Deflation: The Good, the Bad, and the Ugly
During the current recession a number of commentators have made various comparisons to the Great Depression, mostly because of the dramatic decline in the stock market and ongoing troubles in the financial industry. When oil prices also began a dramatic decline in the autumn of 2008, pulling the overall consumer price level downward for the first time in a very long time, yet another fear of the Great Depression era came to the forefront of the public’s consciousness: deflation. Many observers pointed out, quite correctly, that the deflation that followed nearly immediately after the stock market crash in 1929 was a major reason that what would have been a serious, though likely short-lived, recession was transformed into the Great Depression. With these fears of deflation, and the damage it did decades ago, now part of the discussion, it is a good idea to remind ourselves just what we should and should not fear about deflation, and how deflation can be, and was historically, a major contributor to economic catastrophe.
The key to understanding deflation is to realize that it comes in three forms: the Good, the Bad, and the Ugly. To make sense of these three forms we need to be clear on some terminology and definitions. First, the word “deflation” itself requires additional clarity. Normally, the definition is something like “a sustained decline in the average level of prices.” That definition immediately raises the question of why anyone would think deflation is bad. After all, what could be bad about things getting cheaper? For one thing, “prices” are normally understood to include “wages” (although in the Ugly version we’ll see what happens when this isn’t the case), so whatever gains one gets from lower prices are likely to be offset by lower wages. For another, that definition says nothing about whether the process by which prices fall is a painful one. (Could not one say of inflation: “What’s the big deal? Sure, prices are going up, but your wages will too, so aren’t you just even?” We know enough about the process by which prices rise to know it’s not that simple and the same is true of the process by which they fall.)
With that common definition in mind, we then need to make a further distinction about the cause of falling prices. A decline in the general level of prices can come from two broad sources: improvements in economy-wide efficiency (the decreased relative scarcity of some large number of goods) or a deficient supply of money. We might further distinguish between these two by referring to the first as “price deflation” and the latter as “monetary deflation.” Price deflation, as it turns out, is the “Good” of the Good, the Bad, and the Ugly. Monetary deflation is the “Bad” and can lead to the “Ugly.”
Price deflation, sometimes called “benign deflation,” is, or at least should be, the normal by-product of a growing economy. To see why, we need one last digression, this time into monetary theory. Understanding both inflation and deflation requires that we recognize that the demand for money is a demand to hold real cash balances: We demand money when we hold balances in our wallets or our checking accounts. When we spend money we actually reduce our demand for money as we shift how we hold our wealth from money to whatever we buy. Think of a wallet or checking account as part of a larger portfolio of assets we choose to hold at any given time. We want a certain portion of our wealth in the form of housing, some in the form of food, some in the form of clothing, and some in the form of money. Thus our demand for money is a demand to hold money balances, and we care about the real purchasing power of those money balances—what they are capable of buying, not just what number is stamped on the bills.
A correct understanding of the demand for money helps us to understand why sometimes people can have either more or less money than they would prefer. For example, during inflation the monetary authority has created more money than people wish to hold at current prices, so they spend those “excess” money holdings on goods and services, driving up their prices. During a monetary deflation, as we shall see, a deficient supply of money means that people do not have large enough money balances and will act to get more.
All of this implies that a good monetary system is one that supplies exactly the amount of money the public wishes to hold at the current level of prices. It is worth noting that this view, called “monetary equilibrium theory,” implies that not every increase in the supply of money is inflationary. Should the demand for money rise, it is the appropriate response of the monetary system to increase the supply to match it. In our discussion of monetary deflation below, we will see why monetary equilibrium theorists make this argument. This argument also distinguishes those Austrian economists who work from the monetary equilibrium tradition from those who work from a more Rothbardian tradition, in which any increase in the money supply not matched by an increase in the quantity of gold is necessarily inflationary and the ideal monetary system is not one that matches changes in money demand with changes in the money supply.
The Good
If the monetary system is doing its job and matching changes in money demand with changes in supply, the long-term trend of the price level will be gently downward as economy-wide productivity rises. Put differently, increased productivity will cause benign price deflation as the real cost of goods and services falls. This sort of deflation is not only not harmful; it is beneficial because the cost of living is lower. In the United States this is precisely what happened to the price level during the last few decades of the nineteenth century, since the pre-Federal Reserve banking system based on gold was reasonably effective at getting the money supply right much of the time and productivity gains caused a steady, slow fall in the price level. Over the last few decades the same downward pressure on prices from productivity gains has been taking place, but it has been outweighed in the aggregate by the inflationary policies of the Fed, so the price level continues to climb in spite of these productivity-induced deflationary pressures.
One implication of this last observation is that consumer price index figures may well understate the real degree of monetary inflation in a given economy. For example, if productivity increases are pushing prices down 3 percent per year, but excesses in the money supply are pushing prices up by 3 percent per year, the common measures of inflation would show stable prices. However, on the monetary equilibrium view, that stable price level is disguising underlying inflation of 3 percent, as prices should have fallen by 3 percent. Austrian economists have long argued that something like this may well have been at work in the 1920s, where relatively stable prices concealed a multiyear inflationary boom that culminated in the recession and then the stock market crash of 1929.
To the extent that a fall in the overall level of prices reflects increased productivity, it is Good. Similarly, a decline in the price level caused by the decreased relative scarcity of key goods is not problematic. The dramatic fall in oil prices in the autumn of 2008 was enough to cause the average level of prices in the United States to fall, which is the source of much of the concern about deflation. However, this sort of deflation is not the type to be concerned about, and certainly does not warrant the comparisons to the Great Depression. In fact, falling oil prices in this case probably did much to prevent the early months of the recession from being any worse than they were, as lower gasoline prices eased financial pressures on many households.
The Bad
The “Bad” sort of deflation arises from an insufficient supply of money. When people do not have as much of their wealth in the form of money as they would like, they will make attempts to increase those money balances. Assuming that in the short run additional income is not possible, people have essentially only two other options: sell off other assets or reduce their expenditures. Either one will work, but selling off assets is problematic for two reasons. First, it is not totally under the individual’s control since it requires a buyer, and second, if everyone is short on money, finding a buyer will be especially difficult because everyone else is looking to sell. Therefore, the most likely result of a deficient money supply is that people will restrict their expenditures to allow more of their income to build up as checking account or currency balances.
As everyone reduces spending, firms see sales fall. This reduction in their income means that they and their employees may have less to spend, which in turn leads them to reduce their expenditures, which leads to another set of sellers seeing lower income, and so on. All these spending reductions leave firms with unsold inventories because they expected more sales than they made. Until firms recognize that this reduction in expenditures is going to be economy-wide and ongoing, they may be reluctant to lower their prices, both because they don’t realize what is going on and because they fear they will not see a reduction in their costs, which would mean losses. In general, it may take time until the downward pressure on prices caused by slackening demand is strong enough to force prices down. During the period in which prices remain too high, we will see the continuation of unsold inventories as well as rising unemployment, since wages also remain too high and declining sales reduce the demand for labor. Thus monetary deflations will produce a period, perhaps of several months or more, in which business declines and unemployment rises. Unemployment may linger longer as firms will try to sell off their accumulated inventories before they rehire labor to produce new goods. If such a deflation is also a period of recovery from an inflation-generated boom, these problems are magnified as the normal adjustments in labor and capital that are required to eliminate the errors of the boom get added on top of the deflation-generated idling of resources.
Over the course of U.S. history the economy has been subject to a number of deflationary episodes, all of which were the consequence of a variety of government interventions in the monetary system. In each of those cases before the Great Depression, policymakers largely allowed the economy to repair itself by standing by and doing little to nothing while prices and wages fell sufficiently to get the demand for money back into alignment with the supply. No doubt these were painful recessions that could have been avoided by having a banking system that responded to changes in money demand by more quickly adjusting the money supply, rather than allowing the price-level adjustment process to cause the problems noted above. However painful they were, these recessions did not become the “Ugly” version of deflation precisely because policymakers allowed the necessary downward adjustments to take place, which was the correct thing to do given the monetary system’s errors that caused the monetary deflation in the first place.
