Noah Smith has a funny piece on the hermetic system that is Austrian economics , with its multilayered defenses against any kind of criticism. What gets me in particular, because I’ve noticed it a lot lately, is this: 3. “Inflation” doesn’t mean “a rise in the general level of consumer prices,” it means “an increase in the monetary base”, so QE is inflation by definition. So when Austrians were predicting runaway inflation, they didn’t actually mean consumer prices? OK, you know that if the CPI had soared, they would have claimed vindication. But the main point is that nobody else cares about the monetary base, or at any rate they care about it only to the extent that it was presumed to say something about future rises in the CPI. Insisting that the term “inflation” means something else in your private language is just pathetic.

It is only economists of the Austrian school who understand that the desire to hold cash balances also plays an important role in price inflation (as well as changes in productivity), in addition to the role of money growth itself. If the desire to hold cash balances climbs, it will suffocate any price inflation that might be caused by an increase in the money supply. If the opposite occurs and the desire to hold cash balances declines, it will act as an accelerant to any price inflation that might result from an increase in the money supply.



As the Austrian economist Hans-Hermann Hoppe notes in Economic Science and the Austrian Method :

It is possible to make the wrong prediction in spite of the fact that one has correctly identified the event “increase in the money supply” and in spite of one’s praxeologically correct reasoning that such an event is by logical necessity connected with the event “drop in the purchasing power of money.” For one might go wrong predicting what will occur to the event “demand for money.” One may have predicted a constant demand for money, but the demand might actually increase. Thus the predicted inflation might not show up as expected. Hoppe's "demand for money" is what I call the desire to hold cash balances.

It is easy to see then why it is that in times of depression, during the "liquidation of the crisis," interest rates on the money market hover just above the zero level.



It takes some time before the economic system gets the crisis and depression "out of its limbs." It is only after a certain lapse that the crippling feeling of uncertainty wears off, and the risk estimates by potential lenders and borrowers gradually fall. When finally confidence has returned and the spirit of enterprise has reawakened, the firms have accumulated large balances of cash during the period of liquidation find that these liquid funds are superfluous and that there are outlets for them. As soon as the "surplus cash reserves" have found "productive employment" the economic system is moving into the upward phase of the cycle.

By Robert WenzelKrugman writes The Noah Smith piece he references is a Smith response to a semi-decent article by Bob Murphy on Austrian economics, in reference to an earlier Smith piece . But Murphy doesn't come at the question of what inflation is in the same manner that I would. I would recognize that words can often have more than one meaning and that words can also change over time. I think it is beyond question that the general public considers an increase in prices as inflation. Murphy doesn't really discuss this point. He glosses over it and simply states that there is another definition of inflation, that is, the definition that sees an increase in the money supply as inflation. It is important to clearly acknowledge the distinctions between the two definitions and explain why the definition of inflation as an increase in the money supply is an important definition. As I did in 2011, the last time Krugman got all snippy about the definition of inflation. SEE: Paul Krugman is (Mostly) Right on the Definition of Inflation, Although He Gets Slick About It Murphy also throws up his hands and says he blew it when it came to his forecast on price inflation and then goes on to say that Austrian economics is a deductive science, rather than an empirical science, so therefore his forecasts should be ignored. But Murphy here is taking all forecasting out of the sphere of Austrian economics and I think this is a bit much. He seems to be taking a view very similar today that of the financial author/Austrian economist Harry Browne who believed all forecasting was futile. I once had a discussion with Murray Rothbard about Browne's view and we both agreed that Browne was going too far.For sure, Austrians should never attempt what Milton Friedman did when he plugged money growth numbers into an equation and came up with an exact price inflation forecast, an attempt that resulted in Friedman ending up with much egg on his face in the late 1980s, but this doesn't mean that Austrians can't, based on certain factors, have very good guesses about what will happen in an economy, at times.If the minimum wage is raised next week to $1,000 an hour, and enforced strictly, than it would be easy for an Austrian to predict, along with most any other economist, that unemployment wouldsoar well into double digits.If somebody told me that in a very short period of a few years that in the 1920s Germany was going to print billions of trillions of marks, as they did, I would be(but not 100% so) that serious price inflation would emerge.It is not that Austrians can't know anything about the future, it is just that there is not a lot of exactness that can be known, I liken this to the weather forecaster. He can't tell uswhat the weather is going to be exactly in New York City in the year 2015, but he can be very confident in telling us that if it snows, it is much more likely to snow in February 2015 than August 2015--despite the fact that he would be unable to give us exact dates of snowfall, and exact temperatures, now, on specific dates in February and August 2015.Most significantly, Murphy fails to challenge Noah's claim that Austrians have argued that because of the monetary base explosion price inflation should occur. There may be some so-called Austrians that make this point, but, as I have arguedthe key factor to keep in mind is the quantity of money in circulation and not the growth in the monetary base. Literally trillions of dollars of base money has not found its way into the system and sits back at the Fed as excess reserves. It a very poor thinking Austrian who would fail to grasp the significance of this fact and what it means for the economy and price inflation.Murphy also doesn't dig deep enough in his article into Austrian economics to highlight the richness of Austrian thinking relative to money supply growth and price inflation. I did this earlier this year , when I highlighted writing on the topic by the Austrian economist Hans Hermann Hoppe:I also like the way the Austrian economist Fritz Machlup, in his 1931 book The Stock Market, Credit and Capital Formation , wrote about the significance that Austrians put on cash balance demand. Although Machlup is discussing cash balances with regard to a new boom phase in the economy, I consider it an important observation with regard to cash balances, for the present, because he puts it in the context of near zero interest rates, which of course is the environment we are now in, and it is another indication of Austrian consideration of cash balances playing an important role in the economy. He wrote:Something along these lines has been going on at the consumer level in the present US economy, as I have highlighted regularly in the EPJ Daily Alert . Though, of late, I am highlighting in the ALERT that we might be turning the corner on the desire of many to increase cash balances. It appears to me that the desire is now declining, which, of course, would intensify price inflation in the near future. This is not an exact forecast like the type that can be made in the physical sciences but one that is made in a very rough manner based on trends that appear to have been in force and are now changing.Finally, I want to address Krugman's claim that somehow the use of the term inflation by Austrians,as an increase in the money supply, is a "private language." The implication here is that Austrians are spinning the definition out of whole cloth and not that the use of the word inflation, as an increase in money supply, has had a very long history. Indeed the use of the term inflation to mean an increase in the money supply can be traced back to at least 1864 (SEE: WSJ Delves Deeper into the Meaning of the Word "Inflation" ).I will leave it up to the reader to decide whether Krugman is being deliberately misleading or that he simply doesn't know economic history very well.