Austrian Inflation, Austrian Money, and Federal Reserve Policy

Why Salerno's Critiques Are Invalid

Richard Timberlake is a retired professor of economics and author of Monetary Policy in the United States: An Intellectual and Institutional History (University of Chicago Press).

Joseph Salerno’s essay in The Freeman: Ideas on Liberty, October 1999, extensively criticized the series of three articles I had published in previous issues of the magazine.[1] I find none of Salerno’s alternative analyses valid.

My disagreements serve to highlight the dissents many economists have with what passes as “Austrian” monetary analysis. These differences deserve to be aired in depth. However, in the short compass of this reply I can treat only the immediate monetary issues germane to the 1920s and 1930s. Therefore, I limit the remarks to four main topics: the evolution of the word “inflation”; the definition of “money”; Federal Reserve policy before and after 1933; and Federal Reserve-Treasury policy on gold and excess reserves.

Evolution of the Word “Inflation”

Whether the word “inflation” is “new” or “old and venerable” is largely irrelevant to substantive issues. “Inflation” is a word that has emerged in economic thought and theory because of institutional developments and intellectual progress in methods of economic measurement. It is useful as no other word can be for describing general price-level increases. Salerno’s insistence, quoting Murray Rothbard, that it should mean only an increase in the stock of money “not consisting in, i.e., not covered by an increase [in the quantity] of gold,” violates current meaning that the word has both for economists and the public. It deprives us of the word that most robustly describes a general increase in prices.

Some ancient economists undoubtedly used “inflation” to mean an increase in the stock of paper money together with an increase in prices. They had an intuitive understanding of the general level of prices but only an imperfect means of expressing it, because mathematicians had not developed statistical price indices. Nonetheless, most English economists, such as John Stuart Mill, Henry Thornton, and David Ricardo, writing in the early nineteenth century, distinguished clearly between changes in money stocks, whether “covered” by gold or not, and changes in the aggregate of money prices.[2]

Economists of that era were preoccupied with a search for a talisman of value so that they could specify more precisely the value of a money unit.[3] Statistical development of price indices in the mid-nineteenth century provided a more precise means of measuring price level changes. With this tool economists could usefully describe the value of money as the inverse of money prices, an eminently sensible idea. They could also properly distinguish between increases in the stock of money and general increases in money prices.

Everyone is well aware of the limitations of price indices; they are not perfect measuring devices. However, they furnish us with measures of central tendency so we do not have to trust our gut feelings to tell us that inflation or deflation has occurred.

The development and use of the price index is analogous to the development and use of the thermometer. Thermometers do not measure temperature perfectly; to some extent pressure changes and other factors bias the temperature reading. Also, thermometers only measure temperature “objectively”; they do not show how an individual reacts subjectively to whatever the temperature is. So are we to throw away all our thermometers because they are technically imperfect and non-subjective, that is, “non-Austrian”?

During the period 1921-1929 in the United States, the Bureau of Labor Statistics Wholesale Price Index (WPI) fell by 2.4 percent, and the Consumer Price Index (CPI) fell by 4.1 percent. Is it possible to assert in the face of this data, as Salerno-Rothbard dogma would have it, that the economy experienced an “inflation”?

A simple thought experiment best addresses the question of a 1920s “inflation.” Say that a U.S. householder or businessman had the choice between $2,000 of 1921 income in 1921 dollars, or $2,000 of 1929 income in 1929 dollars? Is it conceivable that he, or even an “Austrian” economist, would choose the former income unless he reveled in asceticism? Yet if 1921-1929 witnessed the “inflation” that Salerno laments, he would have chosen the 1921 income. Since average incomes increased over the period, a worker of that era had more dollars of income in 1929 and also lower prices for almost everything. He also had much improved qualities of goods and services and more choices than he had in 1921. Would that the U.S. economy had had such an “inflation” over the last 33 years!

The Definition of Money

The question of which items economists should include in the definition of money has been debated for two centuries. Obviously, any item that is directly exchangeable for goods and services over the counter as a medium of exchange is money. Currency and demand deposits, subject to check, are clearly money. However, what about time and savings deposits, savings and loan share capital, and cash surrender values of life insurance policies—the items Salerno (and Rothbard) include in the accounted money stock?