The Ugly
During the Great Depression, what should have just been a Bad deflation became an Ugly one. This deflation was unlike earlier ones for two reasons. First, the scale of the deflation was unmatched. The U.S. money supply fell over 30 percent between 1929 and 1933, a period in which the demand for money was actually rising as a consequence of the stock market crash and the bank failures that followed it. The combined effect was a massive downward pressure on prices. The Fed did not actively reduce the money supply during this period; it failed to react strongly enough to actions the public and banks were taking, such as the public’s holding more currency rather than bank deposits, which caused a multiplied reduction in the total money supply. As Milton Friedman and Anna Schwartz’s A Monetary History of the United States describes it, there was a great deal of internal debate within the Fed over whether it had the power to respond as we now believe it should have and whether, even if it had the power, such a response was the right one. Those who argued in favor of doing nothing won the day and substantially worsened the depression in the process.
The second difference from earlier recessions was that policymakers adopted the view that the key to recovery was to “maintain” prices and wages at their pre-deflation levels. Both Presidents Hoover and Roosevelt strong-armed business leaders into keeping prices and wages up and pushed laws that directly or indirectly did the same.
The effects of these misguided attempts at price and wage maintenance were devastating. Firms continued to pay unjustifiably high wages, while watching sales slacken because prices also stayed high; they covered their losses out of their profits, causing some firms to fail and others to see severe declines in their stock prices. This contributed to the low levels of private investment that prolonged the depression since firms did not have profits to recycle back into their own activities. More brutally, keeping wages so high led to the horrific unemployment rates of the Great Depression, which peaked at around 25 percent in 1933. Only by around 1934 did prices and wages fall enough to start bringing unemployment rates back down. However, unemployment remained at historic highs because even with the declines in prices and wages, private investors were hesitant to take risks in light of the policymakers’ earlier mistakes and the constantly shifting political environment. During the Great Depression, unemployment stayed above 14 percent from 1931 through 1940.
Current observers are quite right to point to the Great Depression as an example of what can go wrong from deflation. There is no doubt that the very large monetary deflation of the early 1930s made the recession that began in the summer of 1929 much deeper and more severe than it would have been otherwise. But even so, had prices and wages been allowed to adjust, that recession would have been Very Bad, but not Ugly. Attempting to keep prices and wages high during the monetary deflation prevented the cleansing price adjustments from taking place and forced sellers to make “quantity” adjustments in the form of reduced production and historic levels of unemployment.
Avoiding the Last Big Mistake
The price level declines seen in the fall of 2008 and early 2009 do not seem to be harbingers of significant deflation. As noted earlier, the decline in oil prices is the leading factor pushing down the overall price level, and this is the benign price deflation that we have labeled Good. In fact, the Fed’s initial response to the troubles in the banking system in the fall of 2008 was to flood the system with reserves, remembering the mistakes the Fed made at the onset of the Great Depression. Given the worries about a cascade of bank failures and the major deflationary effects this would have had on the money supply and the economy as a whole, injecting some additional reserves was probably the right reaction at the time. Two key questions remain, however:
1) Did the Fed overreact and create too many reserves? A look at the Fed’s balance sheet suggests it may well have done so, especially given how many of those new reserves are just sitting in the banks right now (helped along by the Fed, now paying interest on such reserves).
2) Will the Fed be able to withdraw those reserves as the economy recovers and thereby avoid a potentially massive and damaging inflation? If it cannot do so, we will face a much bigger threat in the near future from inflation than from deflation.
All of that said, we do not know for certain what is going on with the demand for money. We know that expenditures are down, which suggests that people are quite possibly increasing their demands for money. But in the absence of the thousands of bank failures that characterized the 1930s and with evidence that banks, on the whole, are continuing to lend (despite scare-mongering media and government stories to the contrary), the concern that any increase in money demand will translate into significant monetary deflation seems remote. As Milton Friedman once said, central banks are always trying to avoid their last big mistake. In this case, that big mistake was the Great Depression, and the Fed has clearly shown a willingness to err on the side of inflation rather than deflation, even at the cost of putting itself in a difficult position once the recovery starts.
What all of this goes to show is that the best way to avoid both Bad and Ugly deflation and to generate the Good kind is to minimize the role of government intervention in both the monetary system and the regulation of prices and wages. A competitive banking system—one without a central bank but with fractional reserves—would avoid both deflation and inflation. Even under a central bank, the effects of a monetary deflation can be minimized by restricting government’s involvement in the setting of prices and wages. In a free economy the only deflation we would see is the slow, long-run decline in prices that results from the productive powers of competitive capitalism. That deflation would be just another Good produced by truly free markets.
Comment by cjelephant on 6 January 2010:
Just an excellent article!
Comment by DD on 6 January 2010:
Dr. Horwitz,
I do appreciate much of your work but I am always furious with what I believe is an incorrect assessment and deliberate separation of “Rothbardian tradition”, when I believe that almost all of the principles that you are departing yourself from are, in fact, rooted in Misesian economics. The “Rothbardian tradition” with respect to money supply and demand is in complete agreement with the “Misesian tradition”.
There is no argument about whether the market should respond to what ever there is demand for. This includes money and credit. The debate arises only on the account that you treat the issuing of fiduciary media as acceptable forms of money substitutes, from both a legal and economic point of view.
With the exception of Rothbard’s explicit legality views on Fractional Reserve Banking, his economic treatment of “Money and Credit” as presented in depth in “Man Economy and State” and introduced in “Mystery of Banking” is entirely consistent (and practically the same) as Mises’ exposition of the theory in Human Action and most of his other sources. Indeed, Mises, known for his adherence to value-free economics, is much more ambiguous regarding the ethical and legality issue surrounding fiduciary media.
Mises to my knowledge (and certainly according to Human Action) has never given any suggestion that fiduciary media can be productive in any way what so ever. In the very few cases Mises refers to an increase in money supply in reference to market response to demand, he in no way ever suggesting fiduciary media as an economically viable route to meet this demand. He did, however, always emphasize the market’s (more practical) ability to efficiently respond through the price system.
Mises did support free banking, but precisely for the opposite reasons that you are. He did not trust a government regulation mandating 100% reserves, and believed that it was the best mechanism to protect against the expansion of credit, unbacked by real savings, and the best way to reach as close as possible to a hard money 100% reserve system. If you don’t recall this, I suggest you revisit Human Action (Ch 17). There is reference to 100% reserve requirement suggestions. This agrees with Rothbard’s analysis that free banking would in fact converge to a hard money banking system. (See chapter on Free Banking in “Mystery of Banking”).
Mises, as did Hayek (in “Monetary theory and the Trade Cycle”), also attributed the boom/bust to any expansion of fiduciary media set off by the banking system. There is absolutely not even a single minute hint or suggestion that some fiduciary media can be expanded without inducing a cyclical behavior. This is also consistent with Rothbard’s analysis.
In fact, Mises is entirely “Rothbardian” except he did not give a clear and unambiguous opinion regarding the later “Rothbardian” analogies between FRB and counterfeiting. While much of what I have read (and heard) from you is also consistent with the Misesian tradition, I am afraid that with this issue on “free banking” and its relation to “monetary equilibrium” there is nothing at all Misesian. So the “Rothbardian tradition” that you part yourself from is, at large, also the Misesian tradition.
Comment by Steve Horwitz on 6 January 2010:
I beg to differ DD. I think Mises’s views were at the very least ambiguous between Rothbard’s position and the monetary equilibrium position. My own view is that there is plenty of evidence to support the claim that Mises was much closer to my perspective than Rothbard’s.
Rather than recap it here, I suggest you take a look at a series of blog posts of mine from a few months back than include a whole bunch of textual evidence of statements by Mises that simply cannot be reconciled with the Rothbardian position. Note especially the comments section of the third one where Richard Ebeling chimes in.
