The Iinflationist View Of History

This chapter from Human Action is spot on for today:


18. The Inflationist View of History

A very popular doctrine maintains that progressive lowering of the monetary unit’s purchasing power played a decisive role in historical evolution. It is asserted that mankind would not have reached its present state of well-being if the supply of money had not increased to a greater extent than the demand for money. The resulting fall in purchasing power, it is said, was a necessary condition of economic progress. The intensification of the division of labor and the continuous growth of capital accumulation, which have centupled the productivity of labor, could ensue only in a world of progressive price rises. Inflation creates prosperity and wealth; deflation distress and economic decay.[25] A survey of political literature and of the ideas that guided for centuries the monetary and credit policies of the nations reveals that this opinion is almost generally accepted. In spite of all warnings on the part of economists it is still today the core of the layman’s economic philosophy. It is no less the essence of the teachings of Lord Keynes and his disciples in both hemispheres. The popularity of inflationism is in great part due to deep-rooted hatred of creditors. Inflation is considered just because it favors debtors at the expense of creditors. However, the inflationist view of history which we have to deal with in this section is only loosely related to this anticreditor argument. Its assertion that “expansionism” is the driving force of economic progress and that “restrictionism” is the worst of all evils is mainly based on other arguments. It is obvious that the problems raised by the inflationist doctrine cannot be solved by a recourse to the teachings of historical experience. It is beyond doubt that the history or prices shows, by and large, a continuous, although sometimes for short periods interrupted, upward trend. It is of course impossible to establish this fact otherwise than by historical understanding. Catallactic precision cannot be applied to historical problems. The endeavors of some historians and statisticians to trace back the changes in the purchasing power of the precious metals for centuries, and to measure them, are futile. It has been shown already that all attempts to measure economic magnitudes are based on entirely fallacious assumptions and display ignorance of the fundamental principles both of economics and of history. But what history by means of its specific methods can tell us in this field is enough to justify the assertion that the purchasing power of money has for centuries shown a tendency to fall. With regard to this point all people agree. But this is not the problem to be elucidated. The question is whether the fall in purchasing power was or was not an indispensable factor in the evolution which led from the poverty of ages gone by to the more satisfactory conditions of modern Western capitalism. This question must be answered without reference to the historical experience, which can be and always is interpreted in different ways, and to which supporters and adversaries of every theory and of every explanation of history refer as a proof of their mutually contradictory and incompatible statements. What is needed is a clarification of the effects of changes in purchasing power on the division of labor, the accumulation of capital, and technological improvement. In dealing with this problem one cannot satisfy oneself with the refutation of the arguments advanced by the inflationists in support of their thesis. The absurdity of these arguments is so manifest that their refutation and exposure is easy indeed. From its very beginnings economics has shown again and again that assertions concerning the alleged blessings of an abundance of money and the alleged disasters of a scarcity of money are the outcome of crass errors in reasoning. The endeavors of the apostles of inflationism and expansionism to refute the correctness of the economists’ teachings have failed utterly. The only relevant question is this: Is it possible or not to lower the rate of interest lastingly by means of credit expansion? This problem will tb treated exhaustively in the chapter dealing with the interconnection between the money relation and the rate of interest. There it will be shown what the consequences of booms created by credit expansion must be. But we must ask ourselves at this point of our inquiries whether it is not possible that there are other reasons which could be advanced in favor of the inflationary interpretation of history. Is it not possible that the champions of inflation have neglected to resort to some valid arguments which could support their stand? It is certainly necessary to approach the issue from every possible avenue. Let us think of a world in which the quantity of money is rigid. At an early stage of history the inhabitants of this world have produced the whole quantity of the commodity employed for the monetary service which can possibly be produced. A further increase in the quantity of money is out of the question. Fiduciary media are unknown. All money-substitutes–the subsidiary coins included–are money-certificates. On these assumptions the intensification of the division of labor, the evolution from the economic self-sufficiency of households, villages, districts, and countries to the world-embracing market system of the nineteenth century, the progressive accumulation of capital, and the improvement of technological methods of production would have resulted in a continuous trend toward falling prices. Would such a rise in the purchasing power of the monetary unit have stopped the evolution of capitalism? The average businessman will answer this question in the affirmative. Living and acting in an environment in which a slow but continuous fall in