The Golden Revolution, Revisited: Chapter 2

This Insight is the fourth in the serial publication of the new, Revisited edition of my book, The Golden Revolution (John Wiley and Sons, 2012). (The first instalment can be found here.) The book is being published by Goldmoney and will also appear as a special series of Goldmoney Insights over the coming months. This instalment comprises the second chapter of Section I.

View the Entire Research Piece as a PDF here.

Cantillion and the Austrian Economic School on Money and Financial Crises

“There is tragedy in the world because men contrive, out of nothing, tragedies that are totally unnecessary—which means that men are frivolous.”



Beginning in the 1870s with Carl Menger, the “father” of the school if there was one, Austrian School economists determined that market (i.e. free exchange) prices for economic goods were set at the margin where supply and demand met at any given point in time and place, rather than according to their average cost of production or specific cost of labor inputs. Eugen von Boehm-Bauwerk was the first to offer a holistic theory of capital and interest (or rent). Friedrich von Wieser was first to systematically apply the powerful concept of “opportunity cost,” or trade-offs, to all areas of economics. The Austrian economist Friedrich von Hayek was the first to offer a comprehensive explanation for business cycles (for which he would eventually be awarded the Nobel prize in economics). Ludwig von Mises was the first major economist to predict and show how central economic planning would eventually fail in the Soviet Union and elsewhere. Joseph Schumpeter was the first major economist to demonstrate the salutary effects of occasional recessions as a means to qualitatively re-order the capital stock so as to incorporate new technologies and more efficient methods of production, a process he termed “creative destruction.” Indeed, the Austrian School has a formidable history of innovative thinking and of being proven more or less right, time and again, by major historical events.

Economists of the Austrian Economic School (AES) did not overlook or dismiss William Jevon’s view that Cantillon’s insights into money were essential to an understanding of how money and monetary policy can affect an economy and potentially exacerbate inequality. Rather, they thoroughly integrated them into their holistic economic framework. This process began with von Boehm-Bauwerk and Knut Wicksell and continued in the work of von Mises and von Hayek.

Austrian economists place central importance on the role of money and monetary conditions on the real economy. They also focus on how monetary conditions can influence asset as well as consumer prices. This is because the Austrians have a theory of capital formation (or destruction) that is intertwined with the prices of assets. As prices are information, entrepreneurs will seek continuously to allocate and reallocate capital based on the real-time flow of asset price information. This real-time, complex process extends over potentially long periods of time, such as those required to develop new technologies and to build the new plant and equipment required to implement them. Indeed, the sheer, mind-boggling complexity of a modern economy is so great that it cannot possibly be understood by any one person or group of persons. Thus, Austrian economists, while acknowledging that there is no such thing as perfection in human affairs or in an economic marketplace, nevertheless believe that the spontaneous market, and the market alone, is the ideal way for information to flow efficiently through the economy in a way that maximizes social benefits.

If you do intervene and interfere, however, with what would otherwise be a natural and self-regulating capital formation and allocation process directed via asset prices,then these actions can distort price signals and result in resource misallocations, including the boom and then bust of financial crises. That said, markets cannot function efficiently if property is in dispute and the rules and regulations regarding how property can be used are constantly changing. Thus, Austrian economists believe that strong private property rights and a clear, stable rule of law are essential to a healthy economy and the sustainable growth thereof. Uncertainty, while a fact of economic life, is minimized when the ownership and use of property are not in dispute and when rules and regulations are few, easy to understand and have low compliance costs.1

Another important factor that sets the AES apart, among other things, is that unlike the Keynesian or Monetarist schools, it holds that what happens at the “micro” level of the economy necessarily aggregates into the “macro” but also that the same laws must apply consistently at both the micro and macro level, as is the case with Newtonian physics. For example, in the Austrian School there is no “paradox of thrift” in which increased rates of savings can be desirable for individuals but not for an economy as a whole. Unlike Keynesians, Austrians hold that if it sensible and rational for individual economic agents to increase their rate of savings, then this must also be sensible and rational in the aggregate. Nor is there any guarantee that monetary policies of inflation or money targeting at the macro level will prevent imbalances arising at the micro level, for example in housing, banking, or finance generally. Indeed, economists of the AES were almost alone in predicting that the prolonged period of artificially low and stable US interest rates in the period 2002–2006 would eventually lead to a credit bubble and a major financial crisis.


