchange Rates, 1944-73

The world is in permanent monetary crisis, but once in a while, the crisis flares up acutely, and we noisily shift gears from one flawed monetary system to another. We go back and forth from fixed paper rates to fluctuating rates, to some inchoate and aborted blend of the two. Each new system, each basic change, is hailed extravagantly by economists, bankers, the financial press, politicians, and central banks, as the final and permanent solution to our persistent monetary woes.
Then, after some years, the inevitable breakdown occurs, and the Establishment trots out another bauble, another wondrous monetary nostrum for us to admire. Right now, we are on the edge of another shift.

To stop this shell game, we must first understand it. First, we must realize that there are three coherent systems of international money, of which only one is sound and non-inflationary. The sound money is the genuine gold standard; “genuine” in the sense that each currency is defined as a certain unit of weight of gold, and is redeemable at that weight.

Exchange rates between currencies were “fixed” in the sense that each was defined as a given weight of gold; for example, since the dollar was defined as one-twentieth of a gold ounce and the pound sterling as .24 of a gold ounce, the exchange rate between the two was naturally fixed at their proportionate gold weight, i.e., £1 = $4.87.

The other two systems are the Keynesian ideal, where all currencies are fixed in terms of an international paper unit, fluctuating independent fiat-paper moneys. Keynes wanted to call his new world paper unit the bancor while U.S. Treasury official (and secret Communist) Harry Dexter White wanted to name it the unita. Bancor or unita, these new paper tickets would ideally be issued by a World Reserve Bank and would form the reserves of the various central banks. Then, the World Reserve Bank could inflate the bancor at will, and the bancor would provide reserves upon which the Fed, the Bank of England, etc. could pyramid a multiple expansion of their respective national fiat currencies.

The whole world would then be able to inflate together, and therefore not suffer the inconvenience of inflationary countries losing either gold or income to sound-money countries. All the countries could inflate in a centrally-coordinated fashion, and we could suffer manipulation and inflation by a world government-banking elite without check or hindrance. At the end of the road would be a horrendous world-wide hyper-inflation, with no way of escaping into sounder or less inflated currencies.
Fortunately, national rivalries have prevented the Keynesians from achieving their goal, and so they had to settle for “second best,” the Bretton Woods system that the U.S. and Britain foisted on the world in 1944, and which lasted until its collapse in 1971. Instead of the bancor, the dollar served as the international reserve upon which other currencies could pyramid their money and credit. The dollar, in turn, was tied to gold in a mockery of a genuine gold standard, at the prewar par of $35 per ounce. In the first place, dollars were not redeemable in gold coins, as they had been before, but only in large and heavy gold bars, which were worth many thousands of dollars. And secondly, only foreign governments and central banks could redeem their dollars in gold even on this limited basis.

For two decades, the system seemed to work well, as the U.S. issued more and more dollars, and they were then used by foreign central banks as a base for their own inflation. In short, for years the U.S. was able to “export inflation” to foreign countries without suffering the ravages itself. Eventually, however, the ever-more inflated dollar became depreciated on the gold market, and the lure of high priced gold they could obtain from the U.S. at the bargain $35 per ounce led European central banks to cash in dollars for gold. The house of cards collapsed when President Nixon, in an ignominious declaration of bankruptcy, slammed shut the gold window and went off the last remnants of the gold standard in August 1971.

With Bretton Woods gone, the Western powers now tried a system that was not only unstable but also incoherent: fixing exchange rates without gold or even any international paper money with which to make payments. The Western powers signed the ill-fated Smithsonian Agreement on December 18, 1971, which was hailed by President Nixon as “the greatest monetary agreement in the history of the world.” But if currencies are purely fiat, with no international money, they become goods in themselves, and fixed exchange rates are then bound to violate the market rates set by supply and demand.

At that time the inflated dollar was heavily overvalued in regard to Western European and Japanese currencies. At the overvalued dollar rate, there were repeated scrambles to buy European and Japanese moneys at bargain rates, and to get rid of dollars. Repeated “shortages” of the harder moneys resulted from this maximum price control of their exchange rates. Finally, panic selling of the dollar broke the Smithsonian system apart in March 1973. With the collapse of Bretton Woods and the far more rapid disintegration of the “greatest monetary agreement” in world history, both the phony gold standard and the fixed paper exchange rate systems were widely and correctly seen to be inherent failures. The world now embarked, almost by accident on a new era: a world of fluctuating fiat paper moneys. Friedmanite monetarism was to have its day in the sun.

II: Monetarists and FluctuatingFiat Monies, 1973-?

The Friedmanite monetarists had now come into their own, replacing the Keynesians as the favorites of the financial press and of the international monetary establishment. Governments and central banks began to hail the soundness and permanence of fluctuating exchange rates as fervently as they had once trumpeted the eternal virtues of Bretton Woods. The monetarists proclaimed the ideal international monetary system to be freely fluctuating exchange rates between different moneys, with no government intervention to try to stabilize or even moderate the fluctuations. In that way, exchange rates would reflect, from day to day, the fluctuations of supply and demand, just as prices do on the free market.
Of course, the world had suffered mightily from fluctuating fiat money in the not too distant past: the 1930s, when every country had gone off gold (a phony gold standard preserved for foreign central banks by the United States). The problem is that each nation-state kept fixing its exchange rates, and the result was currency blocs, aggressive devaluations attempting to expand exports and restrict imports, and economic warfare culminating in World War II. So the monetarists were insistent that the fluctuations must be absolutely free of all government intervention.

But, in the first place, the Friedmanite plan is politically so naive as to be almost impossible to put into practice. For what the monetarists do, in effect, is to make each currency fiat paper issued by the national government. They give total power over money to that government and its central bank, and then they issue stern admonitions to the wielders of absolute power: “Remember, use your power wisely, don’t under any circumstances interfere with exchange rates.” But inevitably, governments will find many reasons to interfere: to force exchange rates up or down, or stabilize them, and there is nothing to stop them from exercising their natural instincts to control and intervene.

And so what we have had since 1973 is an incoherent blend of “fixed” and fluctuating, unhampered and hampered, foreign currency markets. Even Beryl W. Sprinkel, a dedicated monetarist who served as Undersecretary of Treasury for Monetary Policy in the first Reagan Administration, was forced to backtrack on his early achievement of persuading the Administration to decontrol exchange rates. Even he was compelled to intervene in “emergency” situations, and now the second Reagan Administration is moving insistently in the direction of refixing exchange rates.

The problem with freely fluctuating rates is not only political. One virtue of fixed rates, especially under gold but even to some extent under paper, is that they keep a check on national inflation by central banks. The virtue of fluctuating rates—that they prevent sudden monetary crises due to arbitrarily valued currencies—is a mixed blessing, because at least those crises provided a much-needed restraint on domestic inflation. Freely fluctuating rates mean that the only damper on domestic inflation is that the currency might depreciate. Yet countries often want their money to depreciate, as we have seen in the recent agitation to soften the dollar and thereby subsidize exports and restrict imports—a back-door protectionism. The current refixers have one sound point: that worldwide inflation only became rampant in the mid and late 1970s, after the last fixed-rate discipline was removed.