More than 30 years ago in a path-breaking article, Leland Yeager devised a means of testing this question.[4] Yeager noted that “many definitions of money can be self-consistent. But no mere definition should deter us, when we are trying to understand the flow of spending in the economy, from focusing attention on the narrow category of assets that actually get spent . . . . Certain assets do and others do not circulate as media of exchange . . . . The medium of exchange can ‘burn holes in pockets’ in a way that near moneys do not . . . . These are observed facts, or inferences from facts, not mere a priori truths or tautologies.”[5]

When people try to get rid of excess (unwanted) money, they unwittingly set in motion market machinery that raises the money prices of wealth and income. This activity continues until people have bid up money prices and bid down the value of the money unit to where everyone is content to hold the existing quantity of money at its current value. Money, being an item that appears in all markets, has no single market of its own in which an equilibrium can develop because “the money market” is all markets where money is exchanged.[6]

No such process affects near-moneys, which include savings deposits and the other items mentioned above. If people have excess amounts of any near-money asset, they do not spend the excess in all markets. Indeed, they cannot do so because the item is not a money. The adjustment to “too much” takes place in the particular market affected. People who have “too much” savings and loan shares cannot spend the excess in other markets. They simply turn in their shares for cash. Interest rates and other variables then adjust to this change in preferences, but no disruptive macroeconomic upheavals occur.[7]

Yeager’s discussion provides an unexceptionable means for deciding what to include in “the” stock of money and what to classify as financial assets. The financial items in question, though they are clearly wealth, are not money. Excess supplies of them have no pervasive macroeconomic consequences, but work themselves out in specific markets. For the 1920s, currency, demand deposits, and (possibly) time deposits in commercial banks—banks that also issue checking accounts—were exclusively money.

The Monetary Control Act of 1980, however, changed the ball game. It provided for checking privileges against savings and loan shares and savings bank accounts. The spendable money stock then had to include these issues, just as it included commercial banks’ demand deposits.

Another means of classifying money stocks is by testing the effects of the different classifiable money stocks on the flow of total spending that becomes realized income. The narrow money stock, M1, which includes hand-to-hand currency and demand deposits adjusted for interbank holdings, is the bellwether. No one doubts their moneyness. Changes in this stock fairly well correlate with changes in total spending. If the other financial assets Salerno wishes to classify as “money” have monetary properties, adding them to the narrow stock of money should improve the more inclusive stock’s ability to correlate with changes in gross spending.

A colleague of mine and I carried out an experiment in the late 1960s that used this method.[8] Gross National Product (GNP) data for several reference cycle periods from 1896 to 1966 were our dependent variable. To predict GNP spending, we included the various money stocks noted above.

Our findings were instructive. First, in all non-wartime periods, the correlations between changes in the stock of narrow money, M1, and changes in GNP were very high. Adding time deposits in commercial banks to M1, thus making it M2, did notadd significantly to the effectiveness of M1, except for the period 1933-1938. In all other periods, time deposits had negative effects: For the 1920-1929 period, an increase of one dollar in the stock of currency or demand deposits increased total spending by five dollars. An increase of one dollar of time deposits, however, diminished total spending by one dollar.

Savings and loan share capital and cash surrender values of life insurance were not even in the ballpark. Increases in their stocks all had negative effects on GNP spending changes. These assets, while wealth, have no monetary properties, and by no scientific standard can one include them in any measured money stock. To insist dogmatically that they are money is to deny epistemological progress from painstaking scientific scholarship.

Federal Reserve Policy Before and After 1933

In my original article in The Freeman: Ideas on Liberty (April 1999) I distinguished between the Federal Reserve Banks’ gold assets and their holdings of interest-earning assets—their loans, discounts, and advances to member banks. I labeled the gold “Fed Gold,” and the other assets “Net Fed.” Only the Net Fed assets were under the policy control of the Fed Banks. They could enlarge or reduce this quantity solely by lowering or raising their discount rates.

I reported that overall Fed Bank lending from 1921 to 1929 was decidedly negative. The Net Fed asset total declined from $2.16 billion to $1.39 billion, even while the Fed Banks’ gold stock was increasing from $2.63 billion to $2.86 billion. These data reflect the overall deflationary tendency of Fed policy: Fed Banks allowed their earning assets to decline even as they stockpiled, or “sterilized,” the new gold. Without their earning assets (Net Fed), the Fed Banks would have been nothing more than warehouses for bank-owned gold; their policy effects would have been zero.

Bank of England directors, particularly Montagu Norman, persistently tried to get Fed officials to change to an inflationary policy so that their job with price levels and exchange rates in England would be easier. However, Benjamin Strong and other top Fed executives resisted.[9]

Salerno’s assertion that “During this period, it was the chosen policy of the Fed to lend liberally and continuously to all banks at an interest, or ‘discount,’ rate below the market rate,” is just plain untrue. Fed Bank lending to member banks diminished steadily from 1921 to 1924, and only increased slightly to 1928. In 1921, the monetary base was $6.55 billion, of which Fed Bank lending accounted for $2.16 billion—33 percent. By 1929, the monetary base was $7.10 billion, and the Fed’s contribution to that total was $1.39 billion—20 percent.[10]