Here’s one teaser
You say: “There is absolutely not even a single minute hint or suggestion that some fiduciary media can be expanded without inducing a cyclical behavior.” I say:
>>>>I had the chance this morning to skim through a FEE volume that collected lectures Mises gave at the Foundation in the summer of 1951. Note that date: it is AFTER the publication of Human Action. In the lecture on “Money and Inflation,” Mises defined inflation the following way:
“Inflation is an increase in the quantity of money without a corresponding increase in the demand for money, i.e., for cash holdings.”
This is exactly the same definition of inflation that Mises gives in TTOMAC (p. 272, 1980 Liberty Press edition). The 1951 lectures are available from FEE as The Free Market and its Enemies (2004) or online here. Check page 44. [UPDATE: to be clear, this means that Mises would agree that an increase in the quantity of money that brings the supply up to match the demand for cash balances is NOT inflationary.]<<<<
Mises's definition of inflation is in total contradiction with Rothbard's and he is endorsing, implicitly, the idea that additional issues of fiduciary media are not always inflationary and cycle-inducing.
More here:
http://austrianeconomists.typepad.com/weblog/2009/09/mises-defining-inflation-the-monetary-equilibrium-way-in-1951.html
http://austrianeconomists.typepad.com/weblog/2009/09/is-it-white-is-it-selgin-is-it-horwitz-.html
http://www.coordinationproblem.org/2009/09/mises-and-his-call-for-100-reserves.html
Comment by DD on 6 January 2010:
Dr. Horwitz,
I will go over your suggested at those series of blog posts you suggest but I will just comment briefly on the following quote you provided, which I have encountered many times before. I addressed it in my initial comment if you noticed but I had not provided the quote.
“Inflation is an increase in the quantity of money without a corresponding increase in the demand for money, i.e., for cash holdings.”
To argue about the definition of inflation is to misconstrue the entire debate. The debate over inflation bares no economic significance and sheds no light into who’s economic analysis is more in line with Mises. The definition is arbitrary and as Mises himself emphasized, in Human action, it provides no importance in the study of catallactics. In Human Action, he himself regards “inflation” as a term coined by politicians and their pundits, not economists. What is important is the catallactic description behind the term and if properly defined before its use in debate or writing, then there should be no contusion, and the argument over terminology can be spared.
The quote you provided, as I mentioned in the first response, does in no way suggest that an increase in fiduciary media is a proper economic route to meed this demand. Mises had never suggested that fiduciary media is equivalent to money and therefore can serve to meet such demand. Quite the contrary. In Human Action, he explicitly defined them as NOT money substitutes implying that they are perceived as such merely because the public is unaware of the banking practices. Again, you may want to refresh your memory with Ch 17 in Human Action.
There is, what I sense to be, a frustrating misunderstanding with respect to the core arguments being made by the hard money people. The quote you provided I think reveals this misunderstanding. Rothbard, as most other hard money guys, would never have a problem with market produced money. I’m sure you are aware of this. If Rothbard’s definition of inflation includes the market produced new money (such as new minted gold coins) as inflation, then this is simply indicative of the fact that “Rothbardian” Inflation does not necessarily always mean bad or fraud. There can be legitimate and productive inflation according to Rothbard. But as far as fiduciary media is concerned, this would certainly constitute bad inflation,and I see nothing in Mises that would contradict this assertion, especially with respect to the economic effects of the practice.
The argument then over inflation is irrelevant. The core economic theory of Money and Credit is almost identical in Rothbard’s exposition of it. Perhaps you should revisit some of Rothbard’s writings (which I’m sure you haven’t touched since you were a kid) and see he is in no way departing from Mises.
Comment by Steve Horwitz on 6 January 2010:
Sorry DD, but still no sale.
Read the posts and then tell me what you think. Rothbard’s monetary theory is a deviation from Mises (just like his monopoly theory was). That’s a separate question from whether Rothbard is right or wrong, btw. And I’d like you to find me a place where Rothbard ever says inflation is okay, given that he *defines* inflation as being equivalent to the issuance of fiduciary media: “the process of issuing money beyond any increase in the stock of specie may be called inflation” (MES: p. 851). How exactly can there be good inflation for a Rothbardian if all inflation involves the issue of “uncovered” media, which by his own definition is fraudulent, as he notes on the previous page?
You will not find anything in Mises like that. Not that definition of inflation, nor the claim that fiduciary media are fraudulent. What you will find is an objection to fiduciary media *in a world of central banks* where the market’s own checks on their production are absent. As you’ll see in those posts and the comments, Mises defended free banking not because he thought it would lead to 100% reserve, but because he rightly understood that it limited the production of fiduciary media to just what the public wished to hold and no more.
Fractional reserve liabilities under a truly free banking system are neither inflationary nor fraudulent so there is no reason to think the justification for free banking is that it will eliminate them. It won’t and that’s a good thing.
Comment by DD on 6 January 2010:
Dr. Horwitz,
Bare with me for this long quote from Rothbard’s “Mystery of Banking” below. You will notice the sharp distinction Rothbard makes between the two different ways to increase the effective money supply. One is legitimate and one is fraud. So not all increases in money supply is fraud according to Rothbard. So to answer your question, there can be good “increase in money supply”, if Rothbard makes the proper distinction as he explicitly does below. He does seem to resort to the term “inflationary” as applicable only to the fraudulent means. However, what is important is not terminology and whether he is consistently sticking to it, but rather the fact that he does make a clear economic distinction.
Rothbard:
“How much gold will be mined at any time will be a market choice determined as in the case of any other product: by estimating the expected profit. That profit will depend on the monetary value of the product compared to its cost. Since gold is money, how much will be mined will depend on its cost of production, which in turn will be partly determined by the general level of prices. If overall prices rise, costs of gold mining will rise as well, and the production of gold will decline or perhaps disappear altogether. If, on the other hand, the price level falls, the consequent drop in costs will make gold mining more profitable and increase supply.
It might be objected that even a small annual increase in gold
production is an example of free market failure. For if any M is
as good as any other, isn’t it wasteful and even inflationary for the market to produce gold, however small the quantity?
But this charge ignores a crucial point about gold (or any other money-commodity). While any increase in gold is indeed useless from a monetary point of view, it will confer a nonmonetary social benefit. For an increase in the supply of gold or silver will raise its supply, and lower its price, for consumption or industrial uses, and in that sense will confer a net benefit to society.
There is, however, another way to obtain money than by buying or mining it: counterfeiting. The counterfeiter mints or produces an inferior object, say brass or plastic, which he tries to palm off as gold.6 That is a cheap, though fraudulent and illegal way of producing “gold” without having to mine it out of the earth.
Counterfeiting is of course fraud. When the counterfeiter mints brass coins and passes them off as gold, he cheats the seller of whatever goods he purchases with the brass. And every subsequent buyer and holder of the brass is cheated in turn. But it will be instructive to examine the precise process of the fraud, and see how not only the purchasers of the brass but everyone else is defrauded and loses by the counterfeit.”
Also, you are using the term “inflationary” as if it already contained within it some objective and uncontroversial catallactic effects. So if two people don’t use the definition in the same way, they somehow can’t agree on the economic effects. This, as I pointed out before, cannot be true for the definition and use of the term is arbitrary anyway. One simply must understand what the author means by inflation.
Besides, Mises many times did refer to “Inflation” as simply an increase in the money supply. So the argument over proper definition of the term bares no meaningful insight into the resolving the debate.
Regarding free banking not eliminating the issuing of fiuciary media. I am familiar with your view on this, but again, the disagreement with you on this is not based on a Rothbardian tradition but a Missesian tradition. Mises makes this quite clear in Human Action.
Comment by DD on 6 January 2010:
Dr. Horwitz
I have looked again at the quotes you provided in the blogs. I have seen them before.
I don’t know how you come to the conclusion that these quotes provide some evidence that Mises was closer to your line of thinking then Rothbard.