The refixers are on the march. During November 1985, a major, well-publicized international monetary conference took place in Washington, organized by Representative Jack Kemp and Senator Bill Bradley, and including representatives from the Fed, foreign central banks, and Wall Street banks, this liberal-conservative spectrum agreed on the basic objective: refixing exchange rates. But refixing is no solution; it will only bring back the arbitrary valuations, and the breakdowns of Bretton Woods and the Smithsonian. Probably what we will get eventually is a world-wide application of the current “snake,” in which Western European currencies are tied together so that they can fluctuate but only within a fixed zone. This pointless and inchoate blend of fixed and fluctuating currencies can only bring us the problems of both systems.

When will we realize that only a genuine gold standard can bring us the virtues of both systems and a great deal more: free markets, absence of inflation, and exchange rates that are fixed not arbitrarily by government but as units of weights of a precious market commodity, gold?

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Bank Runs and Water Shortages

By Murray N. Rothbard

It was a scene familiar to any nostalgia buff: all-night lines waiting for the banks (first in Ohio, then in Maryland) to open; pompous but mendacious assurances by the bankers that all is well and that the people should go home; a stubborn insistence by depositors to get their money out; and the consequent closing of the banks by government, while at the same time the banks were permitted to stay in existence and collect the debts due them by their borrowers.
In other words, instead of government protecting private property and enforcing voluntary contracts, it deliberately violated the property of the depositors by barring them from retrieving their own money from the banks.
All this was, of course, a replay of the early 1930s: the last era of massive runs on the banks. On the surface the weakness was the fact that the failed banks were insured by private or state deposit insurance agencies, whereas the banks that easily withstood the storm were insured by the federal government (FDIC for commercial banks; FSLIC for savings and loan banks).
But why? What is the magic elixir possessed by the federal government that neither private firms nor states can muster? The defenders of the private insurance agencies noted that they were technically in better financial shape than FSLIC or FDIC, since they had greater reserves per deposit dollar insured. How is it that private firms, so far superior to government in all other operations, should be so defective in this one area? Is there something unique about money that requires federal control?
The answer to this puzzle lies in the anguished statements of the savings and loan banks in Ohio and in Maryland, after the first of their number went under because of spectacularly unsound loans. “What a pity,” they in effect complained, “that the failure of this one unsound bank should drag the sound banks down with them!”
But in what sense is a bank “sound” when one whisper of doom, one faltering of public confidence, should quickly bring the bank down? In what other industry does a mere rumor or frisson of doubt swiftly bring down a mighty and seemingly solid firm? What is there about banking that public confidence should play such a decisive and overwhelmingly important role?
The answer lies in the nature of our banking system, in the fact that both commercial banks and thrift banks (mutual savings and savings-and-loan) have been systematically engaging in fractional-reserve banking: that is, they have far less cash on hand than there are demand claims to cash outstanding. For commercial banks, the reserve fraction is now about 10%; for the thrifts it is far less.
This means that the depositor who thinks he has $10,000 in a bank is misled; in a proportionate sense, there is only, say, $1,000 or less there. And yet, both the checking depositor and the savings depositor thinks that he can withdraw his money at any time on demand. Obviously, such a system, which is considered fraud when practiced by other businesses, rests on a confidence trick: that is, it can only work so long as the bulk of depositors do not catch on to the scam and try to get their money out. The confidence is essential, and also misguided. That is why once the public catches on, and bank runs begin, they are irresistible and cannot be stopped.
We now see why private enterprise works so badly in the deposit insurance business. For private enterprise only works in a business that is legitimate and useful, where needs are being fulfilled. It is impossible to “insure” a firm, even less so an industry, that is inherently insolvent. Fractional reserve banks, being inherently insolvent, are uninsurable.
What, then, is the magic potion of the federal government? Why does everyone trust the FDIC and FSLIC even though their reserve ratios are lower than private agencies, and though they too have only a very small fraction of total insured deposits in cash to stem any bank run? The answer is really quite simple: because everyone realizes, and realizes correctly, that only the federal government—and not the states or private firms—can print legal tender dollars. Everyone knows that, in case of a bank run, the U.S. Treasury would simply order the Fed to print enough cash to bail out any depositors who want it. The Fed has the unlimited power to print dollars, and it is this unlimited power to inflate that stands behind the current fractional-reserve banking system.
Yes, the FDIC and FSLIC “work,” but only because the unlimited monopoly power to print money can “work” to bail out any firm or person on earth. For it was precisely bank runs, as severe as they were that, before 1933, kept the banking system under check, and prevented any substantial amount of inflation.
But now bank runs—at least for the overwhelming majority of banks under federal deposits insurance—are over, and we have been paying and will continue to pay the horrendous price of saving the banks: chronic and unlimited inflation.
Putting an end to inflation requires not only the abolition of the Fed but also the abolition of the FDIC and FSLIC. At long last, banks would be treated like any firm in any other industry. In short, if they can’t meet their contractual obligations they will be required to go under and liquidate. It would be instructive to see how many banks would survive if the massive governmental props were finally taken away.
Water Not Running
Most people agree that government is generally less efficient than private enterprise, but it is little realized that the difference goes far beyond efficiency. For one thing, there is a crucial difference in attitude toward the consumer. Private business firms are constantly courting the consumer, always eager to increase the sales of their products. So insistent is that courtship that business advertising is often criticized by liberal aesthetes and intellectuals as strident and unmannerly. But government, unlike private enterprise, is not in the business of seeking profits or trying to avoid losses. Far from eager to court the consumer, government officials invariably regard consumers as an annoying intrusion and as “wasteful” users of “their” (government’s) scarce resources. Governments are invariably at war with their consumers.
This contempt and hostility toward consumers reaches its apogee in socialist states, where government’s power is at its maximum. But a similar attitude appears in areas of government activity in all countries. Until a few decades ago, for example, water supplies to consumers in the United States were furnished by private companies. These were almost all socialized, so that government has come to monopolize water services.
In New York City, which shifted to a monopoly of government water several decades ago, there was never, in previous decades, any wailing about a “water shortage.” But, recently, in a climate that is not conspicuously dry, a water shortage has reappeared every few years. This July water levels in the reservoirs supplying New York City were down to an unprecedented 55% of capacity, in contrast to the normal 94%. But surely, nature is not solely to blame, since neighboring New Jersey’s water levels are still at a respectable 80%. It seems that the New York water bureaucrats must have carefully sought out nearby spots that particularly suffer from chronic drought. It also turns out that the New York pipelines were constructed too narrowly to increase water flow from wetter regions.
More important is New York’s typical bureaucratic response to this, as well as to other periodic water crises. Water, as usual with government, is priced in an economically irrational manner. Apartment buildings, for example, pay a fixed water fee per apartment to the government. Since tenants pay nothing for water, they have no incentive to use it economically; and since landlords pay a fixed fee, regardless of use, they too couldn’t care less.
Whereas private firms try to price their goods or services to achieve the highest profit—i.e. to supply consumer needs most fully and at least cost—government has no incentive to price for highest profit or to keep down costs. Quite the contrary. Government’s incentive is to subsidize favored pressure groups or voting blocs; for government is pressured by its basic situation to price politically rather than economically.
Since government services are almost never priced so as to clear the market, i.e. equate supply and demand, it tends to price far below the market, and therefore bring about an artificial “shortage.” Since the shortage is manifest in people not being able to find the product, government’s natural despotic bent leads it invariably to treat the shortage by turning to coercive restraints and rationing.
Morally, government can then have its cake and eat it too: have the fun of pushing people around, while wrapping itself in the cloak of solidarity and universal “sacrifice” in the face of the great new emergency. In short, when the supply of water drops, governments almost never respond the way a business firm would: raise the price in order to clear the market. Instead, the price stays low, and restraints are then placed on watering one’s lawn, washing one’s car, and even taking showers. In this way, everyone is exhorted to sacrifice, except that priorities of sacrifice are worked out and imposed by the government, which happily decides how much lawn watering, or showering, may be permitted on what days in the face of the great crisis.
Several years ago, California water officials were loudly complaining about a water shortage and imposing local rationing, when suddenly an embarrassing event occurred: torrential rains all over the drought areas of the state. After lamely insisting that no one should be misled by the seeming end of the drought, the authorities finally had to end that line of attack, and then the title of the Emergency Office of Water Shortage was hastily changed to the Office of Flood Control.
In New York, this summer, Mayor Edward Koch has already levied strict controls on water use, including a ban on washing cars, and imposition of a minimum of 78 degrees for air conditioners in commercial buildings, plus the turning off of the conditioners for two hours during each working day (virtually all of these air conditioners are water-cooled). 78 degrees is tantamount to no air-conditioning at all, and will wreak great hardship on office workers, as well as patrons of movies and restaurants.
Air-conditioning has always been a favorite target for puritanical government officials; during the trumped-up “energy shortage” of the late 1970s, President Carter’s executive order putting a floor of 78 degrees on every commercial air conditioner was enthusiastically enforced, even though the “energy saving” was negligible. As long as misery can be imposed on the consumer, why worry about the rationale? (What is now a time-honored custom in New York of reluctance to serve water to restaurant patrons originated in a long-forgotten water “shortage” of decades ago.)
There is no need for any of these totalitarian controls. If the government wants to conserve water and lessen its use, all it need do is raise the price. It doesn’t have to order an end to this or that use, set priorities, or decide who should be allowed to drink more than three glasses a day. All it has to do is clear the market, and let people conserve each in his own way and at his own pace.
In the longer run, what the government should do is privatize the water supply, and let water be supplied, like oil or Pepsi-Cola, by private firms trying to make a profit and to satisfy and court consumers, and not to gain power by making them suffer.

