Friday, August 9, 2013

Deflation, Inflation, & Money II: A reply to Jacob Westman

9646432-inflation--decreasing-value-of-moneyJacob Westman, who blogs at the Analytic Economist, has replied to my initial blog post on the topic of deflation, money, monetary history, etc.  It’s an important topic and I’m happy to elaborate on my positions on this subject.

Here is one of the questions posed by Jacob:

Like I said before and explained in my previous post they disfavor cuts in the money supply.  One argument the Austrians utilize is to ALWAYS refer to the price decline due to added production in the late 19th century.  That is not what I am talking about when I am talking about investment.  I am talking about 2% decrease in the money supply each year.  Maybe I did not make that clear.

Apologies if I did not properly address the issue regarding money deflation specifically.  To restate Jacob’s primary question about deflation, it is this:

What would happen if there was a constant decrease in the money supply of 2% per year?  Or stated differently, what is the proper or optimal supply of money? 

Obviously, many neoclassical economists are partial to the Milton Friedman hypothesis that purport's to know the right amount of money an economy needs which he wrote about in The Optimum Quantity of Money

The Austrian school of thought has much to say about this subject and money in general.  An economic analysis about the effects of a stagnate or even falling money supply must occur by also within the context of the demand for money & expectations about the purchasing power of money in the future.  Fractional reserve banking is another important factor in contributing to the money supply.  These are the big hitters pertinent to the question about the supply of money.

In What Has Government Done to Our Money, Rothbard addresses the question of the proper supply of money should be in an economy.

Now we may ask: what is the supply of money in society and how is that supply used? In particular, we may raise the perennial question, how much money "do we need"? Must the money supply be regulated by some sort of "criterion," or can it be left alone to the free market?

First, the total stock, or supply, of money in society at any one time, is the total weight of the existing money-stuff. Let us assume, for the time being, that only one commodity is established on the free market as money. Let us further assume that gold is that commodity (although we could have taken silver, or even iron; it is up to the market, and not to us, to decide the best commodity to use as money). Since money is gold, the total supply of money is the total weight of gold existing in society. The shape of gold does not matter?except if the cost of changing shapes in certain ways is greater than in others (e.g., minting coins costing more than melting them). In that case, one of the shapes will be chosen by the market as the money-of-account, and the other shapes will have a premium or discount in accordance with their relative costs on the market.

Changes in the total gold stock will be governed by the same causes as changes in other goods. Increases will stem from greater production from mines; decreases from being used up in wear and tear, in industry, etc. Because the market will choose a durable commodity as money, and because money is not used up at the rate of other commodities--but is employed as a medium of exchange--the proportion of new annual production to its total stock will tend to be quite small. Changes in total gold stock, then, generally take place very slowly.

What "should" the supply of money be? All sorts of criteria have been put forward: that money should move in accordance with population, with the "volume of trade," with the "amounts of goods produced," so as to keep the "price level" constant, etc. Few indeed have suggested leaving the decision to the market. But money differs from other commodities in one essential fact. And grasping this difference furnishes a key to understanding monetary matters. When the supply of any other good increases, this increase confers a social benefit; it is a matter for general rejoicing. More consumer goods mean a higher standard of living for the public; more capital goods mean sustained and increased living standards in the future. The discovery of new, fertile land or natural resources also promises to add to living standards, present and future. But what about money? Does an addition to the money supply also benefit the public at large?

Consumer goods are used up by consumers; capital goods and natural resources are used up in the process of producing consumer goods. But money is not used up; its function is to act as a medium of exchanges--to enable goods and services to travel more expeditiously from one person to another. These exchanges 3%3 are all made in terms of money prices. Thus, if a television set exchanges for three gold ounces, we say that the "price" of the television set is three ounces. At any one time, all goods in the economy will exchange at certain gold--ratios or prices. As we have said, money, or gold, is the common denominator of all prices. But what of money itself? Does it have a "price"? Since a price is simply an exchange-ratio, it clearly does. But, in this case, the "price of money" is an array of the infinite number of exchange-ratios for all the various goods on the market.