Presented in isolation out of the so many quotes by Mises in the vast amount of literature, I could perhaps give you the benefit of the doubt (in a court of law) that they are rather ambiguous, although I would still personally interpret them to be actually contradictory with your views.
Taking these quotes together with the vast other endless quotes by Mises, I think there is no doubt.
I think the most curious quote is the one you provided from human action about 100% requirement. Taking that quote in the context of the entire chapter, it is evident that Mises is interested in limiting the issuing of fiduciary media to a maxium. He does’t trust the government to enforce it. He clearly doesn’t condemn this suggestion on any other account then that government cannot be trusted. It’s in the quote you provided.
Also, following that quote, the distinction you make between bank notes and deposits regarding the famous quote by I forget the name, can be interpreted as quite a desperate attempt by you to evade that blow also.
I actually respect many of your ideas. I often read what you write. I just particularly don’t think the “Rothbardian”, as oppose to Missesian is fair. I am sure, of course, that this is a disagreement about interpretations and not about sincerity.
Comment by Jean-Christophe Roux on 6 January 2010:
Hello,
You write that “A decline in the general level of prices can come from two broad sources: improvements in economy-wide efficiency (the decreased relative scarcity of some large number of goods) or a deficient supply of money.”
Could not the general level of prices also come from massive waves of liquidation of assets following those economic booms created by monetary policies?
Thanks for your thoughts on that.
Comment by Jean-Christophe Roux on 6 January 2010:
Hello,
When you write “Given the worries about a cascade of bank failures and the major deflationary effects this would have had on the money supply and the economy as a whole, injecting some additional reserves was probably the right reaction at the time.”, are you actually endorsing the idea of central banking or are you on the side of governement-free money and just observing that the Fed did the best it could do?
Thanks!
Comment by DD on 6 January 2010:
“Given the worries about a cascade of bank failures and the major deflationary effects this would have had on the money supply and the economy as a whole, injecting some additional reserves was probably the right reaction at the time.”
For me, to hear or read this sort of stuff from proclaimed followers of Mises is very troubling, although, Dr. Horwitz is an intellectual by his own accomplishments and is entitled to his own views.
This sort of view is first of all completely in conflict with any of the conclusions of the calculation problem (or information problem) of central planning. Dr. Horwitz is now giving a subjective opinion regarding whether the Fed should have acted and if he did, was the amount of liquidity injection appropriate. This is almost like, now that we have a crisis, forget about markets and economic calculation. Let’s centrally “plan” our way out of this. He’s not entirely saying this, but he’s almost saying this.
Also, Dr. Horwitz knows better. He knows that the injection of liquidity is not backed by real savings. He knows that at least some of it in the future will be used as a reserve stock to pyramid multiple loans not backed by real savings causing another (perhaps bigger) crisis in the near future. Some of it is already leaking out via new demand deposits (see growth of M1). So why is temporarily saving big wall street banks a viable economic option when it is only prolonging the “day of reckoning” and setting up a much more devastating problem down the road?
Besides, if Capital theory and the Austrian Business cycle still means something here, then how is the Fed (even hypothetically) taking out the money not going to just trigger the next bust anyway?
These sort of deviations from the sound Austrian theory are very troubling. It is almost as if instead of Monetarists drifting towards Austirans, a few Austrians are drifting towards Monetarism.
Comment by Beefcake the Mighty on 6 January 2010:
Steve finds great significance in some comments Mises makes in this set of lectures:
http://www.fee.org/pdf/books/Free_Market_and_Its_Enemies_The.pdf
specifically in Lecture 6, regarding the definition of inflation. However, he seems to be silent on the discussion in Lecture 8, where Mises makes statements (which, BTW, already existed in his early work, Theory of Money and Credit) clearly at odds with the central tenet of free banking, namely that money supply should change to meet demand for it, as for any other good (the analogy fails due to the fact that demand for fiduciary media is NOT independent of the banks’ willingness to issue them).
The fact is, Mises was very inconsistent in his early writings on monetary theory; he was much sounder in his later work (e.g., Human Action), and, not coincidentally, closer to Rothbard’s position. See the great discussion by Gertchev here:
http://mises.org/journals/jls/18_3/18_3_4.pdf
Hopefully the content of this work can be considered, and not dismissed as being published in a less-than presitigious journal. But hey, we’re at the Freeman blog, right? So that shouldn’t be an issue.
Comment by DD on 6 January 2010:
Beefcake,
The argument just made by you (and often other free bankers) that somehow the debate is (at least partially) about whether the money supply can and should change to meet demand is, in fact, a straw man argument.
See the 1st paragraph of the quote I provided by Rothbard in the comment to Dr. Horwitz above. Here it is again:
“How much gold will be mined at any time will be a market choice determined as in the case of any other product: by estimating the expected profit. That profit will depend on the monetary value of the product compared to its cost. Since gold is money, how much will be mined will depend on its cost of production, which in turn will be partly determined by the general level of prices. If overall prices rise, costs of gold mining will rise as well, and the production of gold will decline or perhaps disappear altogether. If, on the other hand, the price level falls, the consequent drop in costs will make gold mining more profitable and increase supply.”
Rothbard clearly is describing a sort of natural “equilibrium” theory himself regarding the market production of money in response to demand for that money.
The issue according to Rothbard, 100% reserve advocates, and I also contend it is according to Mises, is this:
1. Equilibrium does not have to be reached by changes in money supply, but also by changes in prices. Unless you take the naive view that falling prices is bad (even Milton Friedman conceded this not to be a myth), then the issue of how equilibrium is reached is of no concern. The market is capable of coordinating the structure of production to changes in time preference, it is therefore, certainly capable of coordinating changes to changes in demand to hold cash, which itself is also a change in time preference. Mises describes equilibrium being met by changes in prices many times. He never suggests that fiduciary media can in any way satisfy this purpose or for any other beneficial purpose.
2. The fiduciary media is not money, nor is it money substitutes. Mises himself explicitly points this out in Human Action (Do I need to fetch the quotes?). So to advocate a response to demand by issuing fiduciary media is to completely misunderstand the economic effects of issuing credit in excess of real savings, at least from the point of view of Misesian economics.
Comment by Beefcake the Mighty on 6 January 2010:
DD, just so there’s no misunderstanding, I’m on the Rothbardian side of this debate. And I dispute your claim that the need for an adjustment of money supply to meet money demand is not a key plank of the free bankers platform. I’m guessing Steve would disagree with you as well.
Comment by JCR on 6 January 2010:
From my reading of Rothbard, I have always thought that he found that fractional reserve banking was a crime in the context of the current central-banking-based money system. But, I was also under the impression, that under a free-money system, Rothbard would not say it is a crime but more a dummy business model that would not attract anybody.
Comment by Steve Horwitz on 6 January 2010:
Jean-Christophe,
Your first question: sales of assets at lower prices can’t reduce the price level unless there’s a deficient supply of money. Price indexes may not capture it all, but if some good is selling at a lower price than it was before, the dollars that were previously spent on it are either going into people’s money holdings (which in the absence of a change in the money supply will reduce the price level eventually) or being spent on other goods, which will counteract the decline from the asset. So asset sales by themselves, if the supply of money is sufficient, are not enough to generate across the board deflation. The declining prices of those assets may well be a necessary part of the microeconomic adjustment process of the bust, but they themselves cannot cause deflation.
Your second question: I was simply pointing out what I would argue the central bank should do *given* that central banks exist. I have long been a defender of the elimination of central banks and of open competition in the production of money (free banking, specifically).
Comment by Steve Horwitz on 6 January 2010:
DD,
Your charges of, for lack of a better word, apostasy against Mises and Austrian economics are exactly the problem with so much of the Austrian economics movement these days. The fact that my views don’t match what you think Mises had to say bothers me not in the least. You can ex-communicate George Selgin and Larry White and Roger Garrison while you’re at it too. Like Mises, I am interested in understanding how monetary systems work and I will draw on whatever work I think provides that understanding.