Unfortunately, Federal Reserve policy remained strongly deflationary despite the bank panics in the early 1930s. When bank panics occurred in earlier eras—1893 and 1907—private clearinghouse associations, which the banks themselves managed, created and issued clearinghouse loan certificates to solvent but temporarily illiquid banks. Recipient banks used this media to meet adverse clearing balances at the clearinghouse, and by this means stopped the hemorrhaging of reserves and collapse of bank credit.[11]

The Federal Reserve System came into existence on the presumption that it would make the clearinghouse issues official and legitimate. The 1929-1933 episode of bank fragmentation and destruction, however, emphasized the difference between privately operated clearinghouses and a regulatory government agency: “The Federal Reserve alternative . . . introduced a discretionary political element into monetary decision-making and thereby divorced the authority for determining the system’s behavior from those who had a self-interest in maintaining its integrity.”[12] The governmental clearinghouse system, the Federal Reserve System, failed because the decision-makers in the Fed faced no bottom line.

When Salerno gets to the events of 1929-1933, he makes statements that hardly need any formal refutation. In “answer” to my observation that the Fed “monetarily starved the country into the worst economic crisis it has ever experienced,” Salerno asserts: “On the contrary, the factors controlled by the Fed continued to exercise a highly inflationary impact on bank reserves and the money supply from late 1929 through 1932, as the Fed attempted desperately to ward off the depression precipitated by the termination of the bank credit inflation that it had orchestrated in the 1920s.”[13]

This statement contains at least three errors. First, the “factors controlled by the Fed,” namely, the interest-bearing debt of member banks to Fed Banks, was at the same trivial value—$1.25 billion—in 1932 that it was in 1927. Had the Fed Banks been “trying desperately to ward off a depression,” they would have been lending freely to the member banks on the Bagehot principle.[14] Second, the Fed Banks were absorbers of new gold: Their gold stock increased by $700 million, but their net monetary output increased by only $680 million. Third, as I showed above and in my original article, the “inflation” the Fed Banks “orchestrated” in the 1920s was not an inflation but a deflation.

The real bills doctrine—the core belief of what Salerno refers to as “the Banking School”—ruled Fed policy of that era.[15] The economist Clark Warburton explained in one of his excellent articles on monetary policy how Fed “authorities” let this doctrine paralyze their lending largess. In the early 1930s, Warburton noted, Fed Banks “virtually stopped rediscounting or otherwise acquiring ‘eligible’ paper [that is, real bills]. This was not due to lack of eligible paper . . . . [Fed Banks] did not hold sufficient eligible paper [to extend the necessary credit to member banks] solely because the Federal Reserve authorities had discouraged discounting almost to the point of prohibition.”[16]

The data from the Great Contraction (1929-1933) and resulting Depression (1933-1942) disprove Salerno’s assertions. From a stable value around 74 (CPI) in the late 1920s, money prices tumbled 8 percent per year over the next four years to a value of 55.3 in 1933. Yet Salerno insists that the Fed tried to maintain the “inflation” it had initiated. While it was maintaining all this “inflationary” financing during the great purging of 1929-1933, the price level fell 25 percent, and approximately 9,400 (39 percent) of the commercial banks closed their doors forever.[17] The inability of Fed and Treasury officials to interpret properly their disastrous policies and to make the necessary corrections was as astounding as the event itself.

Federal Reserve-Treasury Policy on Gold and Excess Reserves

I pointed out in the third article on this period, “The Reserve Requirement Debacle of 1935-1938” (June 1999), the factors that most depressed bank credit and the money stock were the complementary policies of raising reserve requirements on member banks and the sterilization of current gold inflows. Those actions plainly continued and enhanced the deflationary thrust of earlier policies. Some economists of the era failed to grasp the full import of the Fed’s deflationary effects because they thought only of the central bank’s ephemeral effect on interest rates. That same mistaken outlook thrives today.[18]

Bankers were both dumbfounded and shell-shocked. The ones who had survived the bank debacles of the early 1930s were the more conservative members of the profession. Additionally, the experience of survival made them even more reluctant to lend no matter how much “excess reserves” they had.

My conclusion in The Freeman article was that the Fed-Treasury gold-reserve requirement policy during 1936-1938 was immensely deflationary. Before the gold could become bank reserves, the Treasury sterilized it. And before the banks could use their existing “excess reserves” to expand credit, the Fed sterilized them by reclassifying them from “excess” to “required.” To the banks those “excess” reserves were already required. So redefining them as “required,” by doubling required reserve percentages, made that portion of reserves deficient in the view of many bankers.