the monetary unit’s purchasing power is deemed normal, necessary, and beneficial, he simply cannot comprehend a different state of affairs. He associates the notions of rising prices and profits on the one hand and of falling prices and losses on the other. The fact that there are bear operations too and that great fortunes have been made by bears does not shake his dogmatism. These are, he says, merely speculative transactions of people eager to profit from the fall in the prices of goods already produced and available. Creative innovations, new investments, and the application of improved technological methods require the inducement brought about by the expectation of price rises. Economic progress is possible only in a world of rising prices. This opinion is untenable. In a world of a rising purchasing power of the monetary unit everybody’s mode of thinking would have adjusted itself to this state of affairs, just as in our actual world it has adjusted itself to a falling purchasing power of the monetary unit. Today everybody is prepared to consider a rise in his nominal or monetary income as an improvement of his material well-being. People’s attention is directed more toward the rise in nominal wage rates and the money equivalent of wealth than to the increase in the supply of commodities. In a world of rising purchasing power for the monetary unit they would concern themselves more with the fall in living costs. This would bring into clearer relief the fact that economic progress consists primarily in making the amenities of life more easily accessible. In the conduct of business, reflections concerning the secular trend of prices do not bother any role whatever. Entrepreneurs and investors do not bother about secular trends. What guides their actions is their opinion about the movement of prices in the coming weeks, months. or at most years. They do not heed the general movement of all prices. What matters for them is the existence of discrepancies between the prices of the complementary factors of production and the anticipated prices of the products. No businessman embarks upon a definite production project because he believes that the prices, i.e., the prices of all goods and services, will rise. He engages himself if he believes that he can profit from a difference between the prices of goods of various orders. In a world with a secular tendency toward falling prices, such opportunities for earning profit will appear in the same way in which they appear in a world with a secular trend toward rising prices. The expectation of a general progressive upward movement of all prices does not bring about intensified production and improvement in well-being. It results in the “flight to real values,” in the crack-up boom and the complete breakdown of the monetary system. If the opinion that the prices of all commodities will drop becomes general, the short-term market rate of interest is lowered by the amount of the negative price premium.[26] Thus the entrepreneur employing borrowed funds is secured against the consequences of such a drop in prices to the same extent to which, under conditions of rising prices, the lender is secured through the price premium against the consequences of falling purchasing power. A secular tendency toward a rise in the monetary unit’s purchasing power would require rules of thumb on the part of businessmen and investors other than those developed under the secular tendency toward a fall in its purchasing power. But it would certainly not influence substantially the course of economic affairs. It would not remove the urge of people to improve their material well-being as far as possible by an appropriate arrangement of production. It would not deprive the economic system of the factors making for material improvement, namely, the striving of enterprising promoters after profit and the readiness of the public to buy those commodities which are apt to provide them the greatest satisfaction at the lowest costs. Such observations are certainly not a plea for a policy of deflation. They imply merely a refutation of the ineradicable inflationist fables. They unmask the illusiveness of Lord Keynes’s doctrine that the source of poverty and distress, of depression of trade, and of unemployment is to be seen in a “contractionist pressure.” It is not true that “a deflationary pressure … would have … prevented the development of modern industry.” It is not true that credit expansion brings about the “miracle … of turning a stone into bread.”[27] Economics recommends neither inflationary not deflationary policy. It does not urge the governments to tamper with the market’s choice of a medium of exchange. It establishes only the following truths: 1. By committing itself to an inflationary or deflationary policy a government does not promote the public welfare, the commonweal, or the interests of the whole nation. It merely favors one or several groups of the population at the expense of other groups. 2. It is impossible to know in advance which group will be favored by a definite inflationary or deflationary measure and to what extent. These effects depend on the whole complex of the market data involved. They also depend largely on the speed of the inflationary or deflationary movements and may be completely reversed with the progress of these movements. 3. At any rate, a monetary expansion results in misinvestment of capital and overconsumption. It leaves the nation as a whole poorer, not richer. These problems are dealt with in Chapter XX. 4. Continued inflation must finally end in the crack-up boom, the complete breakdown of the currency system. 5. Deflationary policy is costly for the treasury and unpopular with the masses. But inflationary policy is a boon for the treasury and very popular with the ignorant. Practically, the danger of deflation is but slight and the danger of inflation tremendous.