I don’t think my arguments about what the Fed should have done (in the world of the second best) are in conflict with what good monetary economics (and a good understanding of history) suggests. Are they in conflict with the Rothbardian reading of Mises? Yes. Are they in conflict with Mises himself? Maybe, maybe not. But it matters not to me. I owe no fealty to Mises or Hayek or anyone else. There’s a whole great big world of good monetary economics out there that can inform our understanding of how markets work and how government screws things up. Mises and Hayek and Rothbard didn’t have it all themselves.
You should perhaps read my book to see more. All I’ll add at this point is that the creation of fiduciary media when done in response to an increased demand to hold bank liabilities is indeed backed by real savings. Your rather condescending suggestion that I know better is simply misguided. I would argue it’s you who have missed the boat on this one in not understanding how the banking system works.
Much of this debate does hinge on whether we can rely on the price system to adjust out monetary disequilibria with less pain than changing the nominal money supply. I think the latter is the way to go. Others disagree. But to be “troubled” because I appear to have committed heresy against the Church of Mises is to reflect the sort of hagiographic attitude that undermines the status of Austrian economics as a serious intellectual enterprise.
Comment by Steve Horwitz on 6 January 2010:
JCR,
Rothbard and many of the current Rothbardians think fractional reserve banking is inherently fraudulent, not just a bad business model, under any circumstances.
The irony of the “bad business model that won’t attract anyone” view is that 100% reserve banking is an *awful* business model, which is the major reason why it has never been able to compete with fractional reserve systems even in the absence of central banking and other government interventions. Who wants to pay someone to store their money when they can lend it to someone else at interest and acquire a more efficient means of payment, with only the tiniest of risks that the bank will breach its contract and not be able to pay outside money on demand? If history is a guide, the answer is “pretty much no one.”
Question: why would the existence of a central bank make a contract that would just be “bad business” otherwise into something fraudulent? If the fraud comes from the very notion that your money isn’t there waiting for you (or that everyone can’t redeem at once), why does central banking make a difference?
Comment by DD on 6 January 2010:
Dr. Horwitz
I find your sarcastic remark about “The Church of Mises” rather ironic.
My whole intention was not to debate free banking but to protest against what I see as a misrepresentation and a false dichotomy that is so often repeaded by you and free banking advocates; namely, that there is Missesian economics as oppose to Rothbardian economics. This is completely fallacious, and to support this false dichotomy, a constant barrage of false interpretations and misunderstandings about Mises and Rothbard must be always repeated. Frankly, I don’t think it is made out of wicked intentions, but out of what I see as misunderstandings. Example; your unfamiliarity with Rothbard’s descriptions of what constitutes “good” and legitimate increase in money supply as explained in the quote I provided. The quote by Rothbard (1st paragraph) actually provides an explanation of a sort of “Equilibrium Theory” for the money supply.
Anyway, I still appreciate the exchange.
Comment by Beefcake the Mighty on 6 January 2010:
Steve, you need to tell Pete that you guys missed a golden opportunity to change your blog name to The Austro-Keynesians.
BTW, I’ve stopped following that thread at NPR; did you ever respond to the guys who exposed your weak understanding of Keynes?
Comment by Steve Horwitz on 6 January 2010:
DD,
The paragraph from Rothbard (I assume you mean the one about gold production responding to demand) misses the point. It assumes away the problem that the monetary equilibrium theorists point to: the fact that prices can’t just adjust smoothly. What I think you want that paragraph to say is that if the demand for money rises and therefore prices fall, the costs of mining fall and more gold (money) will be produced. This process takes time and assumes that the fall in prices in response to the rising demand for money will take place unproblematically.
Maybe it will, maybe it won’t, but this is the point that monetary equilibrium theorists contest. And we contest it because we agree with the Austrian view that markets are processes that take place through real time and thus happen in uneven ways that involve errors etc.. It’s why we think inflation is so problematic too. The Rothbard quote assumes away what the MET folks think is the key problem that has to be dealt with.
Relying on movements in the overall level of prices to “solve” monetary disequilibria is both highly costly and unnecessary, when changes in the nominal supply of money can solve it without the damaging economic consequences of relative prices that don’t respond immediately and smoothly and without creating any real costs of its own.
And it remains the case that my views are suspect in your eyes because I deviate from your understanding of Mises. The implication is that Mises’s views (assuming you have understood them accurately) are the arbiter of economic truth. As you put it “For me, to hear or read this sort of stuff from proclaimed followers of Mises is very troubling.” What’s “troubling” about my argument other than that it doesn’t correspond to what you think a Misesian should believe?
Let’s assume you’re actually right about Mises’s views. Maybe, just maybe, Mises was wrong, or at least ambiguous enough to allow my views to be plausibly Misesian. Thus maybe, just maybe, my “sort of stuff” is right, regardless of whether it’s what Mises believed or not.
To hold Mises’s views as the arbiter of truth is to engage in what I called the Church of Mises. And Mises would be the first one to leave that church.
Comment by Beefcake the Mighty on 6 January 2010:
Rather ironic to see Steve speak of the “Church of Mises,” since he’s the main preacher there when the debate turns to whether Mises and Hayek had differing views on the nature of socialism.
Here’s a couple more papers that more than adequately refute the FB/MET position:
http://mises.org/journals/qjae/pdf/qjae1_1_2.pdf
http://mises.org/journals/qjae/pdf/qjae1_4_2.pdf
Comment by JCR on 6 January 2010:
>Question: why would the existence of a central bank make a contract >that would just be “bad business” otherwise into something >fraudulent? If the fraud comes from the very notion that your money >isn’t there waiting for you (or that everyone can’t redeem at once), why does central banking make a difference?
Because central banking ensures that property rights of every one are damaged by the practice of fractional reserve banking. Central Banking assumes a monopoly over money and its creation.
A contrario, the practice of fractional reserve banking between customers A, B, C and banks Alpha and Beta all using the same money would not affect other people going to bank Gamma using another kind of money and not practicing fractional reserve banking. Also, it is quite clear that the Federal Reserve and other Central banks are not explaining clearly that the money is actually gone and printed if needed.
Comment by DD on 6 January 2010:
“Let’s assume you’re actually right about Mises’s views. Maybe, just maybe, Mises was wrong, or at least ambiguous enough to allow my views to be plausibly Misesian. Thus maybe, just maybe, my “sort of stuff” is right, regardless of whether it’s what Mises believed or not.”
No argument here. If the label “Rothbardian” wasn’t constantly used, I don’t think I would have even mentioned Mises (if i had even commented).
“This process takes time and assumes that the fall in prices in response to the rising demand for money will take place unproblematically.”
No, not at all. It just assumes that the market can coordinate (like there is a choice, right?) the change in the structure of production in precisely the same manner as any increase or decrease in time preference. Rothbard is the very last person to make any analysis, of increase or decrease in the money supply, by committing the monetarist/friedmenite “crime” of analyzing such changes from a macro perspective. Rothbard simply assumes the changes will eventually take place, and he is avoiding the complex hayekian micro-analysis of how the process takes place. This book is a rather basic introduction to banking. Not an exposition in Capital Theory.
“Relying on movements in the overall level of prices to “solve” monetary disequilibria is both highly costly”
You still (in my opinion) never make the case to as why this is any more “costly” then then the general case of any change in time preference and the lowering or rise of the interest rate. There too, the structure of production must, by the [marvelous] price system and entrepreneurship, be coordinated the changes in the structure, coordination changes that, apparently, most mainstream economist still cannot comprehend to this day. A change in demand to hold money is after all, a change in time preference.
“when changes in the nominal supply of money can solve it without the damaging economic consequences of relative prices that don’t respond immediately and smoothly and without creating any real costs of its own.”