The question must thus be asked, given the history above, why has the economic mainstream drifted so far away from the venerable Austrian School of Menger, Mises, and Hayek?

There are several possible reasons. One is what one Murray Rothbard termed “the Whig view of the history of economic thought.”2 This is a subset of the better known, general “Whig view of history,” perhaps best represented by Scottish Enlightenment philosopher David Hume, that history is the evolution of an ever-more perfect world, of constant if not always understood or appreciated progress. Hence, the dominant school of economic thought today is superior to those that have come before, because it is that of today, not yesterday. No further explanation is required or desired. (It is worth noting here that German late Enlightenment / early Romantic philosopher Georg Wilhelm Friedrich Hegel postulated a more subtle, dialectical process of historical progress. Karl Marx would subsequently adapt this particular strain of teleological thought to demonstrate in his unique way the inevitable replacement of Capitalism by an anarchic form of Communism and the “withering away of the state.”)

We know such thinking is flawed. History shows us it is flawed—recessions, financial crises, and depressions, including that in much of the euro-area today, feature with some regularity. Were economic theory and economic and monetary policies truly steadily improving, then 2008 should either not have happened at all, or it should have been relatively short-lived in its effects. But this demonstrably false sense of steady (or sporadic) progress is nevertheless surprisingly common across all knowledge disciplines, not only in economic and monetary matters. Indeed, even in the hard sciences, where presumably only hard facts and evidence should matter, there can be tremendous resistance to new ways of thinking.

In support of his argument, Rothbard cited the work of historian of science Thomas Kuhn, who cogently demonstrated this to be the case in his 1962 masterwork, The Structure of Scientific Revolutions. According to Kuhn, even in hard science, it is not the facts that matter. Rather, it is the “paradigm,” as Kuhn chose to call it. Facts that clearly do not fit the existing paradigm are either conveniently ignored, or those proffering them are persecuted outright, such as with Galileo’s observations of Jupiter’s moons. He explains thus:

Normal science, the activity in which most scientists inevitably spend almost all their time, is predicated on the assumption that the scientific community knows what the world is like. Much of the success of the enterprise derives from the community’s willingness to defend that assumption, if necessary at considerable cost. Normal science, for example, often suppresses fundamental novelties because they are necessarily subversive of its basic commitments. Nevertheless, so long as those commitments retain an element of the arbitrary, the very nature of normal research ensures that novelty shall not be suppressed for very long. Sometimes a normal problem, one that ought to be solvable by known rules and procedures, resists the reiterated onslaught of the ablest members of the group within whose competence it falls. On other occasions a piece of equipment designed and constructed for the purpose of normal research fails to perform in the anticipated manner, revealing an anomaly that cannot, despite repeated effort, be aligned with professional expectation. In these and other ways besides, normal science repeatedly goes astray. And when it does—when, that is, the profession can no longer evade anomalies that subvert the existing tradition of scientific practice—then begin the extraordinary investigations that lead the profession at last to a new set of commitments, a new basis for the practice of science. The extraordinary episodes in which that shift of professional commitments occurs are the ones known in this essay as scientific revolutions. They are the traditionshattering complements to the tradition-bound activity of normal science.3

Given the relative subjectivity of the social sciences, including economics, one should wholly expect that the power of the presiding paradigm to misconstrue, ridicule, or simply ignore inconvenient facts and their associated theories would be all the more powerful in stifling real understanding, productive debate and progress. Kuhn also noted that one reason why paradigms were so hard to break down once established was that those in highest regard within the discipline—akin to the high priests of a hierarchical church—had so much to lose if challenged by unorthodox thinking. We laugh at the Papal persecution of Galileo today, but to them it was no laughing matter. His observations, plain to see as they were through a telescope, directly contradicted the venerable, geo-centric or Ptolemaic paradigm of the day, thus threatening the very foundations of Church power.