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How the Market Creates Jobs and How the Government Destroys Them

By Walter Block

The Creation of Jobs

If the media tell us that “the opening of XYZ mill has created 1,000 new jobs,” we give a cheer. When the ABC company closes and 500 jobs are lost, we’re sad. The politician who can provide a subsidy to save ABC is almost assured of widespread public support for his work in preserving jobs.

But jobs in and of themselves do not guarantee well-being. Suppose that the employment is to dig huge holes and fill them up again? What if the workers manufacture goods and services that no one wants to purchase? In the Soviet Union, which boasts of giving every worker a job, many jobs are just this unproductive. Production is everything, and jobs are nothing but a means toward that end.

Imagine the Swiss Family Robinson marooned on a deserted South Sea island. Do they need jobs? No, they need food, clothing, shelter, and protection from wild animals. Every job created is a deduction from the limited, precious labor available. Work must be rationed, not created, so that the market can create the most product possible out of the limited supply of labor, capital goods, and natural resources.

The same is true for our society. The supply of labor is limited. We must not allow government to create jobs or we lose the goods and services which otherwise would have come into being. We must reserve precious labor for the important tasks still left undone.

Alternatively, imagine a world where radios, pizzas, jogging shoes, and everything else we might want continuously rained down like manna from heaven. Would we want jobs in such a utopia? No, we could devote ourselves to other tasks—studying, basking in the sun, etc.—that we would undertake for their intrinsic pleasure.

Instead of praising jobs for their own sake, we should ask why employment is so important. The answer is, because we exist amidst economic scarcity and must work to live and prosper. That’s why we should be of good cheer only when we learn that this employment will produce things people actually value, i.e., are willing to buy with their own hard-earned money. And this is something that can only be done in the free market, not by bureaucrats and politicians.

The Destruction of Jobs

But what about unemployment? What if people want to work, but can’t get a job? In almost every case, government programs are the cause of joblessness.

Minimum Wage. The minimum wage mandates that wages be set at a government-determined level. To explain why this is harmful, we can use an analogy from biology: there are certain animals that are weak compared to others. For example, the porcupine is defenseless except for its quills, the deer vulnerable except for its speed.

In economics there are also people who are relatively weak. The disabled, the young, minorities, the untrained—all are weak economic actors. But like the weak animals in biology, they have a compensating advantage: the ability to work for lower wages. When the government takes this ability away from them by forcing up pay scales, it is as if the porcupine were shorn of its quills. The result is unemployment, which creates desperate loneliness, isolation, and dependency.

Consider a young, uneducated, unskilled person, whose productivity is $2.50 an hour in the marketplace. What if the legislature passes a law requiring that he be paid $5 per hour? The employer hiring him would lose $2.50 an hour.

Consider a man and a woman each with a productivity of $10 per hour, and suppose, because of discrimination or whatever, that the man is paid $ 10 per hour and the woman is paid $8 per hour. It is as if the woman had a little sign on her forehead saying, “Hire me and earn an extra $2 an hour.” This makes her a desirable employee even for a sexist boss. But when an equal-pay law stipulates that she must be paid the same as the man, the employer can indulge his discriminatory tendencies and not hire her at all, at no cost to himself.

Comparable Worth. What if government gets the bright idea that nurses and truck drivers ought to be paid the same wage because their occupations are of “intrinsically” equal value? It orders that nurses’ wages be raised to the same level, which creates unemployment for women.

Working Conditions. Laws which force employers to provide certain types of working conditions also create unemployment. For example, migrant fruit and vegetables pickers must have hot and cold running water and modern toilets in the temporary cabins provided for them. This is economically equivalent to wage laws because, from the point of view of the employer, working conditions are almost indistinguishable from money wages. And if the government forces him to pay more, he will have to hire fewer people.

Unions. When the government forces businesses to hire only union workers, it discriminates against non-union workers, causing them to be at a severe disadvantage or permanently unemployed. Unions exist primarily to keep out competition. They are a state-protected cartel like any other.
Employment Protection. Employment protection laws, which mandate that no one can be fired without due process, are supposed to protect employees. However, if the government tells the employer that he must keep the employee no matter what, he will tend not to hire him in the first place. This law, which appears to help workers, instead keeps them from employment. And so do employment taxes and payroll taxes, which increase costs to businesses and discourage them from hiring more workers.
Payroll Taxes. Payroll taxes like Social Security impose heavy monetary and administrative costs on businesses, drastically increasing the marginal cost of hiring new employees.

