The Paradox of Sound Money: A Post-Keynesian critique of Austrian monetary theory

“Sound money can become paradoxical when the stability it promises suppresses the credit that growth requires”

- By Chinedu Okoye 

1.0 Austrians Monetary Theory:

Austrians abhor fiduciary credit creation, and fractional reserve banking, preferring a full reserve banking without the ability fo banks to extend credit beyond the reserves they hold. To them [Mises and Hayek] fiduciary credit expansion distorts the structure of production, leading to unsustainable nooms, and central banks, the reason for inflationary pressures overtime, as the credit expansion the enable, pushes interest rates below it's natural rate (the rate it would otherwise be if determined solely by the market and the monetary authorities do not intervene), causing malinvestment from cheap more accessible credit, and accompanied by inflation.

2.0 The Cantillon Redistribution:

The same Austrian logic (F. Hayek) states that when new money is injected into the system, it doesn't spread evenly, and first increases the income or available cash resources from which income can be earned directly or indirectly, and the next beneficiaries bing the sellers of the goods sought after by the first new money receivers and as a result of more money at the disposal of these buyers, prices increase. The Cantillon effect shows money creation reallocates income but does not necessarily create systemic instability.

To this question they respond with the argument that government intervention and the modern banking system (fractional reserve banking) cause missallocation of resources leading to a bubble.

3.0 Credit Scarcity Under Hard Money:

Now, these bubbles exists, but is not unique to any Monetary or banking system. As sellers of production goods, demand more money from entrepreneurs, with increased optimism which leads to increased investment.

Now, since demand [for production goods] for increased, depending on the expected returns and available cash resource of the firm, credit would be sort to invest in new production processes and spur innovation.

4.0 Innovation and Investment Constraints:

These projects sometimes take time to materialize, take pharma drug experiments, engineering systems, software etc. If all loans have to be backed by reserves and there is mo central bank to regulate policy, the increased demand for money to procure these goods would raise interest rates.

This has two effects

1. Producers paying higher interests on loans, which at some level makes the venture unprofitable, and,

2. Consumers; attracted by higher interest reducing consumption. (This is inline with Hayek's roundabout processes)

The above assumes that productivity increases are predictable and periodically determined. But that is not the case and not all new ventures would excel. The ones that don't would create loses for the banks and probably savers. This can easily create a bank run, and deplete capital formation.

Another assumption is that, consumers would just defer consumption because rates are higher, contradicting Keynes's liquidity preference theory.

5.0 Reality: The Investment–Growth Constraint

Since money is the medium if exchange, an increased demand for production goods would lead to an increase in prices of these goods, which then increases the cost and leverage needs of the firm.

The more expensive money becomes, the less attractive investment is, and assuming consumers defer current [final goods] consumption, then revenues of these firms, which validate debt payment reduces.

This revenue decrease from falling demand also raises lenders perceived risk, increasing the burden on producers, and consumer workers who's real wages may have been eroded. This stalls investment, innovation and growth.

Although there are consequences to monetary interventions, it is not unsusal for money to lose value, but Deflationary (sound money) unusual for money to lose value over time. As if money were indeed a facilitator of indirect exchanges, it can be substituted for goods it can purchase. 

Suppose these goods are purchased and stored in a warehouse instead of storing the money in a bank, not only would there no be any interest income earned, but also, it may lose quality, freshness, usefulness, ad outright functionality in some cases.

If the goods for which money can be exchanged (goods are being used only because service provision also requires some good/commodity, and so are affected directly to varying degrees) can lose value overtime, then to expect these same monies exchanged for these goods to increase in value over time is as absurd as expecting the [non marketable or monetary goods] corn or Blackberry phone or Apple you bought today to be consumed in the future to increase in value, quality, and relevance.

6.0 Deflation and Debt Burden

Restricting money supply only restricts growth, and because productivity is relatively constant in varying time periods, and it's increase, unpredictable, it becomes counterproductive to burden the debtor producer to with deflationary money (as they would be paying back more intra terms plus interest that they would in Fiat), and overcompensating the creditor - savers and institutions. 

This, is the real inequality and investment mismatch. As tight money stalls growth in times of low production and overburden borrowers (or debtors). With relief only coming where there a technological breakthrough that improves production efficiency and output. However, innovation have long gestation periods, and expected returns from such investment expenditure is uncertain. 

Strict sound money regimes create a deflationary bias that discourages productive investment and over-rewards creditors relative to producers. This happened during the 19th century gold-standard deflation, and the Great Depression. As full reserve banking and hard money create credit scarcity.

Sound money can become paradoxical when the stability it promises suppresses the credit that growth requires.