Wednesday, July 24, 2013

Deflation, Inflation, & Money: A Reply to Jacob Westman

finance-deflationJacob Westman who blogs at The Analytic Economist wrote a critique of the exchange between Jeff Herbener and Tom Woods regarding deflation (shown below).

I have a lot to say on the subject of Deflation & Inflation as do other Austrian economists.  In actuality, it is one of my favorite subjects and something I’ve spent the better part of the last 4 years trying to better understand.  So, I thought it deserved a more fleshed out blog post instead a long-running post in the comment section.  This post is a continuation of the comments which can be found here and here while Jacob’s replies can be found here and here.

I fully recognize there is a difference between slowing money supply growth and a retraction/decrease in the money supply.  I think Jacob and I both need to be precise in our definitions and terms (i.e. phrases like “mild deflation”).  I'd maybe rephrase to say something like “mild price deflation” as opposed to “mild money supply growth” or “mild money inflation.” 

My argument is that most mainstream economists consider any form of deflation - either a falling aggregate price level (or price deflation) or a slow down/retraction in the money supply (money deflation) - as being bad.  Obviously, I disagree and say neither price deflation nor money deflation are bad per se.  However, many of the economists who frequent CNBC, Bloomberg, or even the Fed Board of Governors do in fact think price deflation (and money deflation) is in fact bad.  They all advocate a constant policy of price inflation and the deflationary boogey man is frequently right around the corner.  Bernanke himself has stated how we must take the advice of Friedman and always have his famous helicopter on standby should deflation rear its head.  I think the constant hysteria of deflation stems from the influence of Irving Fischer and his musing of the mythical deflationary spiral.

I think a good example of what an economy looks like with price deflation and a high economic growth is what we saw in late 19th century of the U.S.  As to a huge drop in the money supply, we see this happening after an inflationary boom whether in 1921, 1929, or in 2008.  What are we to think of an economy that experiences massive money/price deflation as experienced during a recession or depression?  Obviously, the effects of such an event are devastating to those individuals whose livelihoods are now turned upside down and must now pick up the pieces.  But, the Monetarists, Neoclassicals, and Keynesians all are united in the claim the Central Bank must do something and step in, right?  I would say no to this postulate and encourage readers to pick up any type of Austrian economics literature that explains the necessity of how the market economy must allow for prices to adjust and markets to clear.  More could be said of this, but let us return to deflation and inflation.

Friedman and many others Neoclassicals either forget or fail to understand what the monetary policy was during the 1920s.  During that time, the money supply was expanding at a very high rate year over year.  Yet, prices were relatively stable.  If the money supply had stayed relatively constant price should have fallen considering the rise in productivity.  Murray Rothbard provided this analysis in his great work America’s Great Depression 

Update: 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.

When there is high economic output, the price level should generally fall as the volume of goods increases at a faster rate than the supply of money.  Also, there is a non-neutrality of money in that the new money does not effect all prices at the same time or in the same way.  Rather, higher order goods (capital/producer goods) which are further away from the consumer are the most sensitive to inflationary policies and interest rates below the natural rate.  Fractional-reserve banking also complicates things, but that is a whole other blog post.

My point with gold and corn (and the other commodities I mentioned) is that all forms of money start out as goods used for direct exchange that have some type of use value and only become money when they can be valued as means for indirect exchange.  Whether money is beaver pelts/furs (Native Americans), cigarettes (used as money in many prison economies), or whatever that has been money in the past - there is a marginal utility for money like any other good.  There is a supply, demand, and price of money as Mises explained in his pioneering book, Theory of Money & Credit, which was the first to integrate and apply the laws of marginal utility to money.  Gold and Silver have value in their non-money properties where fiat-paper money does not - unless one values it as tinder for a fire, wallpaper, or maybe as a substitute for toilet paper.   I’ve written a lot about money and do not wish to repeat that which can be easily accessed on this blog.

To the point about the entrepreneur looking to put his $100M to its most valued use/end, I understand the statement just fine.  The premise of Jacob’s claim is that a constantly expanding money supply (assuming we're talking about a monetary system like what we have today) would be better than an economy with general price deflation (like the late 19th Century).  An entrepreneur role is to forecast or speculate what future prices of the outputs he/she wants to sell to perspective buyers.  The key to their success is that they aim to select the correct combination of inputs and sell them at a higher price than the cost of the inputs.  This will reward those entrepreneurs who are the best at constantly minimizing their costs and adjusting the combination of how much to spend on capital goods and how much to spend on labor.  Even if the money supply fails to grow at X%, this does not mean the entrepreneurs prices will fall in lock step with the money supply.

Deflation rewards savers and punishes debtors.  The purchasing power of money will increase in a deflationary environment and most likely encourage a strong pool for saving and investment where inflation does the opposite - encouraging debt and consumption.  Deflation rewards those who increase productivity as well as production at an ever falling price – especially in highly competitive industries.  Some of the wealthiest entrepreneurs of history made their money by consistently improving their output while also lowering the price of their goods.

Yes, under a gold/silver standard the money supply would obviously grow at whatever the rate it was profitable for mining companies to recover gold/silver.  I have no idea what the historical or future recovery rate is if gold/silver were money.  I’ve heard close to 2%, but the number is irrelevant since any quantity of money in the economy will suffice so long as prices are allowed to adjust. 

Here is probably the best question of the entire post:

Do you really think the argument of a stable dollar is bad?

I love this question because it begs the question: what is a dollar?  If the definition of a dollar is a fiat-money unit most commonly acknowledged as a piece of paper with green ink and dead presidents which I am required to use as the only form of legal tender for all debts public and private issued by Central Bank and decreed by government – then I’d respond by saying unequivocally yes this is bad.  Given this definition, a stable dollar is an oxymoron.  Now, if the definition of a dollar is a fixed weight of gold, fixed weight silver, or fixed weight of some other durable commodity with the correct money properties, then I’d respond by saying no there is nothing wrong with this type of stable dollar in the same sense a stable foot is to be 12 inches and a stable mile is to be defined as 5,280 feet.

I really wish Milton Friedman extended the virtue of being “Free to Choose” when it came down to advocating the freedom to choose what should be money.  What is wrong with competing currencies and the abolition of legal tender laws?

I’m quite aware of the hostility that exists towards Austrian economists and the various critiques which have been leveled towards the school of thought. However, I cannot seem to understand the lack of appreciation for the pioneering work done by Austrians on Money & Banking – especially for critics who espouse to be pro-free market. 

A constantly expanding supply of gold or silver accepted as money is not the same as a constantly expanding supply of fiat-money issued by a Central Bank.  I understand Friedman was trying to come up with a rule to emulate what the free market would do given some type of gold standard.  However, the key difference as I’ve stated before is the monetary unit itself.  For every gold/silver ounce that is mined, real wealth is brought into the economy that can be used for both direct & indirect exchange.  The mass production of pieces of paper with funny looking people on them yields