Thus, suppose that a television set costs three gold ounces, an auto sixty ounces, a loaf of bread 1/100 of an ounce, and an hour of Mr. Jones' legal services one ounce. The "price of money" will then be an array of alternative exchanges. One ounce of gold will be "worth" either 1/3 of a television set, 1/60 of an auto, 100 loaves of bread, or one hour of Jones' legal service. And so on down the line. The price of money, then, is the "purchasing power" of the monetary unit--in this case, of the gold ounce. It tells what that ounce can purchase in exchange, just as the money-price of a television set tells how much money a television set can bring in exchange. What determines the price of money? The same forces that determine all prices on the market?that venerable but eternally true law: "supply and demand." We all know that if the supply of eggs increases, the price will tend to fall; if the buyers' demand for eggs increases, the price will tend to rise. The same is true for money. An increase in the supply of money will tend to lower its "price"; an increase in the demand for money will raise it. But what is the demand for money? In the case of eggs, we know what "demand" means; it is the amount of money consumers are willing to spend on eggs, plus eggs retained and not sold by suppliers. Similarly, in the case of money, "demand" means the various goods offered in exchange for money, plus the money retained in cash and not spent over a certain time period. In both cases, "supply" may refer to the total stock of the good on the market.

What happens, then, if the supply of gold increases, demand for money remaining the same? The "price of money" falls, i.e., the purchasing power of the money-unit will fall all along the line. An ounce of gold will now be worth less than 100 loaves of bread, 1/3 of a television set, etc. Conversely, if the supply of gold falls, the purchasing power of the gold-ounce rises.

What is the effect of a change in the money supply? Following the example of David Hume, one of the first economists, we may ask ourselves what would happen if, overnight, some good fairy slipped into pockets, purses, and bank vaults, and doubled our supply of money. In our example, she magically doubled our supply of gold. Would we be twice as rich? Obviously not. What makes us rich is an abundance of goods, and what limits that abundance is a scarcity of resources: namely land, labor and capital. Multiplying coin will not whisk these resources into being. We may feel twice as rich for the moment, but clearly all we are doing is diluting the money supply. As the public rushes out to spend its new-found wealth, prices will, very roughly, double--or at least rise until the demand is satisfied, and money no longer bids against itself for the existing goods.

Thus, we see that while an increase in the money supply, like an increase in the supply of any good, lowers its price, the change does not--unlike other goods--confer a social benefit. The public at large is not made richer. Whereas new consumer or capital goods add to standards of living, new money only raises prices--i.e., dilutes its own purchasing power. The reason for this puzzle is that money is only useful for its exchange value. Other goods have various "real" utilities, so than an increase in their supply satisfies more consumer wants. Money has only utility for prospective exchange; its utility lies in its exchange value, or "purchasing power." Our law--that an increase in money does not confer a social benefit--stems from its unique use as a medium of exchange.

An increase in the money supply, then, only dilutes the effectiveness of each gold ounce; on the other hand, a fall in the supply of money raises the power of each gold ounce to do its work. We come to the startling truth that it doesn't matter what the supply of money is. Any supply will do as well as any other supply. The free market will simply adjust by changing the purchasing power, or effectiveness of the gold-unit. There is no need to tamper with the market in order to alter the money supply that it determines.

At this point, the monetary planner might object: "All right, granting that it is pointless to increase the money supply, isn't gold mining a waste of resources? Shouldn't the government keep the money supply constant, and prohibit new mining?" This argument might be plausible to those who hold no principled objections to government meddling, thought it would not convince the determined advocate of liberty. But the objection overlooks an important point: that gold is not only money, but is also, inevitably, a commodity. An increased supply of gold may not confer any monetary benefit, but it does confer a non-monetary benefit--i.e., it does increase the supply of gold used in consumption (ornaments, dental work, and the like) and in production (industrial work). Gold mining, therefore, is not a social waste at all.

We conclude, therefore, that determining the supply of money, like all other goods, is best left to the free market. Aside from the general moral and economic advantages of freedom over coercion, no dictated quantity of money will do the work better, and the free market will set the production of gold in accordance with its relative ability to satisfy the needs of consumers, as compared with all other productive goods. [10]

[10] Gold mining is, of course, no more profitable than any other business; in the long-run, its rate of return will be equal to the net rate of return in any other industry.

Rothbard’s later devotes more time to study the proposition by many economists to stabilize the price level.

Some theorists charge that a free monetary system would be unwise, because it would not "stabilize the price level," i.e., the price of the money-unit. Money, they say, is supposed to be a fixed yardstick that never changes. Therefore, its value, or purchasing power, should be stabilized. Since the price of money would admittedly fluctuate on the free market, freedom must be overruled by government management to insure stability. Stability would provide justice, for example, to debtors and creditors, who will be sure of paying back dollars, or gold ounces, of the same purchasing power as they lent out.

