Supply-Side University Economics Lesson #12
Memo To: Website students
From: Jude Wanniski
Re: Guest Lecturer Ludwig von Mises, on “deflation.”
Of all the economists of the last half-century, I believe the best in his understanding of “deflation” is Ludwig von Mises, who lived to age 92 (1881-1973) and thus had time to see it all two times over. I had no understanding of deflation until by chance I happened to read his magnum opus, Human Action, first published by Yale University Press in 1949. I had been honored by Hillsdale College in 1982, asked to deliver the annual von Mises lecture, which meant I had to read up on what he was about, thereby discovering Human Action. Von Mises is to the “Austrian school,” a branch of supply-side economics, what Milton Friedman is to monetarism and Lord Keynes is to Keynesianism. While I learned supply-side economics from Robert Mundell and Arthur Laffer, the area of deflation is one neither had experienced and appeared to understand primarily from the Keynesian perspective, which was their first exposure to macroeconomics. Where Mundell and Laffer continue to think of the Great Depression as some combination of bad tax and tariff policies and contractionary errors by the Federal Reserve, Von Mises is reluctant to blame the Fed. He offers no hypothesis for the Crash of 1929, but at least senses that it involved a contraction, as distinct from a deflation. In Lesson #10, we discussed two kinds of deflation, monetary and fiscal. Von Mises would agree, preferring the term “contraction” to describe the Great Depression, not deflation. If you follow the current discussion about “deflation,” you will frequently see the press relate it to the 1930s. Von Mises would not make that mistake. In the following passage, which begins on Page 556 of the 1966 Regnery edition of Human Action , we get some of the flavor of his thinking and its relevance to the deflation going on today. I ask you to grapple with this as best you can and raise questions about it. Along the way, I will interject occasionally when I think the great man is being a bit obscure and have some comments at the end of his lecture.
The Gross Market Rate of Interest as Affected by Inflation and Credit Contraction
We assume that in the course of a deflationary process the whole amount by which the supply of money (in the broader sense) is reduced is taken from the loan market. Then the loan market and the gross market rate of interest are affected at the very beginning of the process, at a moment at which the prices of commodities and services are not yet altered by the change going on in the money relation. We may, for instance, posit that a government aiming at deflation floats a loan and destroys the paper money borrowed. Such a procedure has been, in the last two hundred years, adopted again and again. The idea was to raise, after a prolonged period of inflationary policy, the national monetary unit to its previous metallic parity. [This was the procedure prior to the establishment of government central banks. Now, the central bank “floats a loan” to a commercial bank by selling a government bond and “destroying the paper.”] Of course, in most cases the deflationary projects were soon abandoned as their execution encountered increasing opposition and, moreover, heavily burdened the treasury. Or we may assume that the banks, frightened by their adverse experience in the crisis brought about by credit expansion, are intent upon increasing the reserves held against their liabilities and therefore restrict the amount of circulation credit. A third possibility would be that the crisis has resulted in the bankruptcy of banks which granted circulation credit and that the annihilation of the fiduciary media issued by these banks reduces the supply of credit on the loan market.
In all these cases a temporary tendency toward a rise in the gross market rate of interest ensues. Projects which would have appeared profitable before appear so no longer. A tendency develops toward a fall in the prices of factors of production and later toward a fall in the prices of consumers’ goods also. Business becomes slack. The deadlock ceases only when prices and wage rates are by and large adjusted to the new money relation. Then the loan market too adapts itself to the new state of affairs, and the gross market rate of interest is no longer disarranged by a shortage of money offered for advances. Thus a crash-induced rise in the gross market rate of interest produces a temporary stagnation of business. Deflation and credit contraction no less than inflation and credit expansion are elements disarranging the smooth course of economic activities. However, it is a blunder to look upon deflation and contraction as if they were simply counterparts of inflation and expansion. [!!!]
Expansion produces first the illusory appearance of prosperity. It is extremely popular because it seems to make the majority, even everybody, more affluent. It has an enticing quality. A special moral effort is needed to stop it. On the other hand, contraction immediately produces conditions which everybody is ready to condemn as evil. Its unpopularity is even greater than the popularity of expansion. It creates violent opposition. Very soon the political forces fighting it become irresistible.
Fiat money inflation and cheap loans to the government convey additional funds to the treasury; deflation depletes the treasury’s vaults. Credit expansion is a boon for the banks, contraction is forfeiture. There is a temptation in inflation and expansion and a repellent in deflation and contraction.
But the dissimilarity between the two opposite modes of money and credit manipulation not only consists in the fact that while one of them is popular the other is universally loathed. Deflation and contraction are less likely to spread havoc than inflation and expansion not merely because they are only rarely resorted to. They are less disastrous also on account of their inherent effects. Expansion squanders scarce factors of production by malinvestment and overconsumption. If it once comes to an end, a tedious process of recovery is needed in order to wipe out the impoverishment it has left behind. But contraction produces neither malinvestment nor overconsumption. The temporary restriction in business activities that it engenders may by and large be offset by the drop in consumption on the part of the discharged wage earners and the owners of the material factors of production the sales of which drop. No protracted scars are left. When the contraction comes to an end, the process of readjustment does not need to make good for losses caused by capital consumption.
