Rampant Inflation after Boom and Bust

Rampant inflation, unemployment, uncontrollable debt. In Vienna, after the First World War, Hayek saw for himself how government misuse of money can wreak havoc. Across Austria prices had taken off, and so had unemployment. Even the rich were struggling to feed themselves, and no one could quite understand why.

At the height of the crisis, if you walked down this street any time of day or night, you could hear a kind of relentless, heavy, rumbling sound.

Printing Presses

It was the sound of money tearing a country apart. This building housed the Austro-Hungarian bank, and its printing presses that were rolling night and day churning out millions of new banknotes. The war had left the Austrian government with huge bills and low tax revenues. So it ordered the National bank to simply print the money it needed in exchange for bonds or IOUs.

What the people manning these printing presses, and their political masters, had yet to really grasp was they weren’t just producing money here, they were producing rampant inflation.

Austro-Hungarian Bank

The amount of money in the economy was going up, so people had more money to spend, but of course, the amount of things they could buy had stayed more or less the same. That forced up the price of everything. Inflation took off. In fact, the situation got so bad in Austria, the inflation rate hit 10,000%.

Friedrich Hayek

Richard Zundritsch, Friedrich Hayek’s grand nephew “The financial wealth was destroyed. Those that had jobs continue to have them but they could no longer afford, for instance, to have maids and servants. We saw all of these people, all of a sudden, ended up being out of work.”

Richard Zundritsch

With their economy going up in smoke, Austria’s central bankers tried to fight fire with fire. By the summer of 1922, prices were doubling every month, and the central bank was playing catch up, printing higher and higher denomination banknotes, just to reflect what was going on in the shops. In the end, this 500,000 Krone note could maybe buy you a loaf of bread. And of course, by pumping more and more money into the economy they were only making the problem worse.

For Austria’s politicians it was all a crisis of their own making. They’d been printing money to pay their bills since the start of the First World War, and they didn’t understand that that could lead to inflation. It was a crisis caused by ignorance.

Having seen Austria brought to its knees, Hayek had an almost visceral fear of inflation all of his life. It’s a fear that central bankers still share today. What’s interesting to me is the lesson he drew from that experience. Most people focus on the politics, on the fact that the winners of World War I had imposed impossibly high reparations on Austria. But Friedrich Hayek was interested in the economics, and the fact that the Austrian government simply hadn’t understood the power of money.

Market Clamour

What happened next in America led Hayek to conclude there can be something worse than government ignorance – hubris. He thought that entire period showed the calamity that can come when governments try to use the power of money to shape the economy.

Masters of Money

In America in the 1920s the greatest boom the world had ever seen was taking off. Rampant Inflation followed the buying spree. Consumers couldn’t get enough of new products like cars, telephones and record players. The stock market rose higher and higher. As the Roaring Twenties wore on, the finest economic minds in America came to believe the boom would never end.

Chamber of Commerce

Back in Austria, in early 1929, Friedrich Hayek was convinced they’d got it all wrong. He’d become the director of the recently founded Institute for Business Cycle Research. Its job was to understand why economies were always lurching from one boom and bust cycle to another. Friedrich Hayek called it “The 19th-century pattern”, though it was hardly a thing of the past.

The Institute was based here at the Chamber of Commerce, where Friedrich Hayek had been developing a new theory of boom and bust, along with new thinking about the market. The work he did here would change the way people thought about the economy for ever – it’s ups, and its downs.

To many, the downs were unpredictable – a kind of force of nature that might destroy an economy without warning. Hayek had been working on a new idea – that the seeds of busts were sown during booms. Because the world had become increasingly interconnected, Friedrich Hayek had been studying the American boom to help him forecast what would happen to the Austrian economy.

Dry Reports

He had to produce these monthly reports on the state of the European economy. Most of it is pretty dry stuff. It’s things like paper production or that month’s steel exports. But he is credited with making a rather striking prediction in early 1929, because he thought the American stock market boom would end in a few months time. He was right. In October 1929 Wall Street fell off a cliff, and the Twenties roared to an anguished end and rampant inflation.

Friedrich Hayek’s prediction came out of what he saw happening at America’s new central bank. The Federal Reserve had been set up in 1913 to stabilise America’s notoriously shaky private banks by offering them a reliable source of credit. Hayek’s big idea was that the great ups and downs in the economy nearly all started in buildings like this one. It was the cost of borrowing, the interest rate, set by central banks like the New York Federal Reserve that caused unsustainable booms to develop, and caused the inevitable busts.

Benjamin Strong

Benjamin Strong

In the 1920s the governor of the New York Federal Reserve had a revolutionary idea. Benjamin Strong thought he could use the banks power to set interest rates to influence what was happening in the economy. In many ways, that idea of using interest rates marked the start of modern monetary policy. Benjamin Strong began buying government debt on the open market which did have the effect of raising the amount of money in the economy. But unlike Austria’s hapless central bankers, Benjamin Strong had a strategy.

The difference with Austria was that the Fed wasn’t buying Treasury bonds to help the government pay its bills. It was doing it to get money into the market to keep interest rates low. The central bank wanted to encourage everyone, individuals and households, to borrow more from the banks. It worked.

Benjamin Strong’s intervention really paved the way for the financial system we have today. Thanks to all that credit he created the stock market rose higher and higher. With loans so cheap, many borrowed money to buy shares. Others invested heavily in property. The Federal Reserve hoped its intervention would keep the boom going indefinitely, but Friedrich Hayek believed Benjamin Strong’s policy was sowing the seeds of an eventual bust.

External Links

Rampant Inflation or Hyperinflation – Wikipedia Page

Rampant Inflation | Boom and Bust | Richard Zundritsch | Benjamin Strong

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