Today we generally pat ourselves on the back that, whether atheists or not, we tend to treat science as wholly distinct from religion. And yet quasi-faith-based paradigmatic thinking nevertheless still infects science to a great if underappreciated degree. Take the “Big Bang” Theory, for example, which has stood for decades but is still mere theory. This is due in part to the fact that, notwithstanding huge investments in research into the origins of the universe, there is still no convincing data to confirm it. Although I am hardly an authority on this matter, I do note that, in my youth, astrophysicists believed strongly that, due in large part to the Big Bang framework, a Grand Unified Theory of the universe was within reach. All they needed for confirmation was a powerful enough supercollider. Today, some thirty years later, against these optimistic expectations, they are nearing exasperation. All the observational and computing power of which they could only have dreamed a generation ago is today at their disposal, yet they haven’t got qualitatively farther than did Einstein a century ago with math, chalk, and slate? Could it be that astrophysics has become stuck in a paradigm that has outlived its usefulness and is now retarding rather than facilitating progress? I don’t have the answer but no doubt Kuhn would agree the question is clearly worth asking.

I would argue that there is another, somewhat less-subtle process whereby economics drifted away from the powerful tenets of the Austrian School. This can be observed in the process of formally dismissing the Austrian approach began with Irving Fisher and John Maynard Keynes, who strongly disagreed with the Austrians in the 1930s about certain (although hardly not all) causes of the unfolding Great Depression and even more strongly about the potential cures. Keynes and Hayek in particular engaged in a fierce, ongoing debate. Economic historians claim that Keynes eventually won the debate de facto, because economic policy moved in the direction he prescribed, namely a vast increase in and expansion of government fiscal support for aggregate demand at times of weak private demand and a rising propensity to save.

Thus, it can and should be argued that when it comes to actual policy, the Keynesian viewpoint can be seen as a self-serving one. Government officials and bureaucrats of all stripes naturally endorse that which justifies their existence and their innate desire to extend their power and control, something that was in vogue in the 1930s not just in the United States but around the world, as one government after another sought to arrogate more power to itself, in many cases with highly unfortunate consequences.

These consequences were studied somewhat systematically by Nobel laureate James Buchanan, who did not characterize himself as an Austrian School economist but did admit to strong leanings in that direction. As with many economists of his generation, he served in the US military during the Second World War, in his case on the staff of Admiral Chester W. Nimitz. Although identifying at the time as leaning socialist in economic and political matters, following the war he completed a PhD at the generally free-market-oriented University of Chicago. While there, studying under Frank Knight of early Monetarist fame, he came to focus on comparisons and contrasts between the incentive systems obtaining in the public and private economic spheres. He is today considered to be the father of the Public Choice (or Virginia) school of economics, which to this day retains a strong relationship with the AES.4

As Buchanan argued in much of his work, most bureaucratic impulses to regulate and control may seem benign in principle but in practice they can cause much damage due to the skewed incentives at play, which can result in bad policies and resource misallocations. While the debate rages to the present day, many prominent economists, including the Monetarists, hold that there are few if any things the public sector can do better or more efficiently than the private and that the latter should, therefore, be left to itself, with the authorities getting involved only when necessary to help sort out financial crises. (Central banking is a key exception, where Monetarists consider it essential to maintaining financial and thus economic stability.) But what, then, is the cause of financial crises, which clearly do happen with sufficient frequency to merit proper consideration? As it happens, the AES takes a quite different view on the causes of crises than that of the economic mainstream. It is thus to a more detailed discussion of the financial crises that we now turn.