Now you assume that the rise in the money supply will take place unproblematically. The same charge you wrongfully made against Rothbard about falling prices, which I have addressed above. Of course, any increase in money supply,especially by issuing the money in the form of bank loans, would exert micro-effect changes in prices. You almost have to make the Friedmanite error of ignoring the micro effects to claim that the market can better respond to an increase in money supply as oppose to a drop in prices. This just doesn’t make any sense.
The problem is not market money and its producers responding to changes in demand (as Rothbard points out in the quote, the market can produce money in response to demand). The problem is that the fiduciary media is not necessarily equivalent to money or money substitutes for various reasons, which I presume you may not agree with. In any event, you or anybody else, to my knowledge, have not made the convincing case regarding a few very problematic economic objections made many times in the past. Here are just two of them:
1. How do you avoid issuing credit beyond the amount of bank notes that the public is willing to hold on to. That is, not to put the notes into circulation by spending them. In other words, how do you avoid the multiplier factor assuming FRB actually takes place in a free banking environment? It also must assume that banks cannot “cheat” and use clearance mechanisms to avoid tranfers of physical specie, for then, expansion beyond what is actually held (not spent) starts to take place.
For example, Selgin often gives the example of $100 deposited and with 10% reserves, the bank lends $90. So there is no issuing of credit beyond the $100 that is held by the depositor. Even assuming that the $100 is really being held (not spent by check book money and banks use clearance mechanisms). But how do you avoid a second bank receiving the $90 deposited from issuing credit for $81. Already at this point, you have issued more credit then what is actually held/saved. Taking this further of course you will issue $900 of new credit, well beyond the $100 of bank notes held.
2. How can you “insure” against a possible bank run when it is not possible to apply the law of large numbers to any business, let alone, a Fractional Reserve system? This goes into the distinction between class probability and case probability. Banking (as other businesses) fall within the realm of human action. The uncertainty of business ventures is not insurable, thus, it seems that any theory based on probability to calculate a proper reserve ratio is invalid.
Comment by DD on 6 January 2010:
Dr. Horwitz,
The above response (rather long) is addressed to you. Responding to comments in such a forum is not always pleasant. I can understand this. If you choose not to respond, I will not hold it against you and think that you have surrendered.
Comment by Steve Horwitz on 7 January 2010:
JCR writes: “Because central banking ensures that property rights of every one are damaged by the practice of fractional reserve banking.”
That may be true, but that’s not fraud. I take that sentence to mean that the inflationary tendencies of central banks harm the value of everyone’s money – is that right? I don’t see how that is a property rights violation though. I also disagree that the current banking system doesn’t explain to customers the nature of the agreement between the bank and the depositor. At least in the US, you just need to read the paperwork you sign when you open an account. Plus, the fractional reserve contract is not the business of the central bank, it’s between individual banks and their depositors. To me, that’s the key: whether you have central banking or not, the contract that is at dispute in the Rothbardian view is the one between the depositor and the bank.
Comment by Steve Horwitz on 7 January 2010:
DD,
Those are terrific questions and this is indeed not the best forum to answer them, especially since the free banking literature has addressed them in various places. Again, I encourage you, if you haven’t already, to read Selgin, White, or my own work (my book esp.) to see those responses.
Comment by Sheldon Richman on 7 January 2010:
I’m no expert on monetary theory, but I am quite certain that what’s at issue here is whether or not Professor Horwitz’s argument is valid — not whether it conforms to the views of this or that thinker. The article isn’t about the history of economic thought. It’s about monetary theory.
Comment by Beefcake the Mighty on 7 January 2010:
Steve’s latest respsonse comes as no surprise to anyone who’s followed debates at his blog, where questions he can’t answer are characterized as “terrific” and directions given to the larger literature. For example, how would banks under free banking actually meet the demand of the specific market actors whose demand to hold money has increased, given that in actuality banks can only increase their lending to the market as a whole? That non-monopolistic banking could do a better job than central banking (and could it, really) is not an answer.
Comment by Steve Horwitz on 7 January 2010:
One more for DD:
You say Rothbard didn’t advocate prohibiting fractional reserve banking. If he really thought it was fraudulent, which he did, how could he not attempt to prohibit it? Can you think of any other examples where Rothbard thought a behavior was coercive but didn’t think it should be prohibited or punished if practiced?
And…how else to interpret the very end of “The Case Against the Fed”?
“Even though the Fed would be abolished
and the gold coin standard restored, there would, at this
point, be no outlawry of fractional-reserve banking. The
banks would therefore be left intact, but, with the Federal
Reserve and its junior partner, federal deposit insurance,
abolished, the banks would, at last, be on their own, each
bank responsible for its own actions. There would be no
lender of last resort, no taxpayer bailout. On the contrary, at
the first sign of balking at redemption of any of its deposits
in gold, any bank would be forced to close its doors immediately
and liquidate its assets on behalf of its depositors. A
gold-coin standard, coupled with instant liquidation for any
bank that fails to meet its contractual obligations, would
bring about a free banking system so “hard” and sound, that
any problem of inflationary credit or counterfeiting would
be minimal. It is perhaps a “second-best” solution to the ideal of treating fractional-reserve bankers as embezzlers, but it
would suffice at least as an excellent solution for the time
being, that is, until people are ready to press on to full 100
percent banking.”
Rothbard clearly says that his proposal there is a “second best” to the ideal of treating frb as embezzlement and having only 100% reserve banking. How else can one read that but as MNR arguing that in the first-best libertarian world, FRB would be illegal with only 100% reserves allowed?
Comment by Beefcake the Mighty on 7 January 2010:
Wow, for once I’m agreement with Steve. DD, you are clearly wrong about Rothbard’s position: he opposed FRB as inherently fraudulent and advocated its abolition. That is clear throughout his writings.
Comment by David Hillary on 7 January 2010:
I find it hard to understand why Dr Horwitz does not link long term prive level trends, under a commodity money standard, with the relative price of the monetary commodity. If technological progress and productivity improvements will drop the price of potatoes, hamburgers, road tolls, medical services and gasoline, why not the price of the monetary commodity too?
Comment by Jonathan Finegold Catalán on 7 January 2010:
David Hillary,
Increases in productivity does not cause a general fall in the price level. It causes a fall in the price level of the good(s) which are being produced with greater efficiency and in greater quantities. Over time, it is expected that all goods and services will be affected by increases in productivity, so overtime there is a general trend of deflation.
Commodity money, like gold, is chosen because its rare, durable and difficult to inflate. Of course, techniques in gold production may increase the supply of gold, devaluing gold. It has happened before, but gold is notably more difficult to produce in greater quantities than say, computer hardware. But, commodity moneys are not chosen arbitrarily; characteristics of stability are some of the reasons why they are chosen as mediums of exchange.
Comment by David Hillary on 7 January 2010:
Jonathan, good answer, but it is only an empirical answer, Horwitz seems to be arguing as if it is a priori.
Comment by Steve Horwitz on 7 January 2010:
FWIW, I agree completely with Jonathan’s response. The first paragraph is particularly important and is an argument I’ve made in print in a couple of places, following Selgin’s work.
Comment by David Hillary on 7 January 2010:
Steve and Jonathan,
Correct me if I’m wrong, but I thought that inflation adjusted prices of basic materials were supposed to have a downward trend, according to free market economists (e.g. see http://en.wikipedia.org/wiki/Simon-Ehrlich_wager ).
If this applied to the monetary metal, this would imply a long run inflation trend, no?
Comment by Steve Horwitz on 7 January 2010:
Not if the amount of the monetary metal required to “run” the monetary system is progressively less due to advancements in banking technique etc.. The quantity of gold it would take to run a fractional reserve free banking system would actually be very, very small.
Comment by David Hillary on 7 January 2010:
Also, price stability is just one factor for use of a commodity as a money. In the developmental stages, short term transaction costs, e.g. storage, perishing, transport, measurement and divisibility, would dominate, I would think. When the commodity becomes generally accepted, its marketability advantage grows to make it dominant. I don’t see how long term credit contracts (or storage intentions) can drive the adoption of a commodity as money, on the basis of value stability.