Deflation and credit restriction never played a noticeable role in economic history. The outstanding examples were provided by Great Britain’s return, both after the wartime inflation of the Napoleonic wars and after that of the first World War, to the prewar gold parity of the sterling. In each case Parliament and Cabinet adopted the deflationist policy without having weighed the pros and cons of the two methods open for a return to the gold standard. In the second decade of the nineteenth century they could be exonerated, as at that time monetary theory had not yet clarified the problems involved. More than a hundred years later it was simply a display of inexcusable ignorance of economics as well as of monetary history.
Ignorance manifests itself also in the confusion of deflation and contraction and of the process of readjustment into which every expansionist boom must lead. It depends on the institutional structure of the credit system which created the boom whether or not the crisis brings about a restriction in the amount of fiduciary media. Such a restriction may occur when the crisis results in the bankruptcy of banks granting circulation credit and the falling off is not counter poised by a corresponding expansion on the part of the remaining banks. But it is not necessarily an attendant phenomenon of the depression; it is beyond doubt that it has not appeared in the last eighty years in Europe and that the extent to which it occurred in the United States under the Federal Reserve Act of 1913 has been grossly exaggerated. The dearth of credit which marks the crisis is caused not by contraction but by the abstention from further credit expansion. It hurts all enterprises -- not only those which are doomed at any rate, but no less those whose business is sound and could flourish if appropriate credit were available. As the outstanding debts are not paid back, the banks lack the means to grant credits even to the most solid firms. The crisis becomes general and forces all branches of business and all firms to restrict the scope of their activities. But there is no means of avoiding these secondary consequences of the preceding boom. [Here I would disagree with Von Mises in that the contraction from the previous boom could be arrested if tax rates are higher than they need be in one area or another. Frank Knight, who frequently crossed swords with Von Mises in their mid-century careers, understood that if increased risks in one area would cause an incipient contraction, they might be offset by reducing risks in another.]
As soon as the depression appears, there is a general lament over deflation and people clamor for a continuation of the expansionist policy. Now, it is true that even with no restrictions in the supply of money proper and fiduciary media available, the depression brings about a cash-induced tendency toward an increase in the purchasing power of the monetary unit. [In other words, the dollar buys more whether it is deflation or contraction. Von Mises did not live to see the unusual circumstance of the early 1980s, when the dollar bought less even though the economy contracted. The unusual event resulted from the sharp rise and sharp fall in the price of gold.] Every firm is intent upon increasing its cash holdings, and these endeavors affect the ratio between the supply of money (in the broader sense) and the demand for money (in the broader sense) for cash holding. This may be properly called deflation. [Von Mises, though, is describing contraction.] But it is a serious blunder to believe that the fall in commodity prices is caused by this striving after greater cash holding. The causation is the other way around. Prices of the factors of production -- both material and human -- have reached an excessive height in the boom period. They must come down before business can become profitable again. The entrepreneurs enlarge their cash holding because they abstain from buying goods and hiring workers as long as the structure of prices and wages is not adjusted to the real state of the market data. Thus any attempt of the government or the labor unions to prevent or to delay this adjustment merely prolongs the stagnation.
Even economists often failed to comprehend this concatenation. They argued thus: The structure of prices as it developed in the boom was product of the expansionist pressure. If the further increase in fiduciary media comes to an end, the upward movement of prices and wages must stop. But, if there were no deflation, no drop in prices and wage rates could result.
This reasoning would be correct if the inflationary pressure had not affected the loan market before it had exhausted its direct effects upon commodity prices. Let us assume that a government of an isolated country issues additional paper money in order to pay doles to the citizens of moderate income. The rise in commodity prices thus brought about would disarrange production; it would tend to shift production from the consumers’ goods regularly bought by the nonsubsidized groups of the nation to those which the subsidized groups are demanding. [Von Mises could just as easily be discussing an increase in defense spending for war, followed by demobilization.] If the policy of subsidizing some groups in this way is later abandoned, the prices of the goods demanded by those formerly subsidized will drop and the prices of the goods demanded by those formerly nonsubsidized will rise more sharply. But there will be no tendency of the monetary unit’s purchasing power to return to the state of the pre-inflation period. The structure of prices will be lastingly affected by the inflationary venture if the government does not withdraw from the market the additional quantity of paper money it has injected in the shape of subsidies.
Conditions are different under a credit expansion which first affects the loan market. In this case the inflationary effects are multiplied by the consequences of capital malinvestment and overconsumption. Overbidding one another in the struggle for a greater share in the limited supply of capital goods and labor, the entrepreneurs push prices to a height at which they can remain only as long as the credit expansion goes on at an accelerated pace. A sharp drop in the prices of all commodities and services is unavoidable as soon as the further inflow of additional fiduciary media stops.
