Inflation versus Deflation
Deflation Has to Be Deliberated
Ed Bugos
| In theoretical investigation there is only one meaning
that can rationally be attached to the expression inflation:
an increase in the quantity of money (in the broader sense of the
term, so as to include fiduciary media as well), that is not offset
by a corresponding increase in the need for money (again in the broader
sense of the term), so that a fall in the objective exchange value
of money must occur. Again, deflation (or restriction, or contraction)
signifies a diminution of the quantity of money (in the broader sense)
which is not offset by a corresponding diminution of the demand for
money (in the broader sense), so that an increase in the objective
exchange value of money must occur. If we so define these concepts,
it follows that either inflation or deflation is constantly going
on, for a situation in which the objective exchange value of money
did not alter could hardly ever exist for very long - Ludwig von
Mises, The Theory of Money and Credit - Chapter 13, section 7, "Excursus:
The Concepts Inflation and Deflation" pp. 272 |
To exclude credit
from the concept of money, particularly in defining inflation, is to ignore
the lesson that was learned in 1845 when Sir Robert Peel - an economist
from the British Currency School that opposed inflation but helped solidify
central banking - attempted to restrict inflation by confining the
policy to bank notes, rather than including bank deposits as well.
The subsequent financial crises that led
to the suspension of Peel's Act in 1847, 1857, 1866, and 1919 revealed
that Peel failed to understand how bank deposits were also money (fiduciary
media) in the broader sense; but more importantly, von Mises (and Rothbard)
pointed out that restrictionist measures could never really work in the
first place so long as central banking existed, because central banks
were government awarded monopolies exempt from market discipline…
by definition. In other words, if things don't go their way, they could
merely change the (legal tender or other) laws governing money. You all
know this:
"The real obstacle in the
way of an unlimited extension of the issue of fiduciary media is not
constituted by legislative restrictions of the note issue, which after
all, only affects a certain kind of fiduciary medium, but the lack of
a centralized world bank or of uniform procedure on the part of all
credit-issuing banks." (On Peel's Act - Chapter 20: Money and Banking;
pp. 411, Section 2.2 in the Theory of Money and Credit)
The reason central banking is the engine
of inflation is because it is the medium through which all banks under
its umbrella come to agreement on the extension of credit. Without this,
any individual bank that engaged in inflationary credit policies too quickly
on its own would ultimately face a run on its reserves, perhaps initiated
by one of its competitors who would know that it could not cover its outstanding
notes.
Central banks are as much a cartel as OPEC
is, but they are also a monopoly power awarded by the state - "an accumulation
of legal privileges on a single bank."
The government benefits because it gets
to borrow and spend beyond its means. Indeed, Murray Rothbard concluded
that central banks were born of a "crooked deal between a near-bankrupt
government and a corrupt clique of financial promoters" in 17th century
England (though the first central bank was in Holland - recall Tulipmania).
Well, they couldn't do it without the public's
help at any rate. For this truth would have been exposed long ago if the
average person could not be fooled about the positives of central banking
and inflationism… mo' money baby!
It is central banking that is barbaric,
not gold.
Ignorance is not bliss. It is the food
of slaves, and the tyrant's money.
Every year since
2000 I've put out a piece on the debate between inflation and deflation.
And each time it has reflected the same conclusion. The Fed is stuck in
an inflation trap of its own making. Events since have largely proven
us correct.
However, this does not quite mean
that it must continue to inflate in order to avoid deflation. At this
point in the cycle it is probably more accurate to say that it must continue
to inflate in order to support the illusion that underpins the value of
the US dollar as a common medium of exchange. In lay terms, they
gotta' keep it going.
However, the consequence of ending it now
is not deflation, but rather, hyperinflation.
I'm using the word 'hyperinflation'
loosely to depict a circumstance where the Federal Reserve Note loses
its value not merely because the central bank expands its quantity (the
supply side) without abandon. Such a policy anyway is the result of hastily
reacting to valuation judgments by individuals already underway, toward
a quickening diminution of the monetary value of the currency - or fiduciary
media today.
In other words, the demand side has something
to say about it all.
When I talk about the impact of inflation
on the value of the currency, many people presume that I'm applying the
simple version of the quantity theory. It's not true. I don't contend
that a 20% increase in the supply of money would translate into a proportionate
decrease in the value of the currency.