[25]. Cf. the critical study of Marianne von Herzfeld, “Die Geschichte als Funktion der Geldbewegung,” Archiv fuer Sozialwissenschaft, LVI, 654-686, and the writings quoted in this study. [26]. Cf. below, pp. 541-545. [27]. Quoted from: International Clearing Union, Text of a Paper Containing Proposals by British Experts for an International Clearing Union, April 8, 1943 (published by British Information Services, an Agency of the British Government), p. 12.

The Circular Flow Of Income Fallacy

At the Tory Party Conference, the Prime Minister said:

The only way out of a debt crisis is to pay off your debts. That’s why households are paying down their credit card bills and store card bills. It means banks getting their books in order. And it means governments all over the world  – cutting spending and living within their means.

This contrasts with a recent Globe and Mail editorial by Martin Wolf:

What Mr. Cameron recommends is even nigh on impossible. Why is that? Is it not common sense that if one has borrowed too much, one must pay it back? Alas, what makes sense for individuals does not make sense for an economy, because one person’s spending is another person’s income. Consider a closed economy. Income and spending must match. If the private sector decided to spend less than its income, to pay down debt and if the government also decided to stop borrowing, aggregate incomes would fall until they could no longer achieve what they wanted. All they would obtain, by following Mr. Cameron’s advice, is a race to the economic bottom.

This is the gigantic cul-de-sac of the “Circular Flow of Income” that every 1st year economics undergraduate is taught in their opening macro class. Whilst it is true that one man’s spending is another man’s income, this truism says nothing about how that money is spent or whether it is conducive to prosperity. The aggregation makes the circular flow nothing more than a tautological statement.  I previously explored some of the negative routes that economists have embarked upon in this blog post from September 2009. Wolf is one of the FT’s most mainstream high-profile writers. Before Keynes he would have been considered a consumptionist crank of the sort that used to come to fore every few decades or so to be thoroughly discredited by any non-muddleheaded economist of the day. Now he and his type are in the majority. If your household had outgoings of £2,000 per month and income of £1,800, you have to either consume your saved capital, or borrow some else’s to the tune of £200 per month.  If there is no one to borrow from, or the amount you have borrowed is making it very burdensome for you to make any repayments (or even to cover the interest costs), then you need to cut back on your outgoings. Now if you cut back on your outgoings so you now spend £1,700 per month on a £1,800 per month income, it is happy days for you as you are accumulating £100 of capital per month. You are profitable. In this example, substitute you for a company and you can see how a company reliant upon debt can become a profitable contributor to society. Now with a sovereign government, the same logical of living within your means must also apply. Restoration of profitability is the only sure-fire way of establishing long-term recovery in the economy.  The aggregate expenditures of all being the aggregate income of all is in fact a red herring. What matters is the degree of profitability within the aggregate measures in all aspects of the economy, from the Sovereign State, through the corporations, to the humble household. This implies a deflating down of the credit-induced bubble. This is liquidation. This will mean creditors who have lent money unwisely to walking dead businesses, zombie governments and bozo corporations will not get all their money back. This means there will be some pain. The alternative proposed by Wolf and much of the economics profession is to inflate the debt away. This means that all the prudent and wise people who have saved to provide for themselves will see their savings eroded, and will be forced to live on less. Meanwhile, those who unwisely lent to households, corporations and governments who could never fulfill their promises will in nominal terms be spared any default on their debt. Morally, I prefer liquidation, just as I prefer a restoration of profitability to the current approach of maintaining the aggregate incomes and expenditures of all at unsustainable levels without regard to profit. Creating and perpetuating illusions is not for any sane politician or economist, only muddle-heads like Wolf.

Gingrich Adopts Gold Standard Model

American Principles Project:

Washington, D.C.–Republican presidential candidate and former House Speaker Newt Gingrich called for “hard money with a very limited Federal Reserve” at the Republican presidential debate in New Hampshire on Tuesday. Gingrich is the third candidate to take this position. Herman Cain endorsed the gold standard at the American Principles Project Palmetto Freedom Forum in South Carolina last month and Ron Paul, who has been steadily advocating it for much of his career, raised it at last night’s debate.

