The Austrian School and the "Austrian" School
Jude Wanniski
January 30, 2002


Memo To: Website Fans, Browsers, Clients
From: Jude Wanniski
Re: Von Mises and the "Austrians"

[Following is an essay by my colleague at Polyconomics, Nathan Lewis. If you are at all interested in economics, you will find it most interesting and illuminating. JW]

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Gary North, an economist belonging to a group that calls itself the "Austrians," has agreed to a public discussion about the Austrian economists. We modern classicists, known as the Supply-Siders, have always felt a close affinity to the original Austrians, but we have a hard time with the modern-day "Austrians," who don't seem to be aware of the vast differences that have appeared between their own views and the views of their intellectual forbears, particularly Ludwig von Mises. Like John Maynard Keynes, who would have been horrified by the "Keynesians" who succeeded him (if he had lived long enough), we think Mises would have been appalled by the "Miseans" of today. (This does not bode well for the "Supply-Siders" of tomorrow.) North has taken the time to create a series of six well-constructed essays on Mises at the website, and we will honor his efforts by responding in kind. But rather than addressing North point-by-point, which will soon lead us into deep swamps with no hope of escape, we'll try to distinguish a few of the ways in which we think the "Austrians" of today differ from the Austrians of 50 or 90 years ago.

The Original Austrian

The best remembered of the original Austrians is Ludwig von Mises (1881-1973), who emigrated from Austria to the United States. Mises was at heart a classical economist, whose formative years lay at the very zenith of the classical economists' greatest successes (at least for monetary policy), the late 19th and early 20th century, before World War I, when the world was linked together in a gold standard centered on the British pound and the Bank of England. In those days everybody was a classical economist, but Mises was one of the very best. His book, Theory of Money and Credit, published in 1912 when Mises was 31, represents the pinnacle of 19th century classical monetary theory. It made his reputation across Europe. Mises understood how classical monetary economics worked because he lived it, breathed it, and was its greatest champion.

Thus Mises had an advantage over some of his followers, who knew of the 19th century "classical" gold standard only from books (and it is not particularly clear in most books how it worked, just as it is almost impossible to find an accurate description of how the Fed works today). F.A. Hayek appeared as a wunderkind in the 1920s, after World War I had destroyed the 19th century's gold-linked monetary system. The world gold standard was put back together in the late 1920s, but blew apart again in the 1930s. Murray Rothbard was a student of Mises, but, not realizing (as Mises did) that the Bretton Woods system of the 1950s and 1960s was also a gold standard, soon began to weave the most incredible fairy tales of what he imagined a gold standard to be, which bore little resemblance to the institutions of the late 19th century that Mises (presumably) supported. Today most "Miseans" are actually Rothbardians. One reason that the gold standard advocates are roundly denounced as monetary kooks today is that the great majority of gold standard advocates, numerically speaking, are Rothbardians bearing rather bizarre and antiquarian proposals that, if implemented, would almost certainly produce an economic disaster. The Rothbardians are one of the biggest obstacles to the reconstruction of a properly working gold standard. We hope they, at least the younger ones, will begin to understand where the lineage has lost the path.

Value vs. Volume

In this brief essay we will look at one single concept, namely, Value versus Volume. The classical economists have always been concerned with maintaining a stable value of money. You could call them "Value Theorists." The value of money is kept stable by adjustments in the volume of money -- if the currency is weak, the volume is shrunk, and if the currency is strong the volume is expanded. This is even true under a pure bullion (100% coinage) standard, in which case the mechanism for adjusting the volume is the import and export of bullion, as explained by David Hume in the mid-18th century. It is also true that if the process is not attended to properly, and the volume of money becomes excessively large or excessively small, then a change in the value of money will ensue. So there is a direct link between value and volume. But value is on top, with volume a subsidiary or residual factor.

Over time, gold has been adopted as the best (if imperfect) benchmark of money's value, so the value of money is best expressed by the market's trading ratio between the currency and gold. In other words, as long as the value of the currency is stable, i.e., fixed to gold, then monetary conditions are basically fine as far as inflation and deflation are concerned. If the "money supply" doubles or falls by half, it doesn't matter as long as the change is the natural result of the supply-adjustment mechanisms that maintain the fixed currency-gold ratio. The "money supply," whatever it is, is assumed to be "optimal" if the value of the currency is optimal, i.e., at its gold parity. That is why the gold standard could work without anybody actually knowing what the "money supply" was. This is the principle of all gold standards that have ever existed, including the "100% reserve" standards. A gold standard is a link between the value of a currency and the value of a certain amount of gold. There are many ways of creating this link, but as long as there is a link, you have a gold standard.

For a value theorist, "inflation" is a fall in the value of the currency (signaled by a rise in the "gold price"), and "deflation" is a rise in the value of the currency (signaled by a fall in the "gold price"). The "Austrian Theory of the Trade Cycle" is basically a tale of all the terrible things that happen when you ignore the gold standard and induce inflation.