Unemployment Insurance. Government unemployment insurance and welfare cause unemployment by subsidizing idleness. When a certain behavior is subsidized—in this case not working—we get more of it.

Licensing. Regulations and licensing also cause unemployment. Most people know that doctors and lawyers must have licenses. But few know that ferret breeders, falconers, and strawberry growers must also have them. In fact, government regulates over 1,000 occupations in all 50 states. A woman in Florida who ran a soup kitchen for the poor out of her home was recently shut down as an unlicensed restaurant, and many poor people now go hungry as a result.

When the government passes a law saying certain jobs cannot be undertaken without a license, it erects a legal barrier to entry. Why should it be illegal for anyone to try their hand at haircutting? The market will supply all the information consumers need.

When the government bestows legal status on a profession and passes a law against competitors, it creates unemployment. For example, who lobbies for the laws which prevent just anyone from giving a haircut? The haircutting industry—not to protect the consumer from bad haircuts, but to protect themselves against competition.

Peddling. Laws against street peddlers prevent people from selling food and products to people who want them. In cities like New York and Washington, D.C., the most vociferous supporters of anti-peddling laws are established restaurants and department stores.

Child Labor. There are many jobs that require little training—such as mowing lawns—which are perfect for young people who want to earn some money. In addition to the earnings, working also teaches young people what a job is, how to handle money, and how to save and maybe even invest. But in most places, the government discriminates against teenagers and prevents them from participating in the free enterprise system. Kids can’t even have a street-corner lemonade stand.
The Federal Reserve. By bringing about the business cycle, Federal Reserve money creation causes unemployment. Inflation not only raises prices, it also misallocates labor. During the boom phase of the trade cycle, businesses hire new workers, many of whom are pulled from other lines of work by the higher wages. The Fed subsidy to these capital industries lasts only until the bust. Workers are then laid off and displaced.

The Free Market. The free market, of course, does not mean utopia. We live in a world of differing intelligence and skills, of changing market preferences, and of imperfect information, which can lead to temporary, market-generated unemployment, which Mises called “catallactic.” And some people choose unemployment by holding out for a higher paying job. But as a society, we can insure that everyone who wants to work has a chance to do so by repealing minimum wage law, comparable worth rules, working condition laws, compulsory union membership, employment protection, employment taxes, payroll taxes, government unemployment insurance, welfare, regulations, licensing, anti-peddling laws, child-labor laws, and government money creation. The path to jobs that matter is the free market.

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Keynesian Myths

By Murray N. Rothbard

Inflation and Idle Capacity

The Keynesians have been caught short again. In the early and the late 1970s, the wind was taken out of their sails by the arrival of inflationary recession, a phenomenon which they not only failed to predict, but whose very existence violates the fundamental tenets of the Keynesian system. Since then, the Keynesians have lost their old invincible arrogance, though they still constitute a large part of the economics profession.
In the last few years, the Keynesians have been assuring us with more than a touch of their old hauteur, that inflation would not and could not arrive soon, despite the fact that “tight-money” hero Paul Volcker had been consistently pouring in money at double-digit rates. Chiding hard-money advocates, the Keynesians declared that, despite the monetary inflation, American industry still suffered from “excess” or “idle” capacity, functioning at an overall rate of something like 80%. Thus, they pointed out, expanded monetary demand could not result in inflation.
As we all know, despite Keynesian assurances that inflation could not reignite, it did despite the idle capacity, leaving them with something else to puzzle over. Inflation has risen this year from approximately 1 % in 1986 to 6% now, interest rates are rising again, the fall of the dollar has raised import prices, and gold prices are rising again. Once again, the hard-money economists and investment advisors have proved far sounder than the Establishment-blessed Keynesians.
The best way to explain where the Keynesians went wrong is to turn against them their own common reply to their critics: that anti-Keynesians, who worry about the waste of inflation or government programs, are “assuming full employment” of resources. Eliminate this assumption, they say, and Keynesianism becomes correct in the through-the-looking-glass world of unemployment and idle resources. But the charge should be turned around, and the Keynesians should be asked: why should there be unemployment (of labor or of machinery), at all? Unemployment is not a given that descends from heaven. Of course, it often exists, but what can account for it?
The Keynesians themselves create the problem by leaving out the price system. The hallmark of crackpot economics is an analysis that somehow leaves out prices, and talks only about such aggregates as income, spending, and employment.
We know from “microeconomic” analysis that if there is a “surplus” of something on the market, if something cannot be sold, then the only reason is that its price is somehow being kept too high. The way to cure surplus or unemployment of anything, is to lower the asking price, whether it be wage rates for labor, prices of machinery or plant, or of the inventory of a retailer
In short, as Professor William H. Hutt pointed out brilliantly in the 1930s, when his message was lost amid the fervor of the Keynesian Revolution: idleness or unemployment of a resource can only occur because the owner of that resource is deliberately withholding it from the market and refusing to sell it at the offered price. In a profound sense, therefore, all unemployment and idleness is voluntary.
Why should a resource owner deliberately withhold it from the market? Usually, because he is holding out for a higher price, or wage rate. In a free and unhampered market economy, the owners will find out their error soon enough, and when they get tired of making no returns from their labor or machinery or products, they will lower their asking price sufficiently to sell them. In the case of machinery and other capital goods, of course, the owners might have made a severe malinvestment, often due to artificial booms created by bank credit and central banks. In that case, the lower market-clearing price for the machinery or plant might be so low as to not be worth the laborer’s giving up his leisure—but then the unemployment is purely voluntary and the worker holds out permanently for a higher wage.
A worse problem is that, since the 1930s, government and its privileged unions have intervened massively in the labor market to keep wage rates above the market-clearing wage, thereby insuring ever higher unemployment among workers with the lowest skills and productivity. Government interference, in the form of minimum wage laws and compulsory unionism, creates compulsory unemployment, while welfare payments and unemployment “insurance” subsidize unemployment and make sure that it will be permanently high. We can have as much unemployment as we pay for.
It follows from this analysis that monetary inflation and greater spending will not necessarily reduce unemployment or idle capacity. It will only do so if workers or machine owners are induced to think that they are getting a higher return and at least some of their holdout demands are being met. And this can only be accomplished if the price paid for the resource (the wage rate or the price of machinery) goes up. In other words, greater supply or use of capacity will only be called forth by wage and price increases, i.e. by price inflation.
As usual, the Keynesians have the entire causal process bollixed up. And so, as the facts now poignantly demonstrate, we can and do have inflation along with idle resources.