It is interesting to note the displacement of the silver standard with the gold standard. I would expect this would be due to the need to conduct high value transactions, and the development of the composite standard, so that silver and copper coins could become de facto promissory notes for small change (since regular bank notes for small change appears to have been commonly restricted).
Comment by David Hillary on 7 January 2010:
Steve,
if there is a structural adjustment towards replacement of metal with credit (i.e. bank notes and demand deposits), then this would provide a temporary inflation effect: a lower price of gold for a period of time, so that the stock of gold could be depleted, compared to if that change did not occur. After the structural adjustment has taken place, the price of gold must go back up, to bring mine supply back to consumption demand, otherwise the gold stock will continue to deplete to zero. But banks and non-banks still need some non-zero stock of gold to settle their obligations and meet their needs, and I argue that they will demand to hold some gold and will foregone interest on securities to hold it. The price of holding metallic money is foregone interest, and the lower the stock of gold, the higher the price banks etc. are willing to pay to hold a share of it (see White’s bank profit maximisation model).
I argue that the gold stock has a productive yield, and that the capital stock should therefore be balanced between metallic money and other forms of capital. Whatever this balance is, it will have no long term impact on the relative price of gold. The gold stock can go up and down only by periods of time when the gold price is above or below equilibrium.
Pingback by Getting in Deeper | The Freeman | Ideas On Liberty on 7 January 2010:
[...] The government’s money managers are willing to risk inflation to avoid deflation. Good idea? Steven Horwitz distinguishes good deflation from bad. [...]
Comment by DD on 7 January 2010:
Dr. Horwitz,
“Rothbard clearly says that his proposal there is a “second best” to the ideal of treating frb as embezzlement and having only 100% reserve banking. How else can one read that but as MNR arguing that in the first-best libertarian world, FRB would be illegal with only 100% reserves allowed?”
First, it is very important to always remember that Rothbard is always talking about demand deposits with the contractual obligations to redeem all specie on demand without delay (no clause or anything). He wouldn’t see FRB operating in any other way.
But he’s not asking for any special prohibition or regulation. He sees Fractional Reserve Banking as embezzlement and he’s asking to recognize it as such, and therefore to enforce the already existing anti-fraud laws that exist for every other business. He makes this point very clear in “Mystery of Banking”. The “second best” is on the account that the practice is still not fully understood and recognized by the law as embezzlement.
Many good people have never had a chance to read “The Mystery of Banking”. But this is probably the best place to get exactly the “Rothbardian” position on Fractional Reserve Banking. I don’t know if you’ve read it, but I think most people who do will agree with my interpretation.
Comment by Jonathan Finegold Catalán on 7 January 2010:
David Hillary,
I have always believed that the value of individual weights of commodity money, such as gold, would increase over time, yes. This is one of the arguments behind the productivity theory of wages. The price of goods and services would decrease faster than the value of the money being used, and even the money being used would rise in price as other goods deflated in price.
I am sure that free bankers may disagree over the size of the money supply, although I admit to not being very well-read on their beliefs (the only free-banking book I own/have read is Sechrest’s Free Banking, which I consider a mere primer and I am re-reading soon enough). That said, I disagree with Professor Horwitz over his opinions on fractional-reserve banking, but I am sure I would just be regurgitating arguments already put forth. That said, I am also sure that he has no interests in discussing in this thread the merits or the problems with fractional-reserve banking.
So, I agree that the price of gold as a metal would increase over time. I thought this came hand in hand with my previous belief that while goods and services generally undergo steady price deflation, due to higher productivity and capital accumulation, this was not necessarily true of commodity money (at least a commodity money chosen due to its relative stability in value; or, at least, protection against losing value, instead of gaining value).
Before concluding, I wish to inquire upon one of your points in your previous post:
I don’t want to unjustly accuse you of muddling definitions, but I think there needs to be a clarification. Today, inflation generally refers to price inflation in regards to the goods and services you buy with your money substitute (given that we don’t use money, but we can assume we can use money for simplicity). This means that your money, or money substitute, is losing value, or is deflating (in price). When there is a trend of general price deflation, the value of money tends to inflate.
Or did I misunderstand you? I admit to misinterpreting arguments here and there!
Comment by Steve Horwitz on 7 January 2010:
DD,
You say: “But he’s not asking for any special prohibition or regulation. He sees Fractional Reserve Banking as embezzlement and he’s asking to recognize it as such, and therefore to enforce the already existing anti-fraud laws that exist for every other business.”
So now we are arguing semantics. There’s no special prohibition or regulation specifically stating that a Ponzi scheme is illegal because it’s fraudulent, but so what? It’s still “prohibited.” There’s probably no specific law that says I can’t assault my wife with the bone from a standing rib roast, but we all know it’s “prohibited and regulated” by the general laws against assault.
By your logic, my doing that to my wife isn’t prohibited because there’s no specific law against it. Do you really believe that?
As long as you agree that Rothbard thinks FRB is fraudulent, then you agree that it is not permitted in a free society. However such a society enforces prohibitions on fraud in general it will apply to FRB. This is now purely a semantic dispute as you clearly have admitted that in Rothbard’s world, FRB would not be allowed:
“He sees Fractional Reserve Banking as embezzlement and he’s asking to recognize it as such, and therefore to enforce the already existing anti-fraud laws that exist for every other business.”
What the difference is between the above statement and saying FRB is “prohibited” is beyond my ability to discern.
Comment by DD on 7 January 2010:
Dr. Horwitz
“However such a society enforces prohibitions on fraud in general it will apply to FRB. This is now purely a semantic dispute as you clearly have admitted that in Rothbard’s world, FRB would not be allowed:”
The end result may be the same, but I don’t agree that this is just about semantics.
There is a major difference in principle between placing a prohibition against a specific practice, as oppose to identifying it as a fraudulent practice (assuming that it is). The first can be arbitrary and not confine to any property rights violation, while the latter is clearly recognized by society as a violation of private property rights. The property right violation is of course the bank cannot contractually agree to redeem on demand without delay and also to lend out the money. (There is arguments about the 3rd party violations but that is a different debate).
So any accusation against the hard money guys that they are advocating for an authoritarian regulation is a non-sequitur, and show that it is such, you must make the distinction.
Comment by David Hillary on 7 January 2010:
Jonathan,
I’m merely observing that:
1. Some famous free market economists or advocates support the idea that the world is not running out of natural resources, and that the prices of basic industrial inputs or raw materials should be falling *relative* to the whole basket of consumer goods (i.e. finished goods), that is to say ‘inflation adjusted’ prices of such industrial inputs should have a long term falling trend. They even had a wager on it with some famous anti-free-market alarmist and won.
2. Then we have yourself and apparently Horwitz (and I’ve heard the claim from others before too) saying that they think gold should be expected to rise in price compared to consumer goods, when the standard money is gold coin (and perhaps when it’s not).
I am just saying I find it a bit odd, the differences in position here. The two claims are opposite, but apparently held within the same camp. I’m also pointing out that it is an error of reasoning to say that just because productivity increases generally that the price of good A in terms of good B will change. Of course it could be that gold is an exception to the general situation for raw materials, so one could hold both 1. and 2. without contradicting oneself (i.e. 1. is a generalisation only).
I don’t think it matters a lot, but I’d expect that the price of gold would probably fall compared to consumer goods over time, as I’m inclined to believe 1. and not 2.
Comment by Jonathan Finegold Catalán on 7 January 2010:
David,
Even if we assume that we are running out of certain raw materials, this should play little bearing in deciding whether or not prices will rise or fall over the long-run. In fact, greater costs of production will probably lead to a higher efficiency in production to use less of these costly materials. That said, I’m not sure either Professor Horwitz or I ever suggested that all goods will decrease in price overtime. In fact, I explicitly suggest otherwise in my first response, and Prof. Horwitz seems to agree. Increases in productivity will lead to a reduction in the cost of the goods which are subject to the increase in productivity.