On the other side lay the "Quantity Theorists," of which the most numerous are known today as "Monetarists." They ignore value and are always looking at volume. The quantity theorists tend to get worried about inflation when the volume of money increases (depending on some arbitrary and ever-changing definition of "money"). Indeed, it was the Monetarists, led by Milton Friedman, who helped blow up the dollar's link with gold in 1971 with arguments that it interfered with optimal management of the money supply.

Let's take some simple historical examples: in February 1880, with the dollar pegged to gold at $20.67/oz, there was currency in circulation and bank vault cash of $897 million (this is known as "base money"). In December 1932, with the dollar still pegged to gold at $20.67/oz, there was $8.028 billion (including deposits with the Federal Reserve). Big change in volume, no change in value.

In January 1934, the dollar had been devalued to $35/oz, and there was $7.947 billion of "base money." Big change in value, but volume shrank!

In 1960, with the dollar still at $35/oz, there was $49.2 billion of "base money." Big change in volume, no change in value.

To make a long story short, Mises was primarily a value theorist, although some of his writings are a little uncertain. After all, Book Two of his Theory of Money and Credit is entitled “The Value of Money.” (Book One is a warmup and Book Three is about the theory of credit).

The Great Depression

Hayek and Rothbard, on the other hand, eventually morphed into quantity theorists. This happened basically as a result of the Great Depression. The classical economists of the time were very sophisticated about money and banking, but had extremely crude ideas about fiscal policy. The Great Depression was touched off by the threat of passage of the U.S. Smoot-Hawley tariff in 1929, which was matched with threats of huge retaliatory tariff hikes worldwide. More than a thousand classical economists in the U.S. signed a petition against the tariff -- after all, Adam Smith had become renowned for his free-trade arguments -- but when trade barriers around the world shot up and trade predictably shriveled, not one of those thousand economists drew the connection! As the economy slowed down, it was the classical economists' terrible fiscal ideas -- raise tax rates to balance the budget -- that turned the recession into a full-blown collapse. In 1932, Herbert Hoover pushed the top income-tax rate in the United States to 63% from 24%, and the bottom rate to 4% from 1.125%. Similar things happened in Britain and Germany. The classical economists noted that the dollar and other major currencies were solidly fixed to gold and, unaware of the fiscal catastrophe going on around them, predicted a quick return to economic health.

When their predictions turned out wrong, they were brushed aside to make way for the Keynesians, who theoretically were opposed to the whole raise-taxes-to-balance-the-budget strategy that had greatly deepened the Depression.

But instead of blaming the horrible fiscal policies of the time, the classical economists, including Hayek and even, to some degree, Mises, began to contort their monetary theories into pretzels to explain the economic collapse. Mises experimented with a "credit bubble" theory, but he never did change his mind very much (he was fifty years old in 1931). That is why Mises remains so readable today. Hayek, though, was soon trying to explain the Depression as the result of a Terrible Inflation during the 1920s, which was of course in direct contradiction to the fact that the value of the dollar, pound and franc were all solidly fixed to gold in 1926-1931. Hayek had to abandon "value theory" to make his ideas work, and in the process became a quantity theorist, arguing that any increase in the money supply at all constitutes an inflation. (In fact, it is rather difficult to make an inflation case for the 1920s even as a quantity theorist. In September 1925 there was $7.036 billion of base money, and in September 1929, the very height of the "inflationary bubble," there was $7.075 billion.) Another trick is to define "money" to include credit, which is not money. You can see this if you understand that credit can exist without money. I'll give you a ride to the airport today if you watch my dog next week. Anyway, by using quantity theory and a flexible definition of "money," you can eventually argue that the Depression, or any other economic event, was due to a Terrible Inflation (Hayek) or a Terrible Deflation (Friedman), as long as you throw your value theory out the window.


Rothbard got into the act in the 1960s. In his book, America's Great Depression, he tried to make the "Austrian Theory of the Trade Cycle" -- the story about all the bad things that happen when you leave the gold standard and inflate the currency -- fit 1926-1932, which naturally took quite a bit of contortion since the U.S. was on the gold standard until 1933. Rothbard actually devoted several rather good chapters of the book to all the terrible fiscal policy that was recommended by the classical economists of the time, but nevertheless he concludes by trying to explain the Depression as a Terrible Inflation, quite a feat considering that prices dropped 30% between 1929 and 1932. Rothbardians have been warning about a Terrible Inflation ever since, and sometimes they even get it right, as in the 1970s. (Given the definition of inflation as "an increase in the money supply" -- notice no mention of value -- this should hardly be surprising. "Money supply" measures tend to increase continually as a natural consequence of economic growth.) The "Austrians" tend to argue that "money supply" should never change, or should only be allowed to grow at some "slow, stable" rate probably related to the average 2% annual increase in above-ground gold due to mining production, which is rather eerily like Milton Friedman's proposal for a constitutional amendment that requires the "money supply" to grow at 3% a year.