The New International Money Scheme

Ever since the Western world abandoned the gold coin standard in 1914, the international monetary system has been rocketing from one bad system to another, from the frying pan to the fire and back again, fleeing the problems of one alternative only to find itself deeply unhappy in the other. Basically, only two alternative systems have been considered: (1) fiat money standards, each national fiat currency being governed by its own central bank, with relative values fluctuating in accordance with supply and demand; and (2) some sort of fixed exchange rate system, governed by international coordination of economic policies.
Our current System 1 came about willy nilly in 1973, out of the collapse of Bretton Woods System 2 that had been imposed on the world by the United States and Britain in 1944. System 1, the monetarist or Friedmanite ideal, at best breaks up the world monetary system into national fiat enclaves, adds great uncertainties and distortions to the monetary system, and removes the check of external discipline from the inflationary propensities of every central bank. At worst, System 1 offers irresistible temptations to every government to intervene heavily in exchange rates, precipitating the world into currency blocs, protectionist blocs, and “beggar-thy-neighbor” policies of competing currency devaluations such as the economic warfare of the 1930s that helped generate World War II.
The problem is that shifting to System 2 is truly a leap from the frying pan into the fire. The national fiat blocs of the 1930s emerged out of the System 2 pound sterling standard in which other countries pyramided an inflation of their currencies on top of inflating pounds sterling, while Britain retained a nominal but phony gold standard. The 1930s system was itself replaced by Bretton Woods, a world dollar standard, in which other countries were able to inflate their own currencies on top of inflating dollars, while the United States maintained a nominal but phony gold standard at $35 per gold ounce.
Now the problems of the Friedmanite System 1 are inducing plans for some sort of return to a fixed exchange rate system. Unfortunately, System 2 is even worse than System 1, for any successful coordination permits a concerted worldwide inflation, a far worse problem than particular national inflations. Exchange rates among fiat moneys have to fluctuate, since fixed exchange rates inevitably create Gresham’s Law situations, in which undervalued currencies disappear from circulation. In the Bretton Woods system, American inflation permitted world-wide inflation, until gold became so undervalued at $35 an ounce that demands to redeem dollars in gold became irresistible, and the system collapsed.
If System 1 is the Friedmanite ideal, then the Keynesian gold is the most pernicious variant of System 2. For what Keynesians have long sought, notably in the Bernstein and Triffin Plans of old, and in the abortive attempt to make SDRs (special drawing rights) a new currency unit, is a World Reserve Bank issuing a new world paper-money unit, replacing gold altogether. Keynes called his suggested new unit the “bancor,” and Harry Dexter White of the U.S. Treasury called his the “unita.” Whatever the new unit may be called, such system would be an unmitigated disaster, for it would allow the bankers and politicians running the World Reserve Bank to issue paper “bancors” without limit, thereby engineering a coordinated world-wide inflation. No longer would countries have to lose gold to each other, and they could fix their exchange rates without worrying about Gresham’s Law. The upshot would be an eventual world-wide runaway inflation, with horrendous consequences for the entire world.
Fortunately, a lack of market confidence, and inability to coordinate dozens of governments, have so far spared us this Keynesian ideal. But now, a cloud no bigger than a man’s hand, an ominous trial balloon toward a World Reserve Bank has just been floated. In a meeting in Hamburg, West Germany, in late June of two hundred leading world bankers in an International Monetary Conference, bankers urged the elimination of the current volatile exchange rate system, and a move towards fixed exchange rates.
The theme of the Conference was set by its chairman, Willard C. Butcher, chairman and chief executive of Rockefeller’s Chase Manhattan Bank. Butcher attacked the current system, and warned that it could not correct itself, and that a search for a better world currency system “must be intensified” (New York Times, June 23, 1987).
It was not long before Toyo Gyoten, Japan’s vice-minister of finance for international affairs, spelled out some of the concrete implications of this accelerated search. Gyoten proposed a huge multinational financial institution, possessing “at least several hundred billion dollars,” that would be empowered to intervene in world financial markets to reduce volatility.
And what is this if not the beginnings of a World Reserve Bank? Are Keynesian dreams at least beginning to come true?

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The Fraud of GNP

By Llewellyn H. Rockwell, Jr

The Gross National Product grew at an annual rate of 4.4% for the first quarter of 1987,” the Commerce Department recently said. But corporate profits and people’s earning dropped. We’re all supposed to be better off when the GNP grows. Why aren’t we? The reason, as shown by Professor Murray N. Rothbard, is that the GNP is a phony statistic.
The GNP records the dollar amount of goods and services produced in the economy during a period. But it equates government spending with private spending. And it ignores the wealth and potential growth destroyed by taxation.
Imagine that the economy consisted of two small, productive towns. The government decides to destroy one of them—a hotbed of tax resistance—by aerial bombardment, and to tax the other to pay for the clean-up. After a year, the destroyed town is restored. Calculating the net effect of this process, the Commerce Department would say that the GNP of the two-town economy grew by 50%.
GNP records the money spent on goods and services, not the wealth destroyed by bombs, taxation, regulation, or other government activities. So GNP would act as if a third town had been added to the economy, when in fact one had been deducted.
As Professor Rothbard has pointed out, subtracting government spending from GNP, and then adjusting for taxation, gives us a much better idea of the real economy. His “Private Product Remaining (to Producers)” or PPR does exactly that.
Working from Professor Rothbard’s thesis, Professor Robert Batemarco of Manhattan College computed the PPR from 1960 to 1985 for an article in the first issue of the Institute’s Review of Austrian Economics.
The gap shown on the chart between GNP and PPR represents the horrendous growth of government. And the gap is huge and growing, despite promises to get Washington off our backs.
The growth in GNP is almost all attributable to increased government spending, which represents capital consumption, not progress. As shown by the PPR the economy has barely moved, thanks to the government’s incredible taxation, deficits, welfare, borrowing, subsidies, and controls.
Real growth in the U.S. registered a mere 1.3% last year. On the average, the GNP figure is about 52% higher than real growth. And the more government grows, the higher that percentage.
Always be wary of government statistics. They are usually designed to mislead, and GNP is part of that game.