While the boom is in progress, there prevails a general tendency to buy as much as one can buy because a further rise in prices is anticipated. In the depression, on the other hand, people abstain from buying because they expect that prices will continue to drop. The recovery and the return to “normalcy” can only begin when prices and wage rates are so low that a sufficient number of people assume that they will not drop still more. Therefore the only means to shorten the period of bad business is to avoid any attempts to delay or to check the fall in prices and wage rates. [Again, Von Mises accurately describes the contraction scenario, but errs in arguing the government can’t intervene in a way that might check the fall in prices and wage rates. What is missing in his model is the Laffer Curve, by which risks to new enterprise could be reduced if tax rates were unnecessarily high.]
Only when the recovery begins to take shape does the change in the money relation, as effected by the increase in the quantity of fiduciary media, begin to manifest itself in the structure of prices.
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It is illuminating for Von Mises to remind us that in bygone days, prior to modern central banking, the only way the government could restore the value of its “national monetary unit” to its “previous metallic parity” was by “floating loans” and destroying the money received in exchange for bonds. There really are so few economists, financial writers and politicians who understand the difference between the central bank creating money and the Treasury spending it. There is absolutely no connection between the two. None. In today’s world, the Treasury only issues bonds in order to acquire money that it can spend. No amount of such spending can be “inflationary,” as Treasury is simply acquiring money from one party and spending it on another. For the creditor to be able to lend Treasury $1000 for a bond in that amount, the creditor has to have first earned it in the production of goods and services. Von Mises correctly points out, in his example of a welfare recipient -- who also could be a soldier -- that prices will rise in the area where the recipient will spend the money and fall in the area where the creditor would otherwise have spent it. As long as the “metallic parity” is maintained, there is no increase in the general price level. When the welfare payments stop or the war ends, prices fall in one area and rise in another. Over brief periods of time, an index of prices will show an increase even if the national monetary unit is constant in gold. During WWI, when there was a sudden increase in the demand for the goods of war, an ounce of gold bought fewer bullets in 1917 than in 1914. Gold can thus be said to have depreciated in value against that basket of goods. In the 1920s, as spending on wartime goods receded, the value of gold against that basket reasserted itself.
When a war ends and prices of goods in surplus fall, there will be those battered by excess inventories or by debts acquired by borrowing against future production at wartime prices. As Von Mises notes, they will clamour for “easy money,” by which they mean the intervention of the central bank to buy government bonds with “new” money, which only the Fed can create. The Federal Reserve Act of 1913 gave the Fed a checkbook with an unlimited number of blank checks, with which it can buy government bonds -- “monetizing debt.” If the Fed attempts to stop a contraction by monetizing debt, it only will succeed in causing an inflation. On the other hand, if the Fed is faced with a deflation caused by a surplus in the demand for “new” money, it can of course arrest that deflation by supplying the new money, with no increase in inflation.
In December 2nd's Wall Street Journal, an editorialist wrote about the weakness of the Japanese economy and argued that only a tax cut could solve its problem. A fundamental error showed up in the opening of the editorial as the writer dismissed the idea of using “slippery” monetary policy to solve Japan’s problem, on the grounds that it has already tried “easy money” and it has failed to do the trick. By “easy money,” the Journal editorialist cited the extremely low interest rates in Japan. Von Mises would assign an “F” to such an essay in his classroom. [Von Mises also would hand out “F’s” to almost all economic editorials in the NYTimes.] Easy money is only really meaningful when the central bank is supplying enough “new” money with its blank checks so that the price of gold and thence other commodities and wages have nowhere to go but up. For the last 18 months, the Bank of Japan has not increased the supply of yen liquidity to its banking system in the slightest. The yen price of gold, which would balance the interests of debtors and creditors at a range of ¥44000 per ounce to ¥46000 per ounce has been driven down by this “tight money policy” to the ¥38000 level, where it is bankrupting yen debtors.
If Alan Greenspan today were to announce that he intended to raise the gold price from its clearly deflationary $286, he could do it by lowering the federal funds rate, which would require the monetization of debt, or he could simply monetarize debt and allow the funds rate to go wherever the market took it. When the price of gold rose from $350 to $385 following the Clinton tax increases (the two events connected by a decrease in demand for dollar liquidity), Greenspan tried to get the gold price down by raising interest rates and nothing happened, because the higher rates were increasing the demand for liquidity as borrowers believed the rates would go higher, and the Fed was supplying more liquidity to prevent the fed funds rate from rising above its nominal target. The process only ended when the market observed the high rates had weakened the economy sufficiently to end the chance the Fed would raise rates higher.
Similarly, observe what happened when the International Monetary Fund announced its “bailout” of Korea this week. It did so on the condition that if it supplies $55 billion in credits -- which Korea could use to pay off its foreign creditors, including the international banks that control the IMF -- the Bank of Korea has to keep interest rates high. In Robert Novak’s syndicated column on Korea, I am quoted as saying that instead of an IMF bailout, Korea could fix itself by selling bonds out of its central bank portfolio to make its currency scarce. I made the same argument when Mexico was falling apart in January 1994, but the level of incompetence among policymakers is so high that if Von Mises were around he would be flunking almost everyone in sight. Tight money is not a condition of high interest rates. It is a shortage of liquidity relative to its legitimate demand, which the market signals with the price of gold.