In fact, no devaluation can occur at all
so long as the individual economic agents making up a given market do
not alter their demands for money in such a way as to allow it. The increase
in supply of money tends to cause an increase in the stock of money for
those that receive it first. But there is nothing automatic or mechanistic
about the actions that follow, and which determine the impact of that
increased supply of money on its value through the subjective valuations
of individuals.
The incorrect (or older) application of
the quantity theory would suggest otherwise. It would ignore the individual
subjective valuations of individuals altogether. Of
course, such valuations aren't predictable.
If they were, money would not be necessary
to begin with.
Nevertheless, it is ignorant to throw out
the quantity theory altogether, because it can't be disputed that the
interaction between supply and demand does invariably affect the value
of money much like it does any other economic good - except on a different
basis… as a medium of exchange, not as capital, and not as a consumption
good.
The criticism levied against the mechanistic
version of the quantity theory is correct; but to throw it out altogether
is like throwing the baby out with the bathwater. All that has to be done
is to take into account how the demand side actually works.
The point I'm getting at is that it is
the market that decides what is money, and what its value is. And this
is in part determined by its relative scarcity as an economic good. i.e.
Individuals must not believe that the policy of inflation can go on indefinitely.
This is the mission statement the Federal
Reserve should post on its website instead of the lie: "The Federal
Reserve, the central bank of the United States, was founded by Congress
in 1913 to provide the nation with a safer, more flexible, and more stable
monetary and financial system."
In developing the theory of the value of
money, Ludwig von Mises observed that at the point where people finally
see that the policy of inflation is endless, the "crack up boom" begins,
and ends in the abandonment of the current medium as money:
"But then finally the masses
wake up. They become suddenly aware of the fact that inflation is a
deliberate policy and will go on endlessly. A breakdown occurs. The
crack-up boom appears. Everybody is anxious to swap his money against
"real" goods, no matter whether he needs them or not, no matter how
much money he has to pay for them. Within a very short time, within
a few weeks or even days, the things which were used as money are no
longer used as media of exchange. They become scrap pater. Nobody wants
to give away anything against them. It was this that happened with the
Continental currency in America in 1781, with the French mandats territoriaux
in 1796, and with the German Mark in 1923. It will happen again whenever
the same conditions appear. If a thing has to be used as a medium of
exchange, public opinion must not believe that the quantity of this
thing will increase beyond all bounds. Inflation is a policy that cannot
last" - Ludwig von Mises, Human Action, Chapter 17, "Indirect Exchange,
the anticipation of expected changes in purchasing power
The comment that "inflation is a policy
that cannot last," does not mean that it results in deflation; it
means that eventually the currency is no longer money.
In 1923 Germany, the story goes, a woman
brought a basket full of Reichmarks to her baker in order to purchase
a loaf of fresh bread. She succeeded at persuading the baker to give up
the goods. The thing is, he threw the marks out and kept the basket.
At this point, even if the central bank
tightened monetary policy, presumably it would have been too late… people
would know it was to be temporary.
|
Consistently and uninterruptedly continued inflation must eventually
lead to collapse. The purchasing power of money will fall lower
and lower, until it eventually disappears altogether. It is true
that an endless process of depreciation can be imagined.
We can imagine the purchasing power of money getting continually
lower without ever disappearing altogether, and prices getting continually
higher without it ever becoming impossible to obtain commodities
in exchange for notes. Eventually this would lead to a situation
in which even retail transactions were in terms of millions and
billions and even higher figures; but the monetary system itself
would remain.
But such an imaginary state of affairs is hardly within the
bounds of possibility. In the long run, a money which continually
fell in value would have no commercial utility. It could not be
used as a standard of deferred payments. For all transactions in
which commodities or services were not exchanged for cash, another
medium would have to be sought. In fact, a money that is continually
depreciating becomes useless even for cash transactions. Everybody
attempts to minimize his cash reserves, which are a source of continual
loss. Incoming money is spent as quickly as possible, and in the
purchases that are made in order to obtain goods with a stable value
in place of the depreciating money even higher prices will be agreed
to than would otherwise be in accordance with market conditions
at the time. When commodities that are not needed at all or at least
not at the moment are purchased in order to avoid the holding of
notes, then the process of extrusion of the notes from use as a
general medium of exchange has already begun. It is the beginning
of the "demonetization" of the notes. The process is hastened
by its paniclike character. It may be possible once, twice, perhaps
even three or four times, to allay the fears of the public; but
eventually the affair must run its course and then there is no longer
any going back. Once the depreciation is proceeding so rapidly that
sellers have to reckon with considerable losses even if they buy
again as quickly as possible, then the position of the currency
is hopeless - Ludwig von Mises, The Theory of Money and
Credit - Chapter 13, section 3, "Inflationism" pp. 258/259
|
If the older mechanistic version of the
quantity theory were applied this point could never be reached. The currency
would just continue to devalue in proportion to the increase in supply
indefinitely, and all prices would rise, to the same degree, and
proportionately, forever. It doesn't take a genius to refute this in the
real world. It doesn't even take a lot of knowledge of history. One
needs only look to the example of the late nineties to see that an increase
in the supply of money doesn't translate into a currency debasement, either
immediately or proportionately.