The Fed loosened up monetary policy drastically during the war (1942-1946). The results confirm how readily a policy based on the quantity theory of money could have ended the first symptoms of business contraction a dozen years earlier. Once the Fed’s monetary excesses began, the unemployment of the 1930s quickly ended and genuine inflation became the problem. One then wonders: how do “Austrian” economists distinguish a real inflation—one that features greatly expanding fiat moneys and burgeoning price-level increases—from their 1920s “inflation” with its falling prices? And, given the long series of paper-money excesses since 1942, where are the “Austrian” deflations and depressions that would rectify the Fed’s monetary increases over the last 55 years? I have in mind many changes I would have made in Fed policy, but the “Austrian” prescription of monetary desiccation that Salerno offers is clearly a “cure” that is worse than the disease.

The late Paul Heyne reviewed a book for Ideas on Liberty that the publishers advertised as an “economic handbook for beginners from a Marxian viewpoint.” Heyne notes that “Varoufakis [the author], because he does not believe that theories can be either confirmed or refuted by facts, allows himself to make sweeping assertions about what’s wrong with the world and what must be done to repair it on the basis of a theory that is far more melodramatic than plausible. Varoufakis quotes none other than Ludwig von Mises in support of the claim that we cannot use facts to test economic theories.”[19]

Salerno’s arguments on the events and policies of the 1920s and 1930s presume this same methodology. It is also the one Rothbard proudly flaunted. No natural scientist, and no economist who considers his work “scientific,” would accept such a constraint. Scientific method must use and does use both inductive and deductive methods for a valid analysis of events.


  1. Joseph T. Salerno, “Money and Gold in the 1920s and 1930s: An Austrian View,” The Freeman: Ideas on Liberty, October 1999, pp. 31-40. My series appeared in April, May, and June 1999.
  2. See Henry Thornton, The Paper Credit of Great Britain, ed. with an Introduction by F. A. von Hayek (New York: Rinehart & Co., Inc., 1939), pp. 109-110, 195-98, and David Ricardo, The Works and Correspondence of David Ricardo, ed. Piero Sraffa and M.H. Dobb (Cambridge, England: Cambridge University Press, 1953), especially chapters 1, 20, and 27.
  3. I treat this issue in “The Classical Search for an Invariable Measure of Value,” The Quarterly Review of Economics and Business, Spring 1966, pp. 37-44.
  4. Leland Yeager, “Essential Properties of the Medium of Exchange,” Kyklos 21 (1968), pp. 45-69. (Republished in several collections, most recently in The Fluttering Veil (Indianapolis: Liberty Fund, 1997), pp. 87-110. I use this latter source for reference here.
  5. Yeager, Fluttering Veil, p. 89.
  6. Ibid., p. 93.
  7. Ibid., pp. 93-96.
  8. Richard H. Timberlake, Jr., and James Fortson, “Time Deposits in the Definition of Money,” American Economic Review, March 1967, pp. 190-94.
  9. For a definitive review of Federal Reserve policies and actions during this period, see Milton Friedman and Anna J. Schwartz, Monetary History of the United States, 1867-1960, “Gold Movements and Gold Sterilization” (Princeton, N.J.: National Bureau of Economic Research and Princeton University Press, 1963), pp. 279-87. In my first article I wrote, somewhat carelessly, that the Fed wanted to help the Bank of England “achieve and maintain gold payments” (p. 40). But the “help” the Fed offered did not extend to a U.S. price-level increase. It meant only loans and other temporizing measures to the Bank of England.
  10. See Richard H. Timberlake, Monetary Policy in the United States: An Intellectual and Institutional History (Chicago: University of Chicago Press, 1993), Table 17.1, p. 264.
  11. For an extended treatment of the clearinghouse episode, see ibid., chapter 14, “The Central Banking Role of Clearinghouse Associations,” pp. 198-213.
  12. Ibid., p. 212. Highly restrictive banking laws after the Civil War both provoked and aggravated any chance monetary disequilibrium in the commercial banking sector.
  13. Salerno, p. 37; emphasis added.
  14. Richard H. Timberlake, “Money in the 1920s and 1930s,” The Freeman: Ideas on Liberty, April 1999, p. 41 and note 6.
  15. Contrary to Salerno’s charge, I do not subscribe to this doctrine and never have. See Monetary Policy, especially pp. 193, 259-60.
  16. Clark Warburton, “Monetary Difficulties and the Structure of the Monetary System,” Journal of Finance, December 1952, pp. 535-36. I cannot recommend the works of this economist too highly. See especially the book of his collected work, Inflation, Depression, and Monetary Policy (Baltimore: Johns Hopkins University Press, 1966).
  17. See again my Monetary Policy, pp. 266-69, for an account of the public’s attempt to convert demand deposits into currency.
  18. For a contrary view, see my article “The Fed Sets Interest Rates? It Just Ain’t So!” The Freeman: Ideas on Liberty, December 1999, pp. 6-7.
  19. Paul Heyne review of Yanis Varoufakis, Foundations of Economics: Beginner’s Companion (Routledge: New York, 1998), Ideas on Liberty, January 2000, p. 60.