Policy and Reform

Policy and Reform
The political attractiveness of the policy prescriptions based on the Keynesian
theory (spending programmes, tax cuts, deficit finance and monetary expansion)
and the absence of a comparable list of politically attractive policy
prescriptions associated with the Austrian theory go a long way in accounting
for the decisive victory in the 1930s of Keynesianism over Austrianism. Over
the following decades, however, the cumulative effects of the excesses of
Keynesian policy (debt monetization and double-digit inflation) eventually
caused monetarism to be seen as the more responsible alternative. Endorsing
monetarism – though not actually institutionalizing the monetary rule – became
politically viable.
Although credit expansion was curtailed in the 1980s, there was never a
sustained period of steady monetary growth at a pre-announced low rate.
Further, monetary reforms enacted in that same period blurred the distinction
between money and other highly liquid assets, making the implementation of
the monetary rule all but impossible. The very definition of money became
problematic, and the once-stable demand for money (as tracked by ‘velocity’
in the equation of exchange) itself became unstable. By default, the Federal
Reserve reverted to managing interest rates, expanding credit to whatever
extent was necessary to achieve its chosen target rate. With a pro-active
central bank dominating credit markets, the natural rate of interest is a strictly
non-observable rate, but to the extent that the central bank is sensitive to
political considerations, the managed rate is more often than not below the
natural rate.
The Austrians’ policy advice to the central bank consists of prevention
rather than cure: do not engage in credit expansion – not even if ongoing
economic growth is causing some index of output prices to fall. Abiding by
this imperative is not only politically difficult but also technically difficult,
because the central bank cannot know what the natural rate of interest is and
how it might be changing. The difficulties (both political and technical) of the
central bank’s avoiding a credit-induced boom suggest that what is needed is
fundamental reform rather than policy prescription. Late in his career, Hayek
recommended the Denationalisation of Money (1976). Subsequent writings
by contemporary Austrians – Lawrence H. White (1989) and George Selgin
(1988) – have made the case that a thoroughly decentralized banking system,
one in which the market rate of interest is an unbiased approximation of the
natural rate, may be the ultimate solution to the problem of boom and bust