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Creative Economic Semantics

By Murray N. Rothbard

If the federal government’s economists have been good for nothing else in recent years, they have made great strides in what might be called “creative economic semantics.” First they redefined the seemingly simple term “budget cut.” In the old days, a “budget cut” was a reduction of next year’s budget below this year’s. In that old-fashioned sense, Dwight Eisenhower’s first two years in office actually cut the budget substantially, though not dramatically, below the previous year. Now we have “budget cuts” which are not cuts, but rather substantial increases over the previous year’s expenditures. “Cut” became subtly but crucially redefined as reducing something else. What the something else might be didn’t seem to matter, so long as the focus was taken off actual dollar expenditures. Sometimes it was a cut “in the rate of increase,” other times it was a cut in “real” spending, at still others it was a percentage of GNP, and at yet other times it was a cut in the sense of being below past projections for that year. The result of a series of such “cuts” has been to raise spending sharply and dramatically not only in old-fashioned terms, but even in all other categories. Government spending has gone up considerably any way you slice it. As a result, even the idea of a creatively semantic budget cut has now gone the way of the nickel fare and the Constitution of the United States.
Another example of creative semantics was the “tax cut” of 1981-1982, a tax cut so allegedly fearsome that it had to be offset by outright tax increases late in 1982, in 1983, in 1984, and undoubtedly on and on into the future. Again in the old days, a cut in income taxes meant that the average person would find less of a slice taken out of his paycheck. But while the 1981-82 tax changes did that for some people, the average person found that the piddling cuts were more than offset by the continuing rise in the Social Security tax, and by “bracket creep”—a colorful term for the process by which inflation (generated by the federal government’s expansion of the money supply) wafts everyone into higher money income (even though a price rise might leave them no better off) and therefore into a higher tax bracket. So that even though the official schedule of tax rates might remain the same, the average man is paying a higher chunk of his income.
The much-vaulted and much-denounced “tax cut” turns out, on old-fashioned semantics, to be no cut at all but rather a substantial increase. In return for the dubious pleasure of this non-cut, the American public will have to suffer by paying through the nose for years to come in the form of “offsetting,” though unfortunately all-too-genuine, tax increases. Of course, government economists have been doing their part as well to try to sugar-coat the pill of tax increases. They never refer to these changes as “increases.” They have not been increases at all; they were “revenue enhancement” and “closing loopholes.” The best comment on the concept of “loopholes” was that of Ludwig von Mises. Mises remarked that the very concept of “loopholes” implies that the government rightly owns all of the money you earn, and that it becomes necessary to correct the slipup of the government’s not having gotten its hands on that money long since.
Despite promises of a balanced budget by 1984, we find that several years of semantically massaged “budget cuts” and “tax cuts” as well as “enhancements” have resulted in an enormous, seemingly permanent, and unprecedented deficit somewhere around $200 billion. Once again, creative semantics have come to the rescue. One route is to use time-honored methods to redefine the deficit out of existence. The Keynesians used to redefine it by claiming that in something called a “full employment budget” there was no deficit, that is, that if one subtracts the spending necessary to achieve full employment, there would be no deficit, perhaps even a surplus. But while such a sleight-of-hand might work with a deficit of $20 billion, it is a puny way to wish away a gap of $200 billion. Still, the government’s economists are trying. They have already redefined the “deficits” as a “real increase” in debt, that is, a deficit discounted by inflation. The more inflation generated by the government, then, the more it looks as if the deficit is washed away. On the very same semantic magic, the apologists for the disastrous runaway German inflation of 1923 claimed that there was no inflation at all, since in terms of gold, German prices were actually falling! And similarly, they claimed, that since in real terms the supply of German marks was falling, that the real trouble in Germany was that there was too little money being printed rather than too much.
There is no general acceptance for the idea that, based on some legerdemain, the deficit doesn’t really exist. But there is acceptance of the view that a tax increase constitutes a “down payment” on the deficit. Again, in the old days, a “down payment” on a debt meant that part of the debt was being paid off. Washington’s creative economists have managed to redefine the term to mean a hoped-for reduction of next year’s increase in the debt—a very different story indeed.