Many economists and economic historians have studied financial crises, including the Great Depression. Irving Fisher, Hyman Minsky, Charles Kindleberger, and the non-Austrian observers of financial crises generally ascribe severe ones to some form of “market failure,” in which one or more major private sector actors, such as a large bank, say, take excessive financial risks and that when some exogenous shock hits what has become a fragile institution and system, a crisis ensues. But this sort of thinking assumes that the financial markets exist in a vacuum essentially uninfluenced by government economic policies or the policy regime itself. Central banking, as has normally been practiced ever since the First World War and in some specific instances prior, injects an element of moral hazard into the banking system as central banks, in practice, have been able and usually willing time and again, not only in 2008, to rescue so-called too-big-to-fail institutions with artificially low interest rates or even explicit bailouts. They have also facilitated the financing of large government debts through “financial repression,” a euphemistic term for using economic and monetary policy to appropriate the private wealth of savers in order to use it for government debt service without the need for explicit and politically unpopular tax increases.

A comparison between the English and Scottish banking systems during the nineteenth century is highly instructive in this regard. George Selgin, an Austrian monetary economist, has done extensive work in this area. Whereas English chartered banks were regulated by the Bank of England, which had a mandate to provide liquidity to banks that overextended credit and got into trouble, the Scottish chartered banks had no such recourse to any form of emergency liquidity. Indeed, Scottish banks operated in self-regulating way such that, if one bank was perceived by other banks to be extending too much credit and taking excessive risks, they would begin to lose access to the interbank lending market and face higher interest rates on their incremental borrowings. They would then have to make a choice: find a way to pass these rate increases on to clients, thereby losing market share, or simply curtail further lending until such time as their access to incremental credit fell back in line with their peers. In either case, the brakes would be placed on further credit expansion beyond what was generally perceived by participants in the money market to be a sustainable rate of money and credit growth. No central bank was required to maintain what economic historians agree was a stable and resilient Scottish banking system. Moreover, this system provided the financing for the Scottish Industrial Revolution, which at times experienced economic growth rates of as much as 10 percent per annum, such as when Glasgow was the world’s largest shipyard. The idea that a central bank is a necessary part of a stable banking system and rapidly growing economy is hogwash.

By contrast, south of the border, where the Industrial Revolution was also in full swing, banking crises became increasingly common. The Bank of England found it was drawn into liquidity crises nearly every time there was a material economic slowdown. Walter Bagehot, arguably the most famous financial journalist of his era, disparaged this moral hazard and wrote of it frequently. In his private papers, he expressed his desire to get rid of the Bank entirely. In public, he was more restrained in his rhetoric, instead suggesting that the best way to reduce the growing moral hazard problem was to restrict the crisis-activities of the Bank to merely “lend freely, at penalty rates of interest, against good collateral,” which became known as Bagehot’s Dictum.


Bagehot was hardly the only prominent nineteenth-century voice against the moral hazard implicit in the central banking policy regime of the time. There was a raging debate for years between those like Bagehot, Cobden, and members of the so-called banking school on the one hand, and those of the so-called currency school over this topic. The former argued for a competitive banking system along Scottish lines; the latter for a central bank to control credit expansion through bank regulation. For the economists of the AES, central bank monetary policy is not just one but indeed the primary cause of economic instability and systemic disequilibrium. This view was first put forward in robust form by von Mises and von Hayek in the early twentieth century. While this is heresy to the economic mainstream, the Austrians have much evidence to support this view.

Take the Great Depression of the 1930s, by far the most studied financial crises of all time. The mainstream view of the Depression was that it was at first a particularly severe banking panic, along the same lines as those of 1907 and 1921, but due to its sheer scale it shifted the economy so far from equilibrium that banks began to fail in large numbers, and so many workers were displaced that unemployment became chronic and initiated a nasty feedback loop of weaker demand, leading to less supply leading to a collapse of industrial production and even of agriculture.

There is an extensive literature on the causes of the Great Depression, how policymakers responded, and why, eventually, the Depression ended. There is, however, significant disagreement about all of the above. The conventional wisdom, as represented by the bulk of the contemporary economic mainstream, is that the Depression was caused in large part by the US Federal Reserve, which failed to respond adequately to a sharp contraction in the domestic money supply that resulted from a severe drop in interbank lending.