Now, if the 1920s and 1930s were a Terrible Inflation then obviously something was wrong with the gold standard, which was supposed to prevent such things. And if the gold standard of the 1920s wasn't sufficient to prevent a Terrible Inflation, then certainly the gold standard of the 1960s -- Bretton Woods -- wasn't sufficient either. To make sure that a financial crisis, like that of the 1930s, wouldn't turn into a monetary crisis, banknotes should be backed with 100% gold reserves (allowing an instant switch to a fully metallic currency if need be). And if Mises were right that a "credit expansion" caused the Depression, then maybe we should outlaw credit altogether! That eliminated the gold standards of the 18th and 19th centuries, which is what most people think of when they hear the term "gold standard." So, in search of a "real" or "pure" gold standard, Rothbard and his followers took an imaginary journey to 17th century Amsterdam. There, they found that the Bank of Amsterdam was required by law to keep gold bullion reserves of 100% against banknotes and was forbidden to make loans against deposits. In other words, no credit. Perfect! So the Rothbardians decided that the "pure" gold standard they were going to impose on a 21st century world of six billion people was going to be an imitation of the Bank of Amsterdam, which served a city of 100,000-200,000 that was crawling out of the Middle Ages. In the name of "freedom from government control," they would impose draconian government limitations on banking operations. (The Bank of Amsterdam itself was eventually found to be making loans, in violation of the existing laws.) In short, it is a plan that can be rightly labeled "barbaric," and any reasonable politician or mainstream economist (or Supply-Sider) instinctively recoils in horror.

Today the Rothbardians are lost in their reveries. The Supply-Siders remain value theorists in the classical tradition. They recognize that the Bretton Woods system, when it was working as intended, was just as much of a gold standard as the golden coins of Julius Caesar's day. It doesn't really matter who pegs the dollar to gold, as long as its value remains sturdily pegged, through adjustments to supply (in response to market signals), to some appropriate gold value such as $350/ounce. (Or in North's terms: It does not matter who maintains the optimum quantity of money as long as the quantity is maintained at its optimum, i.e., adjusted to produce a stable currency value, signaled by a stable market parity with gold.) Value peg=gold standard. Since the Fed is now managing the value of the currency, or mismanaging it as the case may be, the simplest and most politically expedient thing to do would be for the Fed to just change the way it operates a little teeny bit, targeting gold instead of some spurious interest-rate target.

The great accomplishment of the Supply-Siders was not on monetary policy, most of which was inherited from the 19th century classicists such as Mises, but on fiscal policy. Because the Supply-Siders finally grasped the fiscal causes of the Great Depression, they didn't have to bend themselves into pretzels trying to explain the 1930s as a monetary policy error. We hope this insight will help some Rothbardians, or those who might be in danger of becoming Rothbardians, to instead become classical value theorists in the tradition of Ludwig von Mises.

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Now let's take a final look at Gary North, who, in the concluding section of his recent essay "Mises on Money," quotes Mises as saying in 1951: "Sound money still means today what it meant in the nineteenth century: the gold standard. The eminence of the gold standard consists in the fact that it makes the determination of the monetary unit's purchasing power [value, not volume] independent of the measures of governments."

North then summarizes: "Mises suggested a reform: the re-establishment of a traditional, government-guaranteed gold standard." He quotes Mises again as saying in 1951: "The Classical or orthodox gold standard alone is a truly effective check on the power of the government to inflate the currency."

North also quotes Mises as saying in 1949: "In dealing with the problem of the gold exchange standard [formally established in 1922 and the basis for the Bretton Woods system] all economists -- including the author of this book -- failed to realize the fact that it places in the hands of governments the power to manipulate their nations' currencies easily. Economists blithely assumed that no government of a civilized nation would use the gold exchange standard intentionally as an instrument of inflationary policy."

Without going into technical details, it should be clear from this passage that Mises considered the "gold exchange standard" -- the gold standard of the 20th century -- to be technically adequate but prone to political risk. Indeed political risk is exactly what blew up the system in August 1971, when it took the decision of only one government, the United States, to throw every major country in the world off the gold standard, whether they wanted to or not.

North, writing in 2002, says a page later: "It is time for defenders of sound money to cease being crazy. It is time to stop promoting the traditional [i.e., Classical, or orthodox] gold standard. The traditional gold standard is a game for suckers." Rather strange words from a supposed "gold standard advocate." Does that make Mises a "sucker"?

North later says: "A gold standard that the public can safely rely on must not have anything to do with a government's guarantee to redeem gold on demand." What????

Elsewhere, North dismisses the astounding success of the gold standard under the Bank of England, which stretched over two centuries (1698-1931) and helped make Britain the world's first globe-encircling industrial superpower, because the BoE had an effective monopoly on currency issue granted it by the government and was the model for the rest of the world's "central banks." North, and the other Rothbardians, are basically so angry at the government for messing up the perfectly functional gold standard of the 20th century that they want to create a supposedly "government-proof" gold standard. They will never succeed, because no gold standard can ever be government-proof, nor can it be established without government consent. In the meantime, however, they will continue to frustrate the efforts of the "suckers" to institute a perfectly functional and politically feasible gold standard within our lifetimes. The advantage of a "Bretton-Woods-like" gold standard is that it could be rebuilt just as easily as it was destroyed, with a presidential stroke of the pen. Governments have destroyed all the gold standards that have ever existed, but, in most instances, they created them, too.

Nathan Lewis
January 2002