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Great Economic Myths

By Murray N. Rothbard

Our country is beset by a large number of economic myths that distort public thinking on important problems and lead us to accept unsound and dangerous government policies. Here are ten of the most dangerous of these myths and an analysis of what is wrong with them.
Myth #1: Deficits are the cause of inflation; deficits have nothing to do with inflation.
In recent decades we always have had federal deficits. The invariable response of the party out of power, whichever it may be, is to denounce those deficits as being the cause of our chronic inflation. And the invariable response of whatever party is in power has been to claim that deficits have nothing to do with inflation. Both opposing statements are myths.
Deficits mean that the federal government is spending more than it is taking in in taxes. Those deficits can be financed in two ways. If they are financed by selling Treasury bonds to the public, then the deficits are not inflationary. No new money is created; people and institutions simply draw down their bank deposits to pay for the bonds, and the Treasury spends that money. Money has simply been transferred from the public to the Treasury, and then the money is spent on other members of the public.
On the other hand, the deficit may be financed by selling bonds to the banking system. If that occurs, the banks create new money by creating new bank deposits and using them to buy the bonds. The new money, in the form of bank deposits, is then spent by the Treasury, and thereby enters permanently into the spending stream of the economy, raising prices and causing inflation. By a complex process, the Federal Reserve enables the banks to create the new money by generating bank reserves of one-tenth that amount. Thus, if banks are to buy 100 billion of new bonds to finance the deficit, the Fed buys approximately $10 billion on old Treasury bonds. This purchase increases bank reserves by $10 billion, allowing the banks to pyramid the creation of new bank deposits or money by ten times that amount. In short, the government and the banking system it controls in effect “print” new money to pay for the federal deficit.
Thus, deficits are inflationary to the extent that they are financed by the banking system; they are not inflationary to the extent they are underwritten by the public.
Some policymakers point to the 1982-83 period, when deficits were accelerating and inflation was abating, as a statistical “proof” that deficits and inflation have no relation to each other. This is no proof at all. General price changes are determined by two factors: the supply of, and the demand for, money. During 1982-83 the Fed created new money at a very high rate, approximately at 15% per annum. Much of this went to finance the expanding deficit. But on the other hand, the severe depression of those two years increased the demand for money (i.e. lowered the desire to spend money on goods), in response to the severe business losses. This temporarily compensating increase in the demand for money does not make deficits any the less inflationary. In fact, as recovery proceeds, spending will pick up and the demand for money will fall, and the spending of the new money will accelerate inflation.
Myth #2: Deficits do not have a crowding-out effect on private investment.
In recent years there has been an understandable worry over the low rate of saving and investment in the United States. One worry is that the enormous federal deficits will divert savings to unproductive government spending and thereby crowd out productive investment, generating ever-greater long-run problems in advancing or even maintaining the living standards of the public.
Some policymakers have once again attempted to rebut this charge by statistics. In 1982-83, they declare deficits were high and increasing while interest rates fell, thereby indicating that deficits have no crowding-out effect.
This argument once again shows the fallacy of trying to refute logic with statistics. Interest rates fell because of the drop of business borrowing in a recession. “Real” interest rates (interest rates minus the inflation rate) stayed unprecedentedly high, however—partly because most of us expect renewed heavy inflation, partly because of the crowding-out effect. In any case, statistics cannot refute logic; and logic tells us that if savings go into government bonds, there will necessarily be less savings available for productive investment than there would have been, and interest rates will be higher than they would have been without the deficits. If deficits are financed by the public, then this diversion of savings into government projects is direct and palpable. If the deficits are financed by bank inflation, then the diversion is indirect, the crowding-out now taking place by the new money “printed” by the government competing for resources with old money saved by the public.
Milton Friedman tries to rebut the crowding-out effect of deficits by claiming that all government spending, not just deficits, equally crowds out private savings and investment. It is true that money siphoned off by taxes could also have gone into private savings and investment. But deficits have a far greater crowding-out effect than overall spending, since deficits financed by the public obviously tap savings and savings alone, whereas taxes reduce the public’s consumption as well as savings.
Thus, deficits, whichever way you look at them, cause grave economic problems. If they are financed by the banking system, they are inflationary. But even if they are financed by the public, they will still cause severe crowding-out effects, diverting much-needed savings from productive private investment to wasteful government projects. And, furthermore, the greater the deficits the greater the permanent income tax burden on the American people to pay for the mounting interest payments, a problem aggravated by the high interest rates brought about by inflationary deficits.
Myth #3: Tax increases are a cure for deficits.
Those people who are properly worried about the deficit unfortunately offer an unacceptable solution: increasing taxes. Curing deficits by raising taxes is equivalent to curing someone’s bronchitis by shooting him. The “cure” is far worse than the disease.
For one reason, as many critics have pointed out, raising taxes simply gives the government more money, and so the politicians and bureaucrats are likely to react by raising expenditures still further. Parkinson said it all in his famous “Law”: “Expenditures rise to meet income.” If the government is willing to have, say, a 20% deficit, it will handle high revenues by raising spending still more to maintain the same proportion of deficit.
But even apart from this shrewd judgment in political psychology, why should anyone believe that a tax is better than a higher price? It is true that inflation is a form of taxation, in which the government and other early receivers of new money are able to expropriate the members of the public whose income rises later in the process of inflation. But, at least with inflation, people are still reaping some of the benefits of exchange. If bread rises to $10 a loaf, this is unfortunate, but at least you can still eat the bread. But if taxes go up, your money is expropriated for the benefit of politicians and bureaucrats, and you are left with no service or benefit. The only result is that the producers’ money is confiscated for the benefit of a bureaucracy that adds insult to injury by using part of that confiscated money to push the public around.
No, the only sound cure for deficits is a simple but virtually unmentioned one: cut the federal budget. How and where? Anywhere and everywhere.
Myth #4: Every time the fed tightens the money supply, interest rates rise (or fall); every time the fed expands the money supply, interest rates rise (or fall).
The financial press now knows enough economics to watch weekly money supply figures like hawks; but they inevitably interpret these figures in a chaotic fashion. If the money supply rises, this is interpreted as lowering interest rates and inflationary; it is also interpreted, often in the very same article, as raising interest rates. And vice versa. If the Fed tightens the growth of money, it is interpreted as both raising interest rates and lowering them. Sometimes it seems that all Fed actions, no matter how contradictory, must result in raising interest rates. Clearly something is very wrong here.
The problem here is that, as in the case of price levels, there are several causal factors operating on interest rates and in different directions. If the Fed expands the money supply, it does so by generating more bank reserves and thereby expanding the supply of bank credit and bank deposits. The expansion of credit necessarily means an increased supply in the credit market and hence a lowering of the price of credit, or the rate of interest. On the other hand, if the Fed restricts the supply of credit and the growth of the money supply, this means that the supply in the credit market declines, and this should mean a rise in interest rates.
And this is precisely what happens in the first decade or two of chronic inflation. Fed expansion lowers interest rates; Fed tightening raises them. But after this period, the public and the market begin to catch on to what is happening. They begin to realize that inflation is chronic because of the systemic expansion of the money supply. When they realize this fact of life, they will also realize that inflation wipes out the creditor for the benefit of the debtor. Thus, if someone grants a loan at five percent for one year, and there is seven percent inflation for that year, the creditor loses, not gains. He loses two percent, since he gets paid back in dollars that are now worth seven percent less in purchasing power. Correspondingly, the debtor gains by inflation. As creditors begin to catch on, they place an inflation premium on the interest rate, and debtors will be willing to pay. Hence, in the long-run anything which fuels the expectations of inflation will raise inflation premiums on interest rates; and anything which dampens those expectations will lower those premiums. Therefore, a Fed tightening will now tend to dampen inflationary expectations and lower interest rates; a Fed expansion will whip up those expectations again and raise them. There are two, opposite causal chains at work. And so Fed expansion or contraction can either raise or lower interest rates, depending on which causal chain is stronger.
Which will be stronger? There is no way to know for sure. In the early decades of inflation, there is no inflation premium; in the later decades, such as we are now in, there is. The relative strength and reaction times depend on the subjective expectations of the public, and these cannot be forecast with certainty. And this is one reason why economic forecasts can never be made with certainty.
Myth #5: Economists, using charts or high speed computer models, can accurately forecast the future.
The problem of forecasting interest rates illustrates the pitfalls of forecasting in general. People are contrary cusses whose behavior, thank goodness, cannot be forecast precisely in advance. Their values, ideas, expectations, and knowledge change all the time, and change in an unpredictable manner. What economist, for example, could have forecast (or did forecast) the Cabbage Patch Kid craze of the Christmas season of 1983? Every economic quantity, every price, purchase, or income figure is the embodiment of thousands, even millions, of unpredictable choices by individuals.
Many studies, formal and informal, have been made of the record of forecasting by economists, and it has been consistently abysmal. Forecasters often complain that they can do well enough as long as current trends continue; what they have difficulty in doing is catching changes in trend. But of course there is no trick in extrapolating current trends into the near future. You don’t need sophisticated computer models for that; you can do it better and far more cheaply by using a ruler. The real trick is precisely to forecast when and how trends will change, and forecasters have been notoriously bad at that. No economist forecast the depth of the 1981-82 depression, and none predicted the strength of the 1983 boom.