If one of them disposes of Obama, this will be at the heart of any Republican agenda. When will our senior politicians start to entertain a move to honest money?

The Magicians At The Bank Of England (with close support from No 10 & 11 Downing Street)

Who made this very sound statement two years ago in relation to QE I?

The last resort of desperate governments when all other policies have failed

Answer: George Osborne, our Chancellor.

Sometime soon it will have to stop because in the end printing money leads to inflation.

Answer: our Prime Minister. Both of these statements were made in 2009 when the first round of QE unfolded. If people are spending less, it follows that the money unit is being used less. Indeed corporate balance sheets are paying down debt and chalking up healthy cash balances. Coupled with this, in a fractional reserve system, when money gets repaid and not relent, as we know, it came from nothing, and it goes back to nothing. Personal savings are at their highest for many years as households do the same, pay off debt and replenish cash balances. Bank reserves are the highest they have been for a long time in relation to overall bank balance sheet size. God help us if people do start to spend again in the fashion of old as there will be the mother of all inflations. By the way, many empirical studies, most notably by Friedman, show us that the demand for money is very stable. As we have discussed here before, regime policy uncertainty will cause people to hold precautionary balances, but only for a short period of time. With the first round of QE of £200bn and now the second of £75bn we have nearly added 15% to the money supply. They way out for the Bank of England is to massively raise interest rates as part of a very tight money policy. Either way, this is bad news for us. Hoping a mild inflation will reduce our real debts over time is a very dangerous game. As soon as the inflation genie is out of the bottle, and we all realise that our money is depreciating, we will spend it, retailers will reprice to take into account the new demand, and prices will soar. They are hoping not only for a mild inflation, but also for those in receipt of the new money, the people who have had their gilts bought with the new money, to then go and spend it and get those “animal spirits” working again. So the bankers once again win. More expensive houses, more fast cars and boats, with their bonuses for organizing the buying of the gilts. The banks get the new money deposited with them and can then shore up their balance sheets even further, as I suspect they are still concerned about all the wonky property loans and dodgy sovereign debt they need to wipe off their books. Thus, giving effectively £75bn of money out of the ether to the banks will not have the desired effect of increasing lending or spending (besides the bankers’ toys already mentioned). We all just have our purchasing power diminished while that of the banking system is raised. They get the new wealth effect, not you! As most of these institutions are replete with failed corporate executives, still in the same jobs, who will more than likely repeat the same mistakes, who are regulated by the same people in differently named organizations, we have once more a recipe for disaster. As we always say on this site, the creditors get fleeced . A pensioner buying an annuity today with a £300k pension would have got £22,500 pa and now will get £18,500, should the yields go down to where they want it. The ongoing war on the poor is relentless.  Pensioners just have to swallow a 30% pay cut. Forget looters in Tottenham, we will have geriatrics in the streets of green and leafy middle class suburbia smashing the place up if they are not careful. They will suffer for the mistakes of past governments who in partnership with the banks created the mother of all credit booms, which has led to the largest misallocation of resources since the 30s. As blame for the artificial boom does not lie with the Conservative Party, but with the Blair and Brown money regimes, I can’t fathom why the current government keeps trying to repeat the policy mistakes of the previous one, especially when they condemned this approach to money policy back in 2009. One further thing, if they do pull yields down on gilts, this may well make borrowing costs marginally cheaper, but lets face it: if 50 basis points means you live or die in business, you are kidding yourself that you have a viable business anyway. Likewise, if you are a home owner who is so close to the wire that a fraction of a interest rate move wipes you out, then you are a renter of a home, not an owner. The quicker you default, then better for you and your family. Release your burden, rent, and feed your family. No one will be saying at your funeral “he was a great man, he honoured his mortgage. Even though he never should have taken it out because he could not afford it, he was advised by the bank to do so.  What’s more, they were so kind that they gave him a mortgage worth more than the house, so he could buy his furniture.  Failing to feed his kids and getting divorced did not trouble this honorable man; for the rest of his life he toiled for the bank.” Embrace default and let’s get this correction over and done with, so we can carry on and rebuild our lives in peace.