Yet, if creditors and debtors want to hedge against future changes in purchasing power, they can do so easily on the free market. When they make their contracts, they can agree that repayment will be made in a sum of money adjusted by some agreed-upon index number of changes in the value of money. The stabilizers have long advocated such measures, but strangely enough, the very lenders and borrowers who are supposed to benefit most from stability, have rarely availed themselves of the opportunity. Must the government then force certain "benefits" on people who have already freely rejected them? Apparently, businessmen would rather take their chances, in this world of irremediable uncertainty, on their ability to anticipate the conditions of the market. After all, the price of money is no different from any other free prices on the market. They can change in response to changes in demand of individuals; why not the monetary price?

Artificial stabilization would, in fact, seriously distort and hamper the workings of the market. As we have indicated, people would be unavoidably frustrated in their desires to alter their real proportion of cash balances; there would be no opportunity to change cash balances in proportion to prices. Furthermore, improved standards of living come to the public from the fruits of capital investment. Increased productivity tends to lower prices (and costs) and thereby distribute the fruits of 383 free enterprise to all the public, raising the standard of living of all consumers. Forcible propping up of the price level prevents this spread of higher living standards.

Money, in short, is not a "fixed yardstick." It is a commodity serving as a medium for exchanges. Flexibility in its value in response to consumer demands is just as important and just as beneficial as any other free pricing on the market.

How the government would go about this is unimportant at this point. Basically, it would involve governmentally-managed changes in the money supply.

From Mystery of Banking: Chapter 5 - The Demand For Money:

An intangible, but highly important determinant of the demand for money, is the basic confidence that the public or market has in the money itself. Thus, an attempt by the Mongols to introduce paper money in Persia in the twelfth and thirteenth centuries flopped, because no one would accept it. The public had no confidence in the paper money, despite the awesomely coercive decrees that always marked Mongol rule. Hence, the public’s demand for the money was zero. It takes many years—in China it took two to three centuries—for the public to gain enough confidence in the money, so that its demand for the money will rise from near zero to a degree great enough to circulate throughout the kingdom.

Public confidence in the country’s money can be lost as well as gained. Thus, suppose that a money is King Henry’s paper, and King Henry has entered a war with another state which he seems about to lose. King Henry’s money is going to drop in public esteem and its demand can suddenly collapse.

It should be clear then, that the demand for paper money, in contrast to gold, is potentially highly volatile. Gold and silver are always in demand, regardless of clime, century, or government in power. But public confidence in, and hence demand for, paper money depends on the ultimate confidence—or lack thereof—of the public in the viability of the issuing government. Admittedly, however, this influence on the demand for money will only take effect in moments of severe crisis for the ruling regime. In the usual course of events, the public’s demand for the government’s money will likely be sustained.


Public expectation of future price levels is far and away the most important determinant of the demand for money.

But expectations do not arise out of thin air; generally, they are related to the immediate past record of the economy. If prices, for example, have been more or less stable for decades, it is very likely that the public will expect prices to continue on a similar path. There is no absolute necessity for this, of course; if conditions are changing swiftly, or are expected to change quickly, then people will take the changes into account.

If prices are generally expected to remain the same, then the demand for money, at least from the point of view of expectations, will remain constant, and the demand for money curve will remain in place. But suppose that, as was the case during the relatively free-market and hard-money nineteenth century, prices fell gradually from year to year. In that case, when people knew in their hearts that prices would be, say, 3 percent lower next year, the tendency would be to hold on to their money and to postpone purchase of the house or washing machine, or whatever, until next year, when prices would be lower. Because of these deflationary expectations, then, the demand for money will rise, since people will hold on to more of their money at any given price level, as they are expecting prices to fall shortly. This rise in the demand for money (shown in Figure 3.6) would cause prices to fall immediately. In a sense, the market, by expecting a fall in prices, discounts that fall, and makes it happen right away instead of later. Expectations speed up future price reactions.

On the other hand, suppose that people anticipate a large increase in the money supply and hence a large future increase in prices. Their deflationary expectations have now been replaced by inflationary expectations. People now know in their hearts that prices will rise substantially in the near future. As a result, they decide to buy now—to buy the car, the house, or the washing machine—instead of waiting for a year or two when they know full well that prices will be higher. In response to inflationary expectations, then, people will draw down their cash balances, and their demand for money curve will shift downward (shown in Figure 3.7). But as people act on their expectations of rising prices, their lowered demand for cash pushes up the prices now rather than later. The more people anticipate future price increases, the faster will those increases occur.
Deflationary price expectations, then, will lower prices, and inflationary expectations will raise them. It should also be clear that the greater the spread and the intensity of these expectations, the bigger the shift in the public’s demand for money, and the greater the effect in changing prices.