The next time you are swayed by the jargon or seeming expertise of the economic forecaster, ask yourself this question: If he can really predict the future so well, why is he wasting his time putting out newsletters or doing consulting when he himself could be making trillions of dollars in the stock and commodity markets?
Myth #6: There is a tradeoff between unemployment and inflation.
Every time someone calls for the government to abandon its inflationary policies, Establishment economists and politicians warn that the result can only be severe unemployment. We are trapped, therefore, into playing off inflation against high unemployment, and become persuaded that we must therefore accept some of both.
This doctrine is the fallback position for Keynesians. Originally, the Keynesians promised us that by manipulating and fine-tuning deficits and government spending, they could and would bring us permanent prosperity and full employment without inflation. Then, when inflation became chronic and ever-greater, they changed their tune to warn of the alleged tradeoff, so as to weaken any possible pressure upon the government to stop its inflationary creation of new money.
The tradeoff doctrine is based on the alleged “Phillips curve,” a curve invented many years ago by the British economist A. W. Phillips. Phillips correlated wage rate increases with unemployment, and claimed that the two move inversely: the higher the increases in wage rates, the lower the unemployment. On its face, this is a peculiar doctrine, since it flies in the face of logical, commonsense theory. Theory tells us that the higher the wage rates, the greater the unemployment, and vice versa. If everyone went to their employer tomorrow and insisted on double or triple the wage rate, many of us would be promptly out of a job. Yet this bizarre finding was accepted as gospel by the Keynesian economic establishment.
By now, it should be clear that this statistical finding violates the facts as well as logical theory. For during the 1950s, inflation was only about one to two percent per year, and unemployment hovered around three or four percent, whereas nowadays unemployment ranges between eight and 11%, and inflation between five and 13%. In the last two or three decades, in short, both inflation and unemployment have increased sharply and severely. If anything, we have had a reverse Phillips curve. There has been anything but an inflation-unemployment tradeoff.
But ideologues seldom give way to the facts, even as they continually claim to “test” their theories by acts. To save the concept, they have simply concluded that the Phillips curve still remains as an inflation-unemployment tradeoff, except that the curve has unaccountably “shifted” to a new set of alleged tradeoffs. On this sort of mind-set, of course, no one could ever refute any theory.
In fact, inflation now, even if it reduces unemployment in the short-run by inducing prices to spurt ahead of wage rates (thereby reducing real wage rates), will only create more unemployment in the long run. Eventually, wage rates catch up with inflation, and inflation brings recession and unemployment inevitably in its wake. After more than two decades of inflation, we are all now living in that “long run.”
Myth #7: Deflation—falling prices—is unthinkable, and would cause a catastrophic depression.
The public memory is short. We forget that, from the beginning of the Industrial Revolution in the mid-18th century until the beginning of World War II, prices generally went down, year after year. That’s because continually increasing productivity and output of goods generated by free markets caused prices to fall. There was no depression, however, because costs fell along with selling prices. Usually, wage rates remained constant while the cost of living fell, so that “real” wages, or everyone’s standard of living, rose steadily.
Virtually the only time when prices rose over those two centuries were periods of war (War of 1812, Civil War, World War I), when the warring governments inflated the money supply so heavily to pay for the war as to more than offset continuing gains in productivity.
We can see how free-market capitalism, unburdened by governmental or central bank inflation, works if we look at what has happened in the last few years to the prices of computers. A computer used to have to be enormous, costing millions of dollars. Now, in a remarkable surge of productivity brought about by the microchip revolution, computers are falling in price even as Iwrite. Computer firms are successful despite the falling prices because their costs have been falling, and productivity rising. In fact, these falling costs and prices have enabled them to tap a mass market characteristic of the dynamic growth of free-market capitalism. “Deflation” has brought no disaster to this industry.
The same is true of other high-growth industries, such a electronic calculators, plastics, TV sets, and VCRs. Deflation, far from bringing catastrophe, is the hallmark of sound and dynamic economic growth.
Myth #8: The best tax is a “flat” income tax, proportionate to income across the board, with no exemptions or deductions.
It is usually added by flat-tax proponents, that eliminating such exemptions would enable the federal government to cut the current tax rate substantially.
But this view assumes, for one thing, that present deductions from the income tax are immoral subsidies or “loopholes” that should be closed for the benefit of all. A deduction of exemption is only a “loophole” if you assume that the government owns 100% of everyone’s income and that allowing some of that income to remain untaxed constitutes an irritating “loophole.” Allowing someone to keep some of his own income is neither a loophole nor a subsidy. Lowering the overall tax by abolishing deductions for medical care, for interest payments, or for uninsured losses, is simply lowering the taxes of one set of people (those that have little interest to pay, or medical expenses, or uninsured losses) at the expense of raising them for those who have incurred such expenses.
There is furthermore neither any guarantee nor even likelihood that, once the exemptions and deductions are safely out of the way, the government would keep its tax rate at the lower level. Looking at the record of governments, past and present, there is every reason to assume that more of our money would be taken by the government as it raised the tax rate back up (at least) to the old level, with a consequently greater overall drain from the producers to the bureaucracy.
It is supposed that the tax system should be roughly that of pricing or incomes on the market. But market pricing is not proportional to incomes. It would be a peculiar world, for example, if Rockefeller were forced to pay $1,000 for a loaf of bread—that is, a payment proportionate to his income relative to the average man. That would mean a world in which equality of incomes was enforced in a particularly bizarre and inefficientmanner. If a tax were levied like a market price, it would be equal to every “customer,” not proportionate to each customer’s income.
Myth #9: An income tax cut helps everyone because not only the taxpayer but also the government will benefit, since tax revenues will rise when the rate is cut.
This is the so-called “Laffer curve,” set forth by California economist Arthur Laffer. It was advanced as a means of allowing politicians to square the circle; to come out for tax cuts, keeping spending at the current level, and balance the budget all at the same time. In that way, the public would enjoy their tax cuts, be happy at the balanced budget, and still receive the same level of subsidies from the government.
It is true that if tax rates are 99%, and they are cut to 95%, tax revenue will go up. But there is no reason to assume such simple connections at any other time. In fact, this relationship works much better for a local excise tax than for a national income tax. A few years ago, the government of the District of Columbia decided to procure some revenue by sharply raising the District’s gasoline tax. But, then, drivers could simply nip over the border to Virginia or Maryland and fill up at a much cheaper price. D.C. gasoline tax revenues fell, and much to their chagrin and confusion, they had to repeal the tax.
But this is not likely to happen with the income tax. People are not going to stop working or leave the country because of a relatively small tax hike, or do the reverse because of a tax cut.
There are some problems with the Laffer curve. The amount of time it is supposed to take for the Laffer effect to work is never specified. But still more important: Laffer assumes that what all of us want is to maximize tax revenue to the government. If—a big if—we are really at the upper half of the Laffer Curve, we should then all want to set tax rates at that “optimum” point. But why? Why every one of us to maximize government revenue? To push to the maximum, in short, the share of private product that gets siphoned off to the activities of government? I should think we would be more interested in minimizing government revenue by pushing tax rates far, far below whatever the Laffer Optimum might happen to be.
Myth #10: Imports from countries where labor is cheap cause unemployment in the United States.
One of the many problems with this doctrine is that it ignores the question: why are wages low in a foreign country and high in the United States? It starts with these wage rates as ultimate givens, and doesn’t pursue the question why they are what they are. Basically, they are high in the United States because labor productivity is high—because workers here are aided by large amounts of technologically advanced capital equipment. Wage rates are low in many foreign countries because capital equipment is small and technologically primitive. Unaided by much capital, worker productivity is far lower than in the United States. Wage rates in every country are determined by the productivity of the workers in that country. Hence, high wages in the United States are not a standing threat to American prosperity; they are the result of that prosperity.
But what of certain industries in the U.S. that complain loudly and chronically about the “unfair” competition of products from low-wage countries? Here, we must realize that wages in each country are interconnected from one industry and occupation and region to another. All workers compete with each other, and if wages in industry A are far lower than in other industries, workers—spearheaded by young workers starting their careers—would leave or refuse to enter industry A and move to other firms or industries where the wage rate is higher.
Wages in the complaining industries, then, are high because they have been bid high by all industries in the United States. If the steel or textile industries in the United States find it difficult to compete with their counterparts abroad, it is not because foreign firms are playing low wages, but because other American industries have bid up American wage rates to such a high level that steel and textile cannot afford to pay. In short, what’s really happening is that steel, textile, and other such firms are using labor inefficiently as compared to other American industries. Tariffs or import quotas to keep inefficient firms or industries in operation hurt everyone, in every country, who is not in that industry. They injure all American consumers by keeping up prices, keeping down quality and competition, and distorting production. Tariff or an import quota is equivalent to chopping up a railroad or destroying an airline—for its point is to make international transportation artificially expensive.
Tariffs and import quotas also injure other, efficient American industries by tying up resources that would otherwise move to more efficient uses. And, in the long run, the tariffs and quotas, like any sort of monopoly privilege conferred by government, are no bonanza even for the firms being protected and subsidized. For, as we have seen in the cases of railroads and airlines, industries enjoying government monopoly (whether through tariffs or regulation) eventually become so inefficient that they lose money anyway, and can only call for more and more bailouts, for ever more of a privileged shelter from free competition.

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