Today, even among
gold bulls, there is this feeling that the consequence of the profuse
inflation that we've experienced in credit over the past two decades will
be deflation, and that even as the prices of all things fall, gold will
alone rise.
I full-heartedly reject this view on both
counts. The example of Japan's circumstances is wholly inapplicable because
we've already shown that deflation is not defined merely by what happens
to the general price level. Japan's model is convenient to the Fed because
it represents conditions that nobody wants.
However, the Yen is not money outside Japan
any more than the Canadian dollar is money outside Canada. And
inside Japan or Canada, these currencies are money only because they are
freely convertible into the US dollar, which happens to be the most common
medium of exchange in the world trade arena.
The US dollar competes with gold directly
for this position. The Yen is merely an instrument of mercantilist policies.
The US dollar is too, but it is not yet understood in that light. It will
be this decade.
The United States experienced an enormous
deflation in the short period from 1930-33. It is true that the cause
of these conditions should be connected to the preceding policies of inflationism.
However, it is wrong to conclude that there is some natural economic law,
which dictates that deflation follows inflation. Any contraction in the
money supply that occurred during this time was due solely to the workings
of the gold standard.
Because the US dollar was fully convertible
to gold at a fixed value at the time, when the inflationary boom turned
to bust, people preferred to exchange their overvalued bank notes (or
dollars) for gold - this was the driving force behind the bank runs that
caused a drain on real monetary reserves (gold) and culminated in Roosevelt's
bank holiday, and which ultimately resulted in the inevitable devaluation
of the dollar as well as the final abandonment of the gold standard.
The option of exchanging bank notes for
gold no longer was allowed. People had little choice but to accept this
state of affairs - the motivation for the exchange having been outlawed
altogether - and paper reserves of course are easily inflated.
But it was not some flaw of gold, or natural
market forces per se, or the greed of people that caused the bank runs
which led to the subsequent deflation.
It was the consequence of the preceding
policy of inflationism UNDER a gold standard. It could be argued
that the particular gold standard was inadequate in so far as it did not
restrict the inflation in the first place.
In any case, while gold was fixed, gold
stocks rose after the crash of 1929, and accelerated through 1933, then
blew off in 1935. But by 1935, prices no longer fell. The CRB bottomed
in 1933 as the gold standard was abandoned. The fact that gold stocks
rose then was not evidence that gold rises during periods of deflation.
Rather, I would contend, they rose because
gold stock investors already knew that the road the economy was on would
lead to more inflation not less, much like we knew three years ago that
the Bernanke's of the world would take over the reigns at the Fed.
In other words, the market correctly anticipated
the abandonment of the gold standard, which was already telegraphed at
least a decade earlier. After all, the rhetoric of the day was already
aimed at blaming the gold standard for the state of affairs.
If instead of FDR, for instance, someone
like Thomas Jefferson would have won office who objected to central banking,
you can bet your golden parachute that gold stocks would not have acted
nearly as well because odds are he would have placed the blame where it
should have been placed - on central banking, not gold.
Had the gold standard remained, undoubtedly
more banks would have failed, and deflation would have continued for a
while.
Whether that is a desirable outcome or
not is besides the point here. The
point here is merely that deflation is not an automatic result of money
or credit inflation, and that gold doesn't rise in value during deflation
- defined as a contraction in money supply - unless the value of
each unit of the shrinking supply of money is also falling, in which case
other commodities would also rise in value... though to a lesser extent.
This was the case after 1933, and it was
also the case after 1971. It is the case during ever case of US dollar
devaluation in history.
A real gold standard is supposed to stand
in the way of the policy of inflationism, and the welfare state, as Greenspan
articulated in his essay published by Ayn Rand in her book, "Capitalism,
The Unknown Ideal," in 1952.