Milton Friedman and Anna Schwarz put forward this thesis in detail in their monumental work, A Monetary History of the United States. They contend that, had the Fed done its job correctly by preventing a large contraction of the domestic money supply, the United States would have experienced only a severe recession, not a prolonged depression.

Austrians, however, see the Great Depression very differently. They trace its roots back to the aftermath of the First World War, when European governments, including that of Great Britain, tried all manner of artificial means to restart their devastated economies. Beginning in 1927, even the United States got in on the game, by easing credit conditions at the request of the Bank of England, to help stimulate demand for British exports. This was a major monetary contributing factor to the stock market bubble, which was driving share prices to record highs. But as with all bubbles, it eventually burst in late 1929.

The monetary factors cited above, while no doubt important, are only part of the story, however. While most closely associated with the presidency of Franklin Delano Roosevelt (FDR), in fact it was already under Herbert Hoover that the government initiated a range of unprecedented steps, beginning in 1930, to intervene in the economy in various ways and artificially support aggregate demand. That Hoover did so largely over the famous public objections of his more traditional, laissez-faire Treasury Secretary Andrew Mellon, should not diminish the importance of his actions. For example, Hoover worked with his mentor and friend, Henry Ford, to prevent any reduction in industrial wages, as declining wages were perceived as potentially negative for aggregate demand and hence growth. This was just one of a number of such initiatives began under the Hoover administration.

Hoover’s support of interventionist measures became increasingly explicit as he campaigned for reelection in 1932. In one major speech he boasted:

[W]e might have done nothing. That would have been utter ruin. Instead we met the situation with proposals to private business and to Congress of the most gigantic program of economic defense and counterattack ever evolved in the history of the Republic. We put it into action. No government in Washington has hitherto considered that it held so broad a responsibility for leadership in such times. For the first time in the history of depression, dividends, profits, and the cost of living, have been reduced before wages have suffered. They were maintained until the cost of living had decreased and the profits had practically vanished. They are now the highest real wages in the world.5

While high wages sound nice in principle, they can have a downside, that is, amid weak demand, artificially high wages can result in high rates of unemployment. Indeed, by 1932, unemployment had soared to unprecedented heights. Moreover, it remained stubbornly, persistently high when compared to past recessions, during which wages had normally, naturally declined to reflect the temporarily lower demand for labor. Taking the international context into account further helps to illustrate the point. Great Britain devalued the pound sterling by some 24 percent in 1931, making its exports to the US much more competitive. Much of continental Europe had already devalued during the 1920s, a lingering consequence of the First World War’s destruction of capital and productivity in the most conflict-affected areas. This left the US looking relatively prosperous but increasingly uncompetitive vis-à-vis Europe.

Evidence of this loss of competitiveness began to have political repercussions by the late 1920s, as protectionist pressures grew. By 1929, Congressmen Smoot and Hawley were succeeding in advancing their co-sponsored tariff legislation through the Congress. Suspecting there might be strongly negative consequences for global trade and hence economic growth and corporate profitability generally, Wall Street was spooked. Indeed, some economic historians believe that the proximate trigger for the great stock market crash of October 1929 were reports of a major compromise in the US Senate making it highly likely that the proposed, highly protectionist Smoot-Hawley Tariff Act would pass. When combined with mounting background evidence of a decline in industrial production having begun earlier in the year, this finally provided enough straw to break the great Roaring 20s stock bull market’s back.

The stock market crash began on October 29, subsequently named “Black Tuesday. ”It would not run its full course until 1934, when FDR finally took action to effectively reverse Hoover’s rigid wage policies by devaluing the dollar by some 40 percent by executive order. This action restored US labor competitiveness in one massive stroke, albeit at the one-off cost of also devaluing Americans’ savings by some 40 percent versus gold. While the Great Depression would take over another decade and a world war to play itself out entirely, the deflationary part had ended. Mild price inflation became the norm thereafter, posing a puzzle for those economic historians who trend to treat deflation as a major contributing if not only cause of the Depression. This gently rising-price environment would remain the case under the post-WWII Bretton– Woods system.