A general decrease in the price-level may, and probably would, occur over the long-run, but this does not suggest that all goods will increase in price. Even today, while we are experiencing a general increase in the price-level, a large amount of goods are actually decreasing in price.
So, in regards to point number one, while what you say might be true it has absolutely no bearing over the accuracy of Prof. Horwitz’ article. That said, number two and number one are not mutually exclusive. If one good becomes cheaper in gold, it does not follow that all goods are cheaper than gold. I am not sure where the source of your confusion is, but it is clear that you are not addressing what Prof. Horwitz’ originally claimed in the article above.
You say:
If good B is chasing good A, and the amount of good A increases, then the marginal value of good B will increase as compared to the marginal value of good A. I am not sure where the lacuna in the logic is.
Comment by David Hillary on 7 January 2010:
Jonathan, Horwitz’s article is all about inflation and deflation, he’s talking about, for want of any better measure, consumer price inflation measured by the CPI. Horwitz also says:
“The Good
If the monetary system is doing its job and matching changes in money demand with changes in supply, the long-term trend of the price level will be gently downward as economy-wide productivity rises. Put differently, increased productivity will cause benign price deflation as the real cost of goods and services falls.”
This statement is perplexing for a number or reasons.
Firstly, the monetary equilibrium theory — which is I think what Horwitz is referring to by the term ‘doing its job’ — says (as far as I understand it from the above article) that the banking system is supposed to supply as much money as people demand to hold, no more and no less, so that the price level is static. Taken on its own, this would imply no long term trend — the short run eqililibrium would continue forever, no?
Secondly, he is referring to nominal price declines as a result of changes in the real cost of goods and services. However, under a gold standard, the nominal price level is the real price of gold, compared to consumer goods and services. Horwitz is mixing nominal and real in a confusing way to make a point that doesn’t follow about the price of gold.
Thirdly, he is apparently using labour as a measure of value, in referring to living standards. However, last I heard the labour theory of value was in the intellectual dustbin. What Horwitz is saying is that, *compared to labour* the prices of goods should go down over time, therefore *compared to gold* the prices of goods should go down over time too. That doesn’t follow. I could maintain, contrary to Horwitz, that the long run trend for the price level was up (i.e. inflation, if I followed point 1. in the previous comment), and that living standards would nevertheless rise with productivity improvements. This would imply wages grew faster than prices.
Comment by Steve Horwitz on 7 January 2010:
David,
You are totally misunderstanding the argument. The easiest response is for me to suggest you read Selgin’s *Less than Zero* which can be found here: http://www.iea.org.uk/record.jsp?ID=98&type=book
Monetary equilibrium theory does NOT predict a stable price level if MS = MD. This is exactly the/Selgin’s point. The price level is influenced by both monetary and real factors. If ME is maintained, the price level will move inversely to productivity changes, as I argue above. An economy with a banking system that minimizes deviations from ME will see slow, long-run price deflation as its productivity grows.
Comment by DD on 7 January 2010:
“Monetary equilibrium theory does NOT predict a stable price level if MS = MD”
No, but I’m afraid you may never manage to get rid of these misunderstdings. By the way, when you hear the terms “Monetary theory”, one cannot resist the temptation to accuse you of advocating “planning”. It is a reactionary response of any free marketeer.
Please correct me if I have this wrong.
First, monetary equilibrium is basically about the market equilibrium point between the supply of money and the demand for it just like any other commodity on the market. The market can respond to changes in demand by a drop in prices so that the value of the money (purchaing power) increases, or by production of more money so that the demand can be satisfied by an increase in the money supply.
Your (Horwitz) Monetary equlibrium theory specifically address the latter and claims that this increase in money can be satisfied rather efficiently by bank issuing of fiduciary media.
Comment by David Hillary on 7 January 2010:
Thanks Steve, I’ll take a look.
Comment by Steve Horwitz on 8 January 2010:
DD,
You have it wrong.
“Monetary theory” and “monetary equilibrium” are commonly used phrases in the economics profession and there’s absolutely no reason in the world why anyone should interpret any political content to them whatsoever. Any “free marketeer” who hears that as “monetary planning” is just invoking some reflex ideological response of their own making (that I don’t understand) and revealing ignorance about basic economic ideas, Austrian and otherwise.
Your claim that markets can adjust to monetary disequilibria by movements in prices proves too much. If that’s true, and it’s harmless, then why worry about INflation? If there’s too much money, “the market can respond to changes in supply by a rise in prices so that the value of the money decreases.” What is the logical fallacy there? If you believe that prices can’t just costlessly adjust UPward, why accept that they can do so DOWNward?
Comment by Beefcake the Mighty on 8 January 2010:
Perhaps Steve hadn’t noticed that inflations (as opposed to deflations) are invariably the result of violent interventions in the market, and not changes in supply and demand. Hence the concern.
Comment by DD on 8 January 2010:
Dr. Horwitz,
Nobody is worried about inflation per se. We’re worried about a central authority that even if it wanted to, has no economic and rational means to respond to the true market’s demand for money, and neither does it have any method of injecting it (or taking out) without causing an intertemporal distortion in the structure of production.
I honestly don’t understand the premise that you are working from. but I do plan to read more. The whole “coordination problem” is solved by movements of prices. The market can decide on the most efficient way to meet any changes in demand.
I don’t like the terms “harm” or “harmless” when pertaining to free markets. When the preferences of individuals change then it is, in my opinion, nonsensical to ever describe anything as harmful.
I didn’t quite get you response. Was I wrong about the theory or about the comment about “monetary theory”?
Comment by Steve Horwitz on 9 January 2010:
DD,
I’m worried about that central authority too, which is why I’m a free banker. What makes you think I’m NOT worried about it?
You were wrong about the “monetary theory” part. Your description in the last two paragraphs is more or less correct.
Comment by David Hillary on 10 January 2010:
Steve,
I read Selgin’s deflation work as you suggested and it does not address the flaw at all.
Selgin argues for a particular fiat money central bank monetary standard rule, basically stabilising factor prices rather than consumer prices. Selgin thus connects deflation not with productivity growth as a matter of natural course under a metallic standard, but as a matter of design under his proposed fiat money standard rule.
Under a metallic standard ‘whether there is price inflation or deflation in our economy — that is, a trend in the purchasing power of money — will depend, as in any sort of gold standard regime, on the secular trend in the globally determined purchasing power of gold.’ (White, Free Banking In Britain, p 11). White goes on to argue that this would be determined by the stocks of gold compared with the demand to hold those stocks, and I think this is an error (it should be, like for any other produced commodity, production and consumption demand flows as functions of price). However just a few pages later he finds that even when there is no gold stocks and no demand to hold gold stocks, he correctly argues ‘nominal magnitudes are yet anchored by the redeemability of bank monies for fixed quantities of gold and the relative price of gold set by its non-monetary demand and supply.’ (p 12). So I ask, why doesn’t this anchor operate under non-zero gold stocks and demands to hold gold?
I return to the same points I made before: the price of gold under a gold standard has no logical link with productivity levels. For example, the productivity improvements could be greater in the gold mining business than in the business of making shoes, cars, haircuts, beer or medicine, resulting in rising real wages and rising consumer prices (i.e. wages rise faster than prices). Or the demand to use gold in industry could fall (or rise) resulting in a higher (or lower) price of gold.
The connection between productivity growth and deflation are based on a macroeconomic models and its assumptions. I’m not sure if I understand the models well enough to comment on whether this conclusion follows from the assumptions (I always have this niggling suspicion something isn’t quite right but it is hard to identify what the something is), but the conclusion of the model does not seem to fit the situation where the monetary standard is a produced commodity such as gold, where microeconomic theory would suggest an exogenous anchor.
Comment by David Hillary on 10 January 2010:
Correction to: ‘Or the demand to use gold in industry could fall (or rise) resulting in a higher (or lower) price of gold.’
should be the other way around: Or the demand to use gold in industry could fall (or rise) resulting in a lower (or higher) price of gold.
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