However, the reason it didn't in the 1920's
or afterwards during the reign of the gold exchange standard known
as Bretton Woods has already been shown… because central banking itself
is the engine of inflation. Without it, and the legal tender laws that
support it, the kind of inflation we are used to wouldn't have a chance.
Banks could inflate only slowly, and any
excessive inflation would be quickly corrected.
The conditions under which a gold standard
would work exclude central banking, or any government regulated expansions
in notes (as in the United States before the Civil War when States pushed
for the expansion of fiduciary media).
Contrary to popular opinion, Rothbard showed
that free banking never existed in the United States. But the fact that
people think it did lends weight to the argument that markets are inherently
unstable, because there were numerous financial crises even before the
Fed came to be. Sure banking was decentralized, but it was a matter of
different states with different inflation policies regulating banking
affairs, not the market.
The inhibiting factor that would have prevented
each individual bank from inflating (market discipline) and would have
ensured a greater financial stability was already absent. At
least in terms of banking, capitalism is indeed the unknown ideal.
Nobody is claiming that markets are stable…
just more stable without intervention than with it. Denying this amounts
to denying that individual valuation judgments can neither be predicted
nor ignored.
Socialist policies always tend to produce
instability precisely because they deny the importance of the individual
in the role of resource allocation. Regulation is akin to intervention.
And laws generally do not produce a level playing field for anyone but
the cartels they protect - from prohibition to legal tender to insider
trading.
Don't get me wrong. I am not condoning
the practice of insider trading. I just don't believe laws work to regulate
it. They just keep the little guy from having the same advantage as the
big fish. I'll tell you this, moreover. Having received plenty of insider
tips myself, I have never once acted on any of them. There is good reason
for it. Most such tips are plain bad, and I've done better at outguessing
the market than I would have if I traded solely on inside tips.
However, if inside trading were allowed,
it would be more easily visible in the tape. Any technician could spot
it in an instant. The important thing is, the bad tips would rarely show
up in the chart in the first place.
Hence, the regulation governing insider
trading is not so much a matter of protecting a cartel of inside traders,
as it is a matter of unnecessary costly regulation for the financial industry
resulting in higher trading costs for individuals.
It's just my opinion. I mention it only
to highlight the lack of faith people today have in the market itself
for producing stability, prosperity, and disciplining participants.
There are only
three ways to have deflation today, and one of them is to fake it: a)
a deliberate deflation policy, b) linking the dollar to a gold standard
(which is the same as "a"), and c) the debasement in the dollar overshoots
for the time being (this is the fake, like the one experienced in the
early eighties).
In the third example, note that gold fell
during the early eighties.
But it is important to realize that there
hasn't been a true deflation since the gold standard was abandoned in
1933. And for good reason - there is nothing to restrict the central bank
from inflating, nothing.
Even if one imagines a blow up in the government
sponsored entities that have come to dominate the mortgage markets and
are the largest single medium of inflation outside of the central bank,
he or she must concede that this would result in a devaluation of the
US dollar if only due to the extent of foreign ownership of the dollar
denominated paper.
And it should be clear that if Fannie or
Freddie were to blow up today, that the Fed is committed to its policy
of inflation - which is limited only by the imagination of its governors
in how to print more currency. The analogy of Fed governors throwing money
out of a helicopter if they had to is appropriate, and prevented only
by the knowledge that the party would come to an even quicker ending if
it came to that.
Thus, the inflationary response to current
circumstances is as predictable as it was in the thirties, and seventies.
It is true that there have been circumstances
in the past where central banks employed the policy of deflation under
the belief that they could fix the consequences of prior inflations. But
their resolve never lasted, and it was only ever employed as a matter
of last resort.
This was somewhat true of the actions of
the Fed in the late 1970's when Paul Volcker was appointed Chairman. By
1979, the US stock market was trading at a paltry 10 times earnings, the
dollar had lost about 75% of its value (according to gold), and interest
rates were already exploding skyward.
Thus, by then there was little left to
do but head off the "crack up" boom as best as possible - i.e. to preserve
whatever credibility the central bank could. There was nothing left to
lose. This is not yet the case today.
Had the Fed turned hawkish in 1973 when
the dollar was only beginning to crack, it would have received the blame
for what was to follow with or without the intervention.
This is the case today. If the Fed decided
to adopt a restrictionist policy now to correct the malinvestments and
other consequences of the last two decades of credit inflation, markets
and banks, and maybe even governments would all but fold. The devaluation
in the dollar would not be avoidable. It is already inevitable, but they'd
be blamed.
