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The Impending Demise of the Euro. The Impact of Monetary Policy on the Sustainability of the Euro

©2017 Textbook 117 Pages

Summary

The aim of this thesis is to study the impact of expansionary monetary policy on the European economies through the conceptual framework of the Austrian Business Cycle Theory. The European Central Bank has continually reduced interest rates as a policy measure to counter the sovereign debt crisis and this thesis examines the implications of this venture. From Germany’s perspective, the viability of reverting to the Deutschmark in times of monetary instability is also explored. The results, based on the deductive reasoning principle of the Austrian School, are also discussed.

Excerpt

Table Of Contents


4
Chapter 5: The Deutschmark ... 62
5.1 Agenda 2010 ... 63
5.2 German Stability Culture and Possible Exit from EMU ... 64
5.3 Reverting to the Deutschmark ... 66
5.3.1 Claim: Euro is stronger than the Deutschmark ... 66
5.3.2 Claim: Germany's export industry will collapse with DM ... 67
5.3.3 Claim: Europe will collapse if euro fails ... 70
5.3.4 Claim: Reverting to DM could be costly ... 70
5.4 Benefits of the Euro to Germany ... 72
5.5 Gold-backed DM and Countering Capital Inflows... 78
Chapter 6: Discussion ... 81
Chapter 7: Conclusion... 105
Reference List ... 110

5
List of Abbreviations
ABCT
Austrian Business Cycle Theory
DM
Deutschmark
ECB
European Central Bank
EMU
European Monetary Union
EONIA
Euro Overnight Index Average
ESCB
European System of Central Banks
EU
European Union
Fed
Federal Reserve of the United States
GDP
Gross Domestic Product
OCA
Optimum Currency Area
PIIGS
Portugal, Ireland, Italy, Greece, and Spain
QE
Quantitative Easing
Repo
Repurchase Agreement

6
List of Tables
Table 1 | German Money Supply and Inflation Performance
32
Table 2 | Government Deficit/Surplus in Germany, France and PIIGS
36
Table 3 | Government Debt in Germany, France and PIIGS
36
Table 4 | Current Account Balances of Germany, France and PIIGS
42

7
List of Figures
Figure 1 | Deductive Reasoning
10
Figure 2 | Current Account Balance of Germany
42
Figure 3 | Bank Exposure
44
Figure 4 | EONIA
54
Figure 5 | Interest Rate Comparison between Euro Area and USA
54
Figure 6 | Key Target Central Bank Interest Rates
55
Figure 7 | Average Inflation in Germany and PIIGS
57
Figure 8 | Approximate Gains from EMU
74
Figure 9 | DAX
77
Figure 10 | Official Gold Reserves
79
Figure 11 | EU Money Supply: M3
87
Figure 12 | NASDAQ
89
Figure 13 | Dow Jones
89
Figure 14 | Unemployment Rates in EU
94
Figure 15 | Country-Specific Youth Unemployment
95
Figure 16 | Average Youth Unemployment in Eurozone
95
Figure 17 | EU Favorability in Selected Nations
100
Figure 18 | Three-month Interest Rates in Germany & PIIGS
101
Figure 19 | Approval Rating: Economic Issues
102


9
Chapter 1: Introduction
The sad reality is that the European countries that currently find themselves submerged in
the sovereign debt quagmire are not in a position to get out of it any time soon. It all started
when interest rates fell down drastically, encouraging investments and spending that were not
backed by an increase in savings. Bastasin (2012) observed that the eurozone had been on the
verge of sinking at least three times within the space of a few years; in September 2008, in May
2010, and in November 2011. In all three instances, the political motives behind the existence of
the eurozone have proven stronger than the weaknesses of the vessel and the ineptness of its
command. However, if this process continues for a while longer, it might not make much sense
to have a common currency in Europe.
In today's world where artificially lowered interest rates are undermining the value of
currencies, and policymakers are running out of ideas to kick-start weak economies, this report
presents the Austrian Business Cycle Theory (ABCT) as an alternative to the mainstream
economic line of thinking. The Austrian approach puts strong emphasis on innovation and
entrepreneurship for the sustainability of a healthy economy, and promotes sound money
policies. The hypothesis of our report is that if monetary expansion continues, then the euro will
be unsustainable, and Germany should revert to the Deutschmark.
The structure of this thesis is as follows: we begin with a brief history of the Austrian
School of economics, which discusses the emergence of the Austrian methodology, Austrian
view regarding `mainstream' thought, and identify predominant contributors to the Austrian
School. This is followed by a detailed analysis of the Austrian Business Cycle Theory. The next
chapter provides us with a theoretical look at the role that central banks play in the creation of a
financial crisis. Having discussed this in great detail, we then highlight the fragility of the euro
and how it may prove to be unsustainable in the future. The thesis also comprises of a chapter for
evaluating the possibility of Germany reverting to the Deutschmark in response to current
monetary instabilities. In addition, an elaborate discussion will be undertaken with particular
emphasis on savings, money supply, interest rates, government debt and deficits, unemployment,
inflation as well as deflation. Finally, a way forward is presented as recommendation in chapter
6, before the conclusion is drawn.