While important, however, the expectations component of the demand for money is speculative and reactive rather than an independent force. Generally, the public does not change its expectations suddenly or arbitrarily; they are usually based on the record of the immediate past. Generally, too, expectations are sluggish in revising themselves to adapt to new conditions; expectations, in short, tend to be conservative and dependent on the record of the recent past. The independent force is changes in the money supply; the demand for money reacts sluggishly and reactively to the money supply factor, which in turn is largely determined by government, that is, by forces and institutions outside the market economy

Guido Hulsmann’s essay, Optimum Monetary Policy (2003),  addresses monetary policy from a purely free market perspective where monopoly privilege to produce money does not exist.  That is, money production would occur just like any other good on the market.  Hulsmann argues that paper money is not a natural market good and even if we did have a lifting of legal tender laws, paper money would not be a viable options against other commodity based monies.

Although on a free market, any person could try to produce paper money, there are compelling reasons to assume that the production of money on a free market would in practice boil down to the mining and coining of precious metals, the physical characteristics of which make them more suitable as media of exchange than all other commodities. Theoretical analysis and historical experience both tell us that this will be the case. Paper money is unsuited to withstand the competition of the precious metals. The essential reason for its inferiority is that it does not attract a nonmonetary demand

Currency competition on a free market would thus be confined to the competition between precious metals. Here the relative scarcities of the various known metals play an important role in conjunction with certain technological constraints.
Suppose that the entire economy uses gold coins for its monetary exchanges, and that silver and copper are used only for ornamental purposes. Now suppose further that the economy grows and that as a consequence the purchasing power of gold constantly increases. There will come a point at which it is no longer convenient to produce and use gold coins that are sufficiently small to be used as payment in small transactions, such as paying for a cup of coffee or for a hair cut.

Hulsmann also addresses what would happen if the purchasing power of a given commodity (such as gold) became unusable for smaller transactions given that its purchasing power would consistently rise.  This is relevant to the question of a money deflationary environment where the money supply (where gold is money) may not grow much if at all in relation to the quantity of goods and services.

Another solution is to use a different metal, the purchasing power per weight unit of which makes it expedient to use coins made out of this metal for buying and selling those goods that can no longer be conveniently exchanged for gold. Let us therefore assume that some market participants start using silver coins in small transactions, and that other market participants imitate this successful behavior. As a consequence, our economy would use two monies—gold and silver—that freely circulate in parallel and overlapping networks. At least at the beginning, the gold network would probably be much larger, and silver coins would be used only in those less frequent cases in which neither gold tokens nor gold coins would be convenient.

If economic growth continues, the substitution process would replicate itself, both in the higher and in the lower echelon of money prices. Thus, at one point silver too might have such a high purchasing power that small transactions could no longer be made in silver coins. The market participants then might decide to use copper coins for these small transactions, thus layering a network of copper exchanges over the already existing networks of gold and silver exchanges. Meanwhile, gold coins could have such a high purchasing power that they might be unsuitable for most daily transactions. In this case, silver coins will replace them as the most widely circulating medium of exchange; the gold coins would be used only in transactions involving very expensive goods; and copper coins would be used predominantly in transactions involving goods of a very small value.

As long as a money can be easily divisible and prices are allowed to adjust, this is no problem with any amount of money or multiple monies circulating at once. 

Hulsmann continues to discuss that creating more money does not make an economy wealthier or reduce scarcity.  We desire real goods and not money per se.

Does printing more paper money reduce, by itself, the scarcity of resources? To raise the question is to answer it. Printing more paper tickets does not make us richer than we otherwise would be, because our welfare does not depend on the quantity of money we use, but on the quantities of real goods that can be purchased with this money. The simple fact is that printing money is not identical with producing goods that can be purchased with this money.  Additional money does not make the nation of money users better off than it would otherwise have been. If it were otherwise, we would long since have reached Nirvana. The incontestable fact is that printing more paper money is not the same thing as producing more of the nonmonetary goods that are offered in exchange for money. It follows that the production of money is in any case not a direct cause of those other goods.

Hulsmann’s essay provides a very comprehensive look a monetary policy from many angles.

The chief concern I suspect one would have regarding deflation has more to do with banking than the quantity of money.  Fractional reserve banking is really the culprit for causing serious problems in the economy and sowing the seeds of the business cycle.  During the 19th Century, we see inflationary booms and busts with banks expanding massive amounts of bank credit and loans than they had reserves to cover.

Let us know discuss the element of fractional reserve banking – where banks are only required to keep a fraction of reserves on hand of all deposits that can be redeemed at any point in time.  By deposits I’m including checking and saving account deposits.  Given the current day reserve requirement of 10% (that is banks only need to hold a reserve of 10% of all customer deposits), banks can lend out $9 dollars for every $10 it holds as reserves.  As more and more depositors put money into the banking system, the amount of money available to lend out increases and so on.  This is often known as the money multiplier. 