The resolve that is required to contain
it does not exist, as has always been the case. The policy response to
the current state of affairs is and always has been more money and credit
inflation.
It is ridiculous to suggest that Paul Volcker
succeeded at eliminating inflation. All that he accomplished was to preserve
the credibility and increase the power of central banking for a while
longer. All of the causes and consequences of inflation exist today the
same as they always have.
The key is to keep people believing that
the policy is not endless.
While the Inflationists targeted gold in
1933 as the cause of their problems, they could not prevent its increase
in value. No law could ever do this, as was realized in the seventies
when individuals were again allowed to trade and own gold (from 1934 to
the mid seventies there were severe penalties for owning gold in the United
States).
Although the threat of outlawing the ownership
of gold is real today, it could only be a naďve population that could
allow it under the belief it could work, or that it was the cause of our
troubles. I believe it is a much
harder task today to blame gold.
But maybe my faith in individuals will
be tested yet.
The bottom line is that there is little
possibility of deflation today, and that any contraction in money supply
is temporary barring some new found resolve by central banks to liquidate
the boom themselves, deliberately.
The fear of deflation is a deliberate ploy
provoked by central banks trying to justify the ongoing policy of inflation,
as well as to manage inflation expectations thus cap interest rates -
all designed to keep people from believing that the policy can go on indefinitely,
and to keep them from ending the boom prematurely.
The actions the Fed has taken are indeed
aggressive. But as we said four years ago, it is because they are in an
inflation trap where they have no choice but to keep inflating in the
hope that the bubbles they create can continue to generate fresh interest
for the currency, thus sustain their BOP imbalances, create jobs, and
keep the government solvent. Their policy response was entirely
predictable, and believe me, the true motivation is far removed from the
fight against the deflation bogeyman!
A few concluding remarks here.
First, deflation would not necessarily
be the norm under a pure gold standard, but if it were, it would be mild
so long as there is no credit excess that leads to a bust. The more inflation,
the more deflation - but only under a gold standard... otherwise it's
just more and more inflation.
Second, capitalism is not prone to boom-busts,
at least not the extent to which we've experienced in the 20th century.
That is the obvious result of inflation policy!
Third, capitalism does tend to produce
falling prices, but it is not deflation, and it is not severe if it isn't
caused by an unwarranted expansion in money to begin with. The value of
your dollar increases! You can buy more goods. This is what capitalism
is supposed to do. Productivity translates directly into more real wealth
this way.
Last but not least, all prices do not rise
or fall at the same time during a debasement.
The prices of goods overproduced during
the boom in credit could fall even during the subsequent currency devaluation.
Some people seem to think that inflation
means the overproduction of all things. This is absurd because it ignores
the fact that in a given economy, its productive resources are scarce
in the first place. Inflation causes them to be misdirected… towards
the overproduction of the wrong goods, and/or uneconomic enterprise.
Thus, while some things are overproduced,
others, like gold, tend to be under-produced during the best part of the
artificial boom in paper. When the paper boom busts and THE MARKET devalues
the currency, the relative scarcities become increasingly apparent.
I am not stubborn about this. If anyone
can refute my arguments about deflation, or show me how deflation is possible
regardless, I'd be happy to listen.
But I will not entertain any arguments
that suggest:
a) Central banks are somehow restricted
from inflating money by the market in the absence of a gold standard
b) Deflation is simply falling prices, as opposed to contracting money
c) Falling asset values somehow manifest in stronger currency values
d) Inflation automatically results in deflation
e) The value of money is determined only by its supply, or by the government
or banking cartel's wishes
Such arguments have long been shown to
be fallacious.
Massive currency devaluations in the midst
of a monetary bust do cause interest rates to rise, but the rise in interest
rates does not immediately cause the currency to find support, or cause
deflation. If they did, the seventies crisis (or commodity boom) wouldn't
have lasted the whole decade.
Gold is rising in value today because the
market knows this to be true, as was the case in the late sixties and
the twenties. And to the extent that
the majority of people don't believe it, yet, they merely represent a
pool of skeptics from which the bull market in gold will thrive until
they do… until the pool is empty.
So the fact that even in the gold camp
there are those who forecast deflation is but another signal that the
bull market in gold is young. It means the market isn't yet generally
aware that the policy of inflation is endless.
Ed Bugos
Editor - The GoldenBar Report
www.goldenbar.com
February 24, 2004
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