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11
The second analysis states that as a result of lower interest rates, the pressure on
government debt service declined in the periphery, and government spending increased. Real
estate bubbles started to develop in Ireland and Spain, and until 2007, revenue generated from
these bubbles largely offset the significant increases in public spending. However, when
financial conditions worsened and the bubbles burst, the precariousness of fiscal positions in the
periphery came to the surface. So overall, low interest rates, reckless investments by German and
French banks, fiscal profligacy, government indebtedness and low efficiency in the peripheral
countries, all played a part in causing the sovereign debt crisis.
At the heart of this problem lies government intervention in the market. By buying
government securities and artificially lowering interest rates, a central bank can trigger an
increase in money supply and in the available funds for banks. The idea that governments could
smooth out the volatility of free markets by expanding the supply of money and running large
budget deficits in times of crisis is the main viewpoint of what is known as Keynesian
economics. The theories forming the core of Keynesian economics were first presented by the
British economist, John Maynard Keynes during the Great Depression of the 1930s.
Keynesianism allows governments to pretend that they have the power to raise living standards
with the assistance of a money printing press. The advocates of Keynes, called Keynesians, came
into conflict with the "Austrian School" of economic thought which followed the views of
economists like Ludwig von Mises and Frederick Hayek.
The Austrian economists have the opinion that recessions are necessary to compensate
for unwise decisions made during the boom phase that always precede the bust in a business
cycle. Austrians also believe that the booms are created by the false signals given to businessmen
when governments artificially lower interest rates in the hope of stimulating economies. So,
whereas the Keynesians look to mitigate the adverse impact of the busts, Austrians look to
prevent artificial booms from happening in the first place.
In this report, we encapsulate under the name of Keynesianism, not only John Maynard
Keynes's economic theories, but also the ideas of all schools of economic thought that seek to
allow excessive government interventions. In our view, any government influence that extends

12
far beyond the essential sovereign tasks of ensuring security and property rights should be
considered excessive. So, just like Vogt & Leuschel (2011), we draw no distinction among
multiple schools of economic thought, all of which demand a vigorous role for the government in
the society and economy.
Woods (2009) notes the fact that the Austrians warned of the formation of bubbles and
predicted the financial crash before anyone else did. Austrian economists consider the central
bank to be the main culprit of financial crises. The Austrian approach to understanding what has
happened to the economies of the world holds far greater explanatory power than does any
competing school of thought. According to Hammond (2012), the most important contribution of
the Austrian school to the field of economics is its theory of the business cycle (ABCT), which
offers a unique, comprehensive and coherent description of the process of booms and busts that
takes place frequently in a cyclical pattern. It highlights monetary intervention by the
government in cooperation with the banking system as the origin of these booms and busts. So,
let us now move on to the next chapter to discuss the Austrian school and its business cycle
theory in greater detail.