Daniel Hannan On Our Money-Printing Masters

As we feared, the wise men at the Bank of England have decided that what our ailing economy needs is another dose of QE. I was about to blog the event, but it’s hard to match the eloquence of Daniel Hannan’s latest post:

According to the BBC, the Bank of England has decided to ‘inject a further £75 billion into the economy’. Who knew it was that easy? I mean, why not inject £500 billion? Or a trillion? According to the BBC’s logic, it would surely make us the wealthiest nation on Earth. I can’t believe I’m having to write this, but nothing new will be manufactured, invented or developed as the result of this monetary splurge, no services offered, no businesses founded. Rather, the money already in circulation – the money in your bank account, in your purse, under your mattress – will be worth less. The government, in other words, is helping itself to your savings – and, in doing so, is damaging productivity, disincentivising work and weakening the competitiveness of the British economy.

These themes will be familiar to regular Cobden Centre readers, as will his conclusion:

It’s a paradox. If I were to print counterfeit £20 notes and buy goods with them, I’d be perpetrating a fraud: I’d be buying something of real value with something I had magicked out of thin air. Yet when a central bank does the same thing, the half-educated economists who dominate our universities and television stations nod approvingly and mumble cliches about ‘boosting demand’. You can’t keep boosting demand without producing anything, for Heaven’s sake. That’s what got us into this mess.

We’ll post more on this latest act of folly in due course, but in the meantime Steve Baker has posted a warning straight from Human Action:

Do Nothing: A Positive Proposal For Recovery

It was recently pointed out to me that certain free market orientated friends dislike policies that fail to restore immediate growth:

Basic economic theory posits that as households and businesses become more uncertain about the future, the more they save from their after-tax incomes — and a rising savings rate in the private sector at a time of belt-tightening in the public sector is not the prescription for growth, unless somehow exports emerge as a critical safety valve. For sure, if there is one development that does seem encouraging, it is that there is something of a manufacturing renaissance taking hold, but the effects on the overall economy are going to pale next to the round of consumer retrenchment we are likely to see in coming quarters and years.

On the face of it, who would not want growth when we are on our knees awaiting the next blood letting that will inevitably unfold as the second phase of the Great Recession comes upon us? A large credit boom such as the one we saw from the mid 90’s to the late 00’s causes many more goods to be produced, with the newly created credit, than there are savings to buy these goods. With only a limited amount of factors of production and productivity gains not creating more goods and services fast enough, we have businesses biding up resources and thus prices against each other. This causes local asset price booms. Think Think housing. This causes the general price level to rise, rather than fall. Productivity and technology gains should allow price falls (think of the costs of your computer over the last two decades), but economy-wide, they never do. People eventually reduce their consumption of goods, having depleted their savings. As consumers disappear, and turn their attention once more to saving, the boom goes to bust. So what needs to happen is that prices be allowed to fall. We should embrace this process. When prices fall, the consumers become more and more confident that what they are being offered is fair value or even undervalued, and they start to increase their buying volume again. This is when the seeds of recovery start to show fruit. We should also remember that the only way to create wealth is for entrepreneurs to find better ways to combine the existing factors of production in better ways to make goods and services that people want. They do this by using their savings to invest in better capital formation. This is done brick by brick, over time. It is done by entrepreneurs, not governments. The only thing the latter can do is provide the legal framework, the rules of the game, so that entrepreneurs can get on with producing the goods and services of the economy that satisfy the needs of their fellow man. However the government tries to intervene — through bailouts, deficit spending, quantitative easing, credit easing, enterprise zones, ‘green’ subsidies, or tax gimmicks — they cannot help but produce uncertainty, which is the real killer of the recovery. When people aren’t sure how the rules are about to change, they put more money into precautionary savings. All private enterprises do the same: it is the only rational response. In this paper (PDF), which won the 2010 Frisch Medal of the Econometric Society for its author, Nicholas Bloom shows how uncertainty can be one of the most disruptive factors for an unbalanced economy attempting recovery. He does not show how the economy comes to be so unbalanced in times of recessions, but his analysis of the impact of “uncertainty shocks” is compelling. Bloom concludes:

The uncertainty shock also induces a strong insensitivity to other economic stimuli. At high levels of uncertainty the real-option value of inaction is very large, which makes firms extremely cautious. As a result, the effects of empirically realistic general equilibrium type interest rate, wage, and price falls have a very limited short-run effect on reducing the drop and rebound in activity. This raises a second policy implication, that in the immediate aftermath of an uncertainty shock, monetary or fiscal policy is likely to be particularly ineffective

So the only way to cure this recession is for the policy makers to get out of the way, let prices fall, let debt get written off, and let people start buying again those good and services they want, at prices they can afford to pay. Prior to 1929, this of course was the usual public policy response. After World War I, in the belligerent countries, we had a large build-up of capital to produce weapons of destruction. This distortion away from what consumers would normally need had to unwind. In the USA, for example, this was painfully deflationary, from Jan 1920 – July 1921, but within 18 months the whole recession was over. Since that recession we have been faced with a mix of policy activism by our elected representatives and interventions of various shapes and sizes leading for example to the prolonged Great Depression. I contend that with all the frantic policy activism we see over in Europe, especially now, we can expect the Great Recession go on for many years to come. I know that advocating a “do nothing” policy is for a politician like advocating that all new born babies should be eaten, but sometime what seems the least palatable — letting prices fall and debts be written off — is in fact the quickest and least painful option. As an Ironman athlete, my coach prescribes one rest day per week when I do no physical activity at all, and one calendar month per year when I remain largely inactive. This is a very important part of my training program, and it needs to be given as much attention as the swim, bike and the running aspects. Inactivity can be good! As an investor, instead of looking at the stock market going up, down, sideways, backwards, and every which way as the herd charges around, being busy and active on a whisper here, a phrase said there, by a politician or policy maker, I suggest a different course: choose your companies based on their true fundamentals. Do they have great management? Do they have original owner participation? Do they make great products that are needed all the time? Do they have good barriers to entry? Do they have a strong balance sheets and little or no debt? Then you can make your choices, sit back and do NOTHING as a positive investment strategy. If our bust is allowed to unfold, there will be momentary panic as the voices of the political class fall silent, but people will soon realize that as they still need to eat, drink, and keep warm. The world goes on, the sun rises and sets, and as long as people need things, there will be people who will supply those things. Entrepreneurship will never be snuffed out. I advocate a POSITIVE policy of doing nothing.


Since I wrote this, Sean Corrigan has sent me an article (PDF) by our friend Prof Steve Horwitz about the Hoover administration. It covers the 29 – 31 crash period, and is very pertinent to today. This administration, we are always told, was a “do nothing” free market administration, and it was Hoover’s non-policies that actually deepened the Great Depression.  Horowitz concludes:

Despite overwhelming evidence to the contrary, from Hoover’s own beliefs to his actions as president to the observations of his contemporaries and modern historians, the myth of Herbert Hoover’s presidency as an example of laissez faire persists. Why that is so is beyond the scope of this study, but it surely remains a source of comfort to those among the intelligentsia who deeply believe that the Great Depression demonstrates the problems with free-market capitalism and the importance of government intervention in stabilizing a market economy. The truth, of course, is nearly the opposite. This misinterpretation of the Great Depression lies at the bottom of much of their more general belief in the deep flaws of market economies, as we have seen in the way the media and many intellectuals have cheered on the activism of Bush and Obama since 2008. Accepting Hoover’s role as the father of the New Deal would challenge the fundamental argument at the core of their preferred narrative that laissez faire made matters worse during the Depression and that government intervention was the solution. Everyone agrees that Hoover’s presidency made things worse, but for the critics of capitalism to accept the truth of Hoover’s activist policies would require that they question the effectiveness of such activism and drop the claim that laissez faire failed. In the past three years the failure of massive government intervention to deal with our own economic crisis has become clearer each day. Facing a failed ideology, it should not come as a surprise that defenders of the interventionist faith would cling to the Hoover myth like a plank in the ocean. Un- fortunately for them, the historical facts are not on their side and, unfortunately for the American economy, the persistence of the Hoover myth continues to justify the counterproductive policies of the Obama administration and thereby prevents markets from generating the economic recovery of which they are fully capable.