Does Monetary Inflation Cause a Business Cycle?

Tom Woods – on his wonderful podcast – recently had Joe Salerno and Jonathan Newman on to discuss the Austrian Business Cycle Theory (ABCT).

Specifically, the three of them were responding to an article by Steve Horwitz that they saw as a criticism against the Austrian Business Cycle Theory.  I am not certain if the article was supposed to be an outright criticism of the ABCT, or if it was just to show its limitations.  There were parts of Horwitz’s article I agreed with, and parts I didn’t agree with.

A little before the halfway mark of the podcast, they discussed one particular claim from the article.  In discussing the Great Depression, Horwitz writes, “The theory’s adherents have argued that the recession that began in 1929 was the result of an unsustainable boom initiated by an excess supply of money at some point in the 1920s.”

On the podcast, Salerno was quick to disagree with this point.  He said that the excess supply of money doesn’t cause the business cycle.  He said that it is how the increase in the money supply is injected through the financial system, and thus lowering interest rates, that causes the business cycle.

Specifically, Salerno stated that an increase in the money supply that was used directly for war spending would not cause a business cycle.  He said, “That only causes a simple inflation.  It causes prices to rise.  It does not cause a business cycle.”

I believe Salerno gets this wrong.  An increase in the money supply to finance war spending (or anything else) is not just a simple rise in prices.  It is a misallocation of capital.  It is also a redistribution of wealth.

A correction – which is the bust phase – occurs when those misallocated resources get realigned.  So if you create new money to finance the military industrial complex and then that flow of new money comes to an end, there is going to be something of a bust with the war industry.  The makers of weapons will see higher unemployment.  Stock prices will probably fall.

The biggest bust of the recession in 2008 was housing.  And yes, this was largely due to the artificially low interest rates, also coupled with easy money.  But we can’t completely discount the government’s incentives of encouraging banks to lend and supporting the mortgage market through its government enterprises (Fannie Mae and Freddie Mac).

You could have an increase in the money supply that goes directly to the government, which then uses the money to help people make down payments on houses.  This would likely result in more demand for purchases of houses and a bidding up of prices.  It would likely cause a bubble in housing.  You don’t have to have an artificially low interest rate for the government to cause a bubble.  It certainly helps, and it certainly can exaggerate the situation, but it isn’t an absolute necessity.

Maybe Salerno would argue that an increase in the money supply would just cause misallocations in certain industries, limited to those areas where the government spends its money.  In his eyes, maybe this doesn’t constitute the business cycle because it is not widespread.

But in any bust phase, there are always certain industries that get hit harder than others.  Some industries are virtually untouched.  The housing bust was devastating because it is such a major asset and also because it impacted the banking system from all of the bad loans.

I know many Austrian school economists will disagree with me on this point, but I believe that an increase in the money supply can cause artificial booms and busts.

Usually the easy money and low interest rates go hand in hand.  So in today’s system, this internal debate may be somewhat moot.  But I hope that Salerno at least recognizes the fact that an increasing money supply misallocates resources.  And unless those resources continue to be misallocated forever, there is going to be some kind of bust.

That is one of the most devastating effects of an increasing money supply.  It distorts savings and investment and it misallocates resources.  This misallocation makes everyone poorer, except for the few beneficiaries who see the money first.

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