13
Chapter 2: The Austrian School of Economic Thought
The Austrian School of economics is one of the oldest schools of economic thought.
Birner & van Zijp (1994) highlights the fact that the Austrian School has contributed several
major ideas to what can be termed `mainstream' economics, most notably, the concepts of
opportunity cost and subjective value. The Austrian School was founded by Carl Menger with
the publication of Grundsätze der Volkswirtschaftslehre or Principles of Economics in 1871. The
Austrian method is largely based on theoretical deductive reasoning based upon axioms of
human action. By studying human action and reasoning logically, such seemingly complex
economic phenomena as interest, prices, profits and inflation could be explained and understood
as being grounded in the actions of individuals. They also
strive to solve complex economic
issues by means of outside-the-box thinking.
Austrian economists believe that human behavior is
too distinctive to be accurately modeled in mathematical terms and that it is best to have minimal
government intervention in an economy.
The Austrian School places special emphasis on interest rates and according to them, it is
determined by the time preference of borrowers and lenders. In other words, subjective decision
of individuals to spend money now or in future determines the rate of interest. F
rom an Austrian
economist's point of view, business cycles are caused by distortion in interest rates due to the
government's attempt to control money. When a government indulges in artificial manipulation
of interest rates, it results in the misallocation of capital and resources.
Moreover, the Austrian School insists that innovation and entrepreneurial profit seeking
are the two most important attributes that drives growth (Kirzner, 1997). According to them,
entrepreneurship is central to creating the growth and prosperity that most Keynesian economists
believe can be regulated by government intervention. Entrepreneurs are risk-takers, who
combine labor and natural resources with the purpose of creating profit. The personal gain from
the profit seeking activity helps not only the entrepreneur himself, but also raises the living
standards of everyone else. Furthermore, entrepreneurs help to enhance productivity by utilizing
resources efficiently, which makes it possible for people to consume more. So the economy does

14
not actually prosper due to a rise in consumption first, but rather the increase in consumption is
brought about as a result of the growth of an economy (Schiff & Schiff, 2010).
Austrian economists suggest that government intervention kills the entrepreneurial spirit
by setting up regulatory obstacles to enter the markets, and high taxation also decreases the
incentive to strive for success. However, if entrepreneurs do fail, the Austrian School is adamant
about allowing them to be eliminated. Companies that are not able to survive are considered to
be a misallocation of capital. Regardless of the size of these companies, those who have made
wrong decisions must be discarded from the market and the capital which is left behind would
then be reallocated and put to productive use. When such companies are bailed out by
government money, the unprofitable companies are kept in business, which prevents the tied up
capital from being better utilized elsewhere. Bailouts promote an environment of bad decision
making, and the issue of moral hazard arises. Woods (2009) defines moral hazard as the
increased likelihood of risky behavior arising whenever the acting party believes that any costs
of his behavior will be borne not by himself alone but by a large group of people.
2.1 Money
Almost everybody wants more money, and we generally use money without thinking too
much about its function. Few people are concerned about who controls the supply of money,
where it comes from, or why it has value. Since money is an integral part of our daily lives, it is
high time we take an interest in the aforementioned aspects to make sure that money remains
sound and does not become something that keeps on losing value.
Due to the inconvenience of bartering (where goods are directly exchanged for other
goods), money was invented out of necessity, and it has some major functions. Firstly, it is a
medium of exchange, which has eliminated the inefficiencies of the barter system, by being
generally accepted as payment for goods and services. Secondly, it is a unit of account which
facilitates the calculation of valuation, and most importantly, price comparison. In addition,
money is portable, implying convenience of usage, and last but not least, it is also supposed to
act as a store of value.

15
For money to be valuable, it must have limited supply. Ever since 1971, when U.S.
president Richard Nixon formally ended the convertibility of US dollars ($) to gold, all
currencies have become fiat currencies (money not backed by anything). Fiat currency is
considered as money solely because a sovereign government says it is money. It has no intrinsic
metallic or redemption value, and its nominal value is what the government engraves on the face
of the respective paper note or coin. However, the real value of fiat money is what it is worth in
exchange for the currency of another country (Schiff & Downes, 2009). Bonner & Wiggin
(2003) identifies clearly the main problem with all fiat currencies. It is that the fiat money
managers may create more of it, as per their convenience, without giving due importance to the
fact that they should never create so much that the illusion of scarcity is destroyed.
2.2 Business Cycles
A business cycle can be defined as fluctuations of aggregate economic activity. The most
widely used measure of this is the gross domestic product (GDP) variable. Other measures that
are included for a broader perspective on aggregate economic activity are unemployment figures
and financial market figures, such as the short term interest rate. The Austrian School and
Keynesians view business cycles in a contrasting manner. An Austrian business cycle goes from
a period of expansion to a period of contraction and is measured from trough to trough, while in
the eyes of Keynesians, an entire business cycle is a period of contraction followed by a period
of expansion and is measured from peak to peak. The period of time where aggregate economic
activity is growing is called the expansion or the boom phase. This phase goes from trough to
peak. In contrast, a contraction or recession goes from peak to trough, and represents the period
of time where aggregate economic activity is falling. If a recession is severe enough, it is referred
to as a depression.
Austrians explain business cycles with particular focus placed on the money supply. They
consider money supply, controlled largely by the central bank, to be explanatory of fluctuations
in aggregate economic activity. Austrians are convinced that they know what causes the bubbles
preceding a recession, while Keynesians believe that they have the necessary tools for avoiding a