When the demand to hold money as cash balances falls, the money multiplier works in reverse and causes a massive downturn as we’ve seen countless times.  Banks are always susceptible to depositors pulling their money out and demanding redemption of their deposits in the form of currency.  If even a small amount of depositors pull their money out of the banks so as to hold some currency instead of deposits, the banks will be forced to reduce the amount of loanable they can lend out, which are considered assets by the banks. 

So, here we see the reason behind the logic for a the necessity of a Central Bank given a fractional reserve system that is always reliant on a constant money supply growth.  More could and should be said on FRB, but hopefully this will suffice for now.  For more information on this, I highly recommend Joe Salerno’s MIses University 2013 lecture on the Economics of Fractional Reserve Banking.


I usually do not quote large sections of books in a blog post, but the passages I’ve posted are extremely relevant to the issue at hand regarding the proper supply of money, the type of money unit being used, and the very idea of that one can know what a proper policy needs to be for controlling the supply of money.

As for the concern about a significant drop in the supply of money & credit (like what occurred in 1929), one needs to ask whether this event was precipitated by a period of significant increases in the supply of money and credit.  Also, one needs to understand and analyze what happened to interest rates during this time that lead up to the crash?  Were they being suppressed and kept artificially low despite a surge for loanable funds from banks?  If such a surge in demand for loanable funds (otherwise known as a increase in demand for money & credit), then interest rates should subsequently risen to reflect this reality. 

As I stated in my original blog post, Rothbard’s analysis of the 1920s stands as a significant response to the Friedman/Schwartz account of the 1920s.  As I posted in an update to my previous blog post:

I’d recommend special attention to Chapter 4 in Rothbard’s AGD where he discusses the inflationary boom despite stable prices or slightly falling prices in the economy.  Rothbard’s analysis properly points out that interest rates were stable despite great demand for loanable funds during the 1920s.  This appetite for loans should have caused interest rates to go up without Federal Reserve policy that pushed rates down through manipulation of the expansion of the money supply.  This is essential to the Austrian Theory of the Business Cycle, which I hold is a far superior explanation than other schools of economic thought, including Friedman’s “Plucking Model” or the Keynesian one.

Jacob takes issue with my characterization that a stable dollar is an oxymoron.  I stand firm in this claim and submit any money unit controlled by a government under a fiat-monetary system will suffer from this charge.

I assume the primary confusion rests on the definition of what we mean by a dollar.  One reason might be the term dollar has changed so many time over the last 200 years.  It’s as if the definition is meaningless.  This is the nature and essence of fiat-money in that the authority presiding over a given territory.  After all, fiat mean “let it be done.”  So, by definition, a fiat-dollar can mean whatever the governing body wants it to mean.

Now, if you are concerned about a money unit with stable purchasing power that stays constant over time and space, that is something worth investigating.  But, this has already been covered above in Rothbard’s chapter in What Has Government Done to Our Money.

On the issue of competing currencies and something Hayek recommended, I have a slightly different take on what the theory of competing currencies in that paper money would not last (as Hulsmann eluded) against other commodity based currencies.  Paper money (while we accept it now a days based on the fact it had purchasing power in the past and we hope it will have purchasing power in the future) is not a natural free market phenomenon.  There is a difference between fiduciary media or money substitutes and money proper.  If the legal tender laws were lifted, paper monies would virtually evaporate and dissolve.  So, I think Hayek’s analysis of a market chosen paper money is not realistic.  While I am encouraged by something like BitCoin as an alternative to modern fiat monetary system, I see problems with it being demanded as the most saleable good which is one of the core properties of money.


Rothbard, Murray N. [1983] 2008. The Mystery of Banking. Auburn, AL.: Ludwig von Mises Institute

-- 1990. What Has Government Done to Our Money. Auburn, AL.: Ludwig von Mises Institute

-- [1963] 2000. America’s Great Depression. Auburn, AL.: Ludwig von Mises Institute

Hülsmann, J. Guido. 2003. “Optimal Monetary Policy” Quarterly Journal of Austrian Economics IV: 37-60

Salerno, Joseph T. “Economics of Fractional Reserve Banking.” Ludwig von Mises Institute, Mises University. Auburn, AL. 23 Jul. 2013.

1 comment:

  1. I don't know much about these topics but would you say that the migrants in EU are causing deflation in the region? (sorry, I'm not a native speaker)