If the causes of the Depression are somewhat misunderstood in key respects, what of the cures? The conventional wisdom is that FDR’s Keynesian “New Deal” programs, including fiscal stimulus intended to create jobs, are of central importance. Yet when one understands that the persistently high unemployment of the Depression was in large part the result of government policies to support real wages, which otherwise would have declined more quickly to market-clearing levels, then alternative explanations become rather more plausible.

Once FDR took over, he took expansionary actions on both the fiscal and monetary fronts, including the large dollar devaluation. But growth remained weak, and unemployment remained high throughout the 1930s, notwithstanding (or, perhaps, due to) a huge expansion of government in many sectors of the economy. By the early 1940s, the United States was at war and, as the Keynesians celebrate to this day, government deficit spending soared to unprecedented heights.

Many within the modern economic mainstream cite this as the primary reason why the Depression finally ended. But guess what? As part of the war effort, workers were forced to accept sharply lower wages. Also overlooked is that the US private savings rate soared in the 1940s as businesses and households paid down debt and rebuilt savings. Of course, many households were more able to save as they now had two incomes, with the work-force expanding dramatically as women entered it en masse for the first time in US history. In this revisionist view, it was not war spending that ended the Depression; rather, it was a dramatic reduction in wages to more competitive levels and a large increase in the savings rate, the very developments that were strongly opposed by Presidents Hoover and FDR from 1930 to 1939!

The Austrian School thus has a strong claim to the best explanation of what causes financial crises generally, including that in which we remain mired, now a full business cycle on from the spectacular monetary responses to 2008. In this explanation also lies to ability to forecast future crises in terms of their rough scale, although not with any precise measure of timing. However, the Austrian School also offers a comprehensive view on how economies function generally in all aspects, crisis or no.

We should, therefore, give due consideration to the highly developed, sophisticated Austrian viewpoint that monetary policy can at the very least be a source, if not necessarily the only cause of economic crises. This is particularly true in the event that monetary policy is highly activist in nature, manipulating the money supply aggressively in a futile attempt to smooth business cycles or to support economic growth generally, as central banks routinely do today.

The insidious effects of an activist monetary regime, however, go beyond the causes of misallocations, imbalances, and the associated economic instability. They are also an important source of economic inequality, as they distort the information used to determine efficient allocations not only of capital, but of labor. Attempts to prop up asset (capital) values with expansionary monetary policies, including quantitative easing, thus over time siphon off the labor share of income in favor of capital. The economic mainstream generally fails to see this, as did Smith and the Monetarists, as they are viewing the economic through a flawed paradigm including a critically flawed assumption of “neutral” money. And so it is to an exploration of the monetary sources of inequality that we turn in the following chapter.

1Critics of the Austrian School sometimes suggest that it contradicts itself because it wants the state to stay out of the economy, yet the state is required to enforce property rights. Some modern members of the Austrian School do border on holding Libertarian views of the ideal role of the state, if any. Classical Austrian School economists were far more accepting of the role of the state in enforcing property rights and adjudicating disputes. Indeed, they believed the state’s role was absolutely essential. The Constitution of the United States, strictly limiting the role of the federal government in the economy and society, yet giving the Congress the power to regulate commerce, is entirely consistent with such thinking.

2Murray Rothbard, Classical Economics: An Austrian Perspective on the History of Economic Thought, vol II, (Edwin Elgar Publishing), 1995.

3Thomas Kuhn, The Structure of Scientific Revolutions, (Chicago: University of Chicago Press) 1970.

4Ronald Coase, a contemporary of Buchanan and also a Nobel laureate, had Austrian leanings in some of his views and much of his work can be understood as at least a partial affirmation if not confirmation that the Austrian framework has much to offer the economics profession more generally.

5Murray Rothbard, America’s Great Depression, fifth edition (Auburn, AL, Ludwig von Mises Institute), p. 187.

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