16
recession when it emerges. Therefore, it comes as no surprise that these two schools of economic
thought always clash with each other due to the difference in viewpoints.
2.3 The Austrian Business Cycle Theory
The Austrian business cycle theory (abbreviated as ABCT) was first introduced by
Ludwig von Mises in 1912 in the book "The Theory of Money and Credit" and has since been
developed further. Two other predominant contributors to this development are Nobel Prize
winner, Friedrich Hayek, and Murray Rothbard (Ebeling, 1978). ABCT focuses primarily on
credit expansion, un-backed by savings, as being the cause of an unsustainable boom. Un-backed
credit expansion results from interest rates prevailing in the economy at a rate much lower than
that which clears the market. As interest rates coordinate present and future consumption, this
un-backed credit expansion initiates a boom by distorting the productive structure of an economy
with both unsound investments, mainly in interest sensitive producer goods, and
overconsumption. This unsustainable boom is inevitably followed by a bust.
When the mistakes are exposed, the malinvestments, as Mises called them, are liquidated,
creating the bust. Expansions that are financed by actual savings do not need such economic
busts. It is only the un-backed credit expansion that sows the seeds of their ultimate demise. As
Mises saw it, investors were not carelessly overinvesting; rather they were duped into responding
to false economic signals sent to them courtesy of the easy money policy (excessive monetary
expansion). According to Schiff & Downes (2009), this is the reason why Mises called such
mistakes, malinvestments, instead of over-investments. In any case, these malinvestments must
be liquidated, as prolonging their existence prevents the economy from shifting production and
consumption patterns to those that would otherwise contribute to long-term growth. (Bagus &
Howden, 2011)
Now, let us discuss in further detail, how credit expansion misdirects spending and
investment in an economy. First of all, credit expansion implies an increase in the money supply
but not an increase in real savings. Printing more money, or increasing the supply of credit, does
not make more resources available. Such a monetary expansion causes interest rates to fall down
even though there is no increase in real savings. At these artificially low rates, investment

17
projects become profitable that would be unprofitable if the rates were higher. As we know,
investment projects can be of varying lengths, so the entrepreneurs must decide which projects to
start. A high interest rate would naturally make entrepreneurs more cautious and prevent them
from tying up resources in long-term projects, unless they are sure that they can generate large
gains from such investments. In contrast, a low interest rate reduces the risk associated with
longer investments, and thus acts as a signal to tie capital up in lengthy projects (Murphy, 2016).
As a result, investment projects are undertaken that cannot be successfully completed with the
available real savings in the economy.
The second point to note regarding credit expansion is that it leads to an increased level
of consumption, beyond what it would have been if interest rates had been at their natural
(higher) rate. Just like in the case of any other good, the supply and demand of loanable funds
goes up and down, and they determine the price (interest rate). In a free market economy, interest
rates naturally go down if families are saving more or more banks are lending. By contrast, if
there is a shortage of loanable funds, interest rates go up, making it costlier for investors to
borrow money (Woods, 2009). In the absence of free market forces and
enticed by the artificially
reduced interest rate, people increase their current consumption, which naturally means that
savings decline.
Third, there is a shift to the financial sector where credit expansion creates the greatest
profits. Banks make use of this fresh liquidity prior to its use by others, thereby generating
profits before Cantillon effects set in (see page 24-25 for details). Prices will rise only after other
firms utilize the money. Moreover, Bagus & Howden (2011) explains that by extending loans
against its deposit base, the financial sector creates new money endogenously, and attracts
resources (and gains the associated profits) from all over the economy. Provided this process
continues long enough, the banks ultimately find themselves in a situation where they are being
surpassed (in relative profit terms) by firms engaging solely in financial speculation. It no longer
remains beneficial for these institutions to earn money exclusively by relying on extending loans,

18
instead speculation becomes the real profit driver, with profits relying on the continual influx of
money and credit.
1
According to the Austrian School, monetary expansion to finance government spending
sows the seed for a business cycle to take place. This credit expansion not only causes significant
increases in the money supply, but also large gains in asset prices (particularly in the housing and
stock markets). As observed by the ABCT, artificially inflated prices during the boom period
result in the eventual sharp decline in the value of stocks and housing. As the bust phase of the
business cycle is a period where resources are reallocated to their highest value use, any policy
which prevents this spontaneous market process from occurring, such as propping up of bankrupt
firms, must be avoided. An important observation garnered from the Austrian Business Cycle
Theory is that the economy will reallocate resources quicker in the absence of monetary
intervention, resulting in a shorter recessionary period.
2.4 Credit Creation and Liquidation
In an ideal world, credit creation should be the result of savings by depositors in banks. In
such a scenario, banks act as financial intermediaries and provide a link between savings and
investment. People deposit money with the banks in return for interest and these savings are then
loaned out to borrowers who also pay interest. The difference between the two rates of interest
generates the profit for banks. However, what we witness nowadays is that most credit comes
about through money printing which allows banks to issue loans that are not backed by adequate
amount of savings. This type of credit expansion is a clear violation of the monetary irregular
deposit contract. In this case, a bank's main purpose is to provide safety over the customer's
assets. The bank is obliged to pay the full amount of the deposit if and when it is demanded by
the customer. When this rule is not adhered to and money is printed out of thin air, the false
signal entrepreneurs receive from this increased supply of credit is that there has been a rise in
savings that will inevitably result in an increase in future consumption. This illusion brings about
1
Philipp Bagus ("Asset Prices--An Austrian Perspective," Procesos de Mercado: Revista Europea de Economía
Política 4, no. 2 [2007]: pp. 57­93, "Monetary Policy as Bad Medicine") discusses the herd behavior that results
from this process.

19
an increase in the level of investments, which would not have taken place otherwise. (De Soto,
2009).
When the interest rate is set by genuine market forces, it gives the correct guidance to
entrepreneurs and hence only the most profitable projects would be undertaken, without any
malinvestments. If consumers are willing to defer immediate gratification, they save large
amounts of their income, which frees up real resources from current consumption. Naturally, this
pushes down interest rates and thus provides the right incentives for entrepreneurs to invest. In
stark contrast, artificially lowering rates result in unnecessary investments and encourages the
formation of unsustainable economic booms. F.A.Hayek was awarded the Nobel Prize in
economics for explaining this phenomenon by showing how central bank manipulation of
interest rates and money, create distortions throughout the economy and sets up the stage for an
inevitable bust.
It must be said that in the beginning, the unsustainable expansion appears prosperous.
Growth is visible in most industries, unemployment declines, while wages and commodity prices
go up. However, sooner rather than later, it all comes crashing down. Woods (2009) points out
that soon the realization strikes a large number of entrepreneurs that the pool of real savings is
actually smaller than what they had initially anticipated. Thus the complementary factors of
production turn out to be scarcer. The prices for labor and other resources will therefore be
higher than expected, and business costs will rise. Firms will then need to borrow more to
finance these unanticipated increases in input prices. This increased demand for loanable funds
will raise the interest rate, thereby bringing into question the feasibility of some of these projects.
To add to the woes, the banking sector starts to get nervous at this point. As banks become more
reluctant to lend, interest rates start to rise even further. The tightening in the credit markets
gradually becomes a source of pain for more and more businesses, especially the most leveraged
ones. Entrepreneurs finally figure out that they were too ambitious, as it becomes impossible for
them to complete the long-term projects they had begun. Workers get laid off as investment
projects are abandoned, paving the way for the painful bust to set in.

20
Central banks often try to delay this painful period of financial reckoning, where the
malinvestments are liquidated for an economy to be restored to its true health. They do this by
cutting interest rates again and again. It is just like kicking a can down the road, hoping against
hope that the inevitable would not happen, and the can will keep on rolling forever.
Unfortunately, what they fail to realize is that the can will ultimately reach a dead-end. They do
this in order to maintain labor employment by keeping unhealthy businesses afloat, but this only
prolongs and enlarges the adverse effects of the credit injection. As a consequence, the
corrections in the market become much larger in magnitude, making the subsequent recession
significantly worse.
Instead of letting the markets function under the pricing mechanism, Keynes believed
that government spending and monetary injection into the economy could instigate a rise in
demand for the goods of companies, and keep people employed. The key point here is that
Keynesians want to prevent the bust, whereas Austrians want to prevent the artificial booms,
created by false signals in the markets (Schiff & Schiff, 2010). Moreover, as mentioned earlier,
Austrians argue that unprofitable companies should be allowed to fail and go out of business.
This would open up the possibility for entrepreneurs with excess capital to purchase the valuable
assets for profit seeking activities. Such a process would assist in creating new sustainable
businesses and related employment.
Writing during the Great Depression of the 1930s, F.A. Hayek highlighted the adverse
effect of an easy money policy:
To combat the depression by a forced credit expansion is to attempt to cure the evil by the very
means which brought it about; because we are suffering from a misdirection of production, we
want to create further misdirection ­ a procedure that can only lead to a much more severe crisis
as soon as the credit expansion comes to an end.
2
Robbins (1934) reiterates that nobody likes unemployment and bankruptcy, but they
would not have been necessary had the artificial boom not been stimulated in the first place.
Producer-goods industries attract more investment than the consumer-goods industries because
2
See F. A. Hayek, Prices and Production and Other Works, ed. Joseph T. Salerno (Auburn, Ala.: Ludwig von Mises
Institute)

21
that sector is the most sensitive to interest-rate changes, and so the impact of the downturn is felt
heavier there.
In a similar vein, Ron Paul (2009) continues by stating that when the need arises,
liquidation is necessary and will eventually prove to be beneficial. The financial world requires
this form of liquidation now.
2.5 Criticisms of ABCT
As with any other theory, over the years, some criticisms regarding ABCT have been
raised by economists belonging to different schools of thought. This discussion will mention the
two main critiques of ABCT, and refute them along the way.
First of all, based on the rational expectations hypothesis (REH), developed by American
economist Muth (1961), several economists have criticized ABCT arguing that the theory
requires economic agents to display a certain degree of economic irrationality. Caplin (1997)
raises an important question: why are entrepreneurs tricked into excessive investing by
government-induced artificial low interest rates, instead of correctly predicting central bank
policy and realizing that interest rates will be higher in the future?
To refute this,
Callahan
(2006) asks a counter-question: considering the fact that central banks throughout the world has
been manipulating interest rates for a protracted period of time, how would an entrepreneur
actually determine the `natural' rate of interest in the first place? For businessmen to figure out
the distortionary
effects of un-backed credit expansion, widespread knowledge of ABCT would
be necessary, which is unfortunately not the case today (Davidson, 2013). Even those
entrepreneurs, who have a clear understanding of the Austrian theory, may still find it hard to
resist the temptation of borrowing money when interest rates are artificially low. They may
consider it to be advantageous to invest while rates are low and attempt to ride the boom. A new
project might be launched in the hope that it will be one of the lucky ones and that the
entrepreneur will be able to get out before the downturn hits. Woods (2009) suggests that if these
businessmen are clever enough not to react to the artificially lowered rates, their competitors
surely will, which might enable them to gain market share at the former's expense. So, it
becomes part of human nature to take the bait.

22
Tulloch (1988) points out another criticism of ABCT, which is that the theory does not
explain why inflation cannot be continued indefinitely. In response, Rothbard (2009) states that
continued inflationary policies will be met with a decreased demand for cash holdings by the
general public. Cash holdings will decrease as there will be increased investment in goods which
might eventually instigate a period of hyperinflation and a flight from the currency. Let us now
move on to the next segment for a more detailed discussion about the important concept of
inflation.
2.6 Inflation
The Austrian School has the firm opinion that any increase in money supply which is not
accommodated by a rise in the production of goods and services leads to an increase in prices.
However, the prices of all goods do not increase simultaneously. Prices of some goods may
increase comparatively faster, while the first users of the newly printed money benefit at the
expense of others, leading to greater disparities in the economy.
A central bank is supposed to be independent, but to a large extent, it actually ends up
complying with the policies of the government in the financial markets. This means that it tries
to eliminate business cycles by printing money and financing deficit spending to avoid
recessions. When the central bank injects money into the financial system, the private banks
expand their level of credit. In this way, the Austrian School sees inflation as an increase in the
money supply which causes prices to rise, thereby posing a big danger to society (Schiff &
Downes, 2009). Most politicians and economists insist on defining inflation as a rising price
level, when in fact, rising prices is a harmful consequence of monetary inflation.
While attending
a
conference on the Economics of Mobilization, held at West Virginia, in April 1951, Ludwig
von Mises elaborated on the definition of inflation by stating that:
People today use the term "inflation" to refer to the phenomenon that is an inevitable
consequence of inflation, that is the tendency of all prices and wage rates to rise. The result of
this deplorable confusion is that there is no term left to signify the cause of this rise in prices and
wages...Those who pretend to fight inflation are in fact only fighting what is the inevitable
consequence of inflation, rising prices. Their ventures are doomed to failure because they do not

23
attack the root of the evil. They try to keep prices low while firmly committed to a policy of
increasing the quantity of money that must necessarily make them soar.
3
So in simple words, contrary to the generally accepted view, inflation is not a general rise
in prices, but rather it is a term that denotes an increase in the money stock. Mises claimed that
this confusion over defining inflation was mischievous and a deliberate attempt by governments
to get people to focus only on prices when thinking about inflation. Paul (2008) suggests that if
we understood inflation properly as an increase in money supply, we would instantly know that
the best way to cure it is by placing a demand on the central banks to cease manipulating the
money stock. Moreover, Paul (2009) adds that if it is considered only as a price problem, then
blame can be attached to speculators and profiteers. This deflects attention away from the real
source of the problem which is the central bank and its money printing press. Hence, the central
bank's role in the inflation is largely ignored.
Austrians believe that a rise in the money supply do not always manifest in economy-
wide increases in the consumer price index, which is considered as the standard definition of
inflation. Instead, the excess cash might flow into specific areas of the economy, depending on
real-world factors (Doherty, 2012). According to Paul (2008), it is also wrong to believe that
prices rise in conjunction with wages and salaries, and as a result, inflation causes no real
problems. In order to explain how inflation benefits certain parties at the expense of others, he
highlighted the distribution effects, or Cantillon effects of inflation, (named after economist
Richard Cantillon):
The price increases that take place as a result of inflation do not occur all at once and to the
same degree. Those who receive the new money first receive it before prices have yet risen. They
enjoy a windfall. Meanwhile, as they spend the new money, and the next wave of recipients
spend it, and so on, prices begin to rise throughout the economy ­ well before the new money
has trickled down to most people. The average person is now paying higher prices while still
earning his old income, which has not yet been adjusted to account for the higher money
supply...The enrichment of the politically well connected ­ in other words, those who get the
3
As quoted in The Commercial and Financial Chronicle, April 26, 1951.

24
newly created money first: government contractors, big banks, and the like ­ comes at the direct
expense of everyone else.
4
To sum it up, expansionary monetary policies create inflation. Stabilizing prices is a
priority for both the Austrians and Keynesians, but the tools they use are totally different. In the
mainstream Keynesian line of thinking, the economy needs stimulus to avoid recessions, which
for Austrian economists is equivalent to the creation of widespread inflation.
2.7 Deflation
Deflation is commonly defined as a fall in the price level. The real definition of deflation
would be a decline in the supply of money. So, it the opposite of inflation, and is another form of
saying that money becomes more valuable over time. Deflation can be economically clarifying
as it causes banks to tighten up their lending standards and encourages businesses to run tighter
operations. Deflation also raises the real value of government debt and it can actually act as a
restraint on government spending, as it becomes harder to service the debt.
It is true that deflation can become a major cause for concern when demand disappears
due to a complete collapse of income in an economy. However, that is an extreme case as
generally, there is always demand at some level of prices. In simple terms, deflation means that
supply exceeds demand, causing consumer prices to fall. According to Schiff & Downes (2009),
most economists worry about falling prices for two main reasons. The first concern is that people
will stop spending and postpone purchases, as they anticipate cheaper prices, but there is no
evidence to justify the notion that this actually happens. He dismissed this concern by pointing
out that computers and cell phones are becoming cheaper day by day, but they continue to sell in
large volumes.
The other fear is that corporate profits would take a hit, causing companies to reduce
production, downsize and reduce future investments. However, what most people tend to forget
is that profitability is about margins. When costs and prices fall together, margins remain the
4
See Ron Paul, 2008 p. 103

25
same. In fact, constant margins often lead to greater profitability, as sales increase due to falling
prices.
Neo-classical Keynesian theory has generated deflation paranoia, and created an almost
universal acceptance that prices must keep on increasing to prevent a fall in prices. It must be
said that falling prices is not always good for an economy, but there is also a good form of
deflation, which Keynesians tend to ignore. Austrians argue that some prices fall naturally over
time due to competition, efficiency, innovation and technological progress. Computers, mobile
phones and televisions can be considered as prime examples of technological goods that have
become both better and cheaper, over the years.
2.8 Summary
Having discussed inflation and deflation at length, let us now recap some of the other
important issues that we have covered in this chapter:
· Economists belonging to the Austrian School believe that human behavior cannot be
accurately modeled in mathematical terms and
puts emphasis on the
distortion in interest
rates brought about by the government's attempt to control money to explain why we
experience frequent booms and busts.
· It is a common fallacy of the Keynesians that increasing consumption can be the solution
to current economic problems. In reality, an economy does not prosper due to a rise in
consumption first, but rather the increase in consumption is brought about by the growth
of the economy.
· The Austrian Business Cycle Theory (ABCT) highlights that interest rates can come
down in two ways: either naturally when the general population saves more; or
artificially when central banks force the rate down.
· If interest rates are lowered, businessmen respond by starting new projects. These
projects are usually undertaken in the most interest-rate sensitive areas, especially in the
so-called higher-order stages of production: construction, raw materials, and capital
equipments to name a few. In other words, these are the production processes that are
farthest removed in time from finished consumer goods.

26
· When the interest rate is lower because of a natural cause like increased saving, then the
market works efficiently without any hiccups. The decision of the general public to defer
consumption to a later date provides the incentive and necessary resources for the new
investment projects initiated by businesses' to be seen through to completion. However,
if the interest rate is lower because of artificial manipulation by a central bank then the
aforementioned projects cannot all be completed. The essential materials needed to
complete them have not been saved by the public, and hence it is soon discovered that
investors have been duped into production lines that cannot be sustained.
· Once these malinvestments become apparent, ABCT suggests that it is essential to
liquidate them. The sooner the monetary manipulation comes to an end, the faster
malinvestments can be eradicated and misallocated resources are redirected into
sustainable ventures. On the other hand, the longer governments try to prop things up in
the form of bailouts and rescue packages, the worse the inevitable bust will become in the
future.

27
Chapter 3: Central Banks and Monetary Union
Now, let us discuss in detail, the major roles of a central bank. The mission of a central
bank is to provide the nation with a safe and stable financial system. Its main functions are: (i)
being the bank of the government and commercial banks, (ii) being the lender of last resort, and
(iii) regulating the banking system and managing monetary policies (Parkin et al., 1997).
Being the bank of the government means financing its spending which can be done in
two ways. It can be done either by issuing a direct loan which is equivalent to money printing, or
alternatively, by selling government bonds. The central bank changes the supply of money by
buying or selling bonds in the bonds market in what is called open market operations. If it wants
to decrease the amount of money in circulation it sells existing bonds in the market, thereby
removing money from the existing supply. On the other hand, if the central bank wishes to
increase the amount of money in the economy, it buys bonds by creating money (Blanchard,
2003). The price of these bonds and their interest rates has an inverse relationship. The lower the
bond price, the higher the interest rate and vice versa. Thus, financing debt through open market
operations can be used to control the interest rate in financial markets.
Being the bank of the commercial banks imply keeping their reserves, regulating the
banking sector and acting as their lender of last resort. When central banks extend credit to
commercial banks in times of a credit crunch, it means they are serving the purpose of being a
lender of last resort. Restoring the cash levels of commercial banks helps to avoid a possible
bank run. In theory, the central bank can also regulate the money supply by increasing the
minimum reserve requirement.
A central bank can also directly set the interest rate at which commercial banks borrow
funds. Increasing the interest rate makes it more costly to loan money from the central bank,
encouraging commercial banks to cut down on their lending, while a fall in the interest rate
naturally stimulates lending. The banks are required to keep a specific fraction of their deposits
on reserve, to be made available for customer withdrawal. Banks can find themselves below the
reserve requirement set by the central bank if they have made a lot of loans or if an unusually

Details

Pages
Type of Edition
Erstausgabe
Year
2017
ISBN (PDF)
9783960676768
ISBN (Softcover)
9783960671763
File size
3.1 MB
Language
English
Institution / College
University of Applied Sciences Worms
Publication date
2017 (July)
Grade
1.7 (German Scale)
Keywords
Austrian Business Cycle Theory Deutsche Mark Expansionary monetary policy European economy European Central Bank Debt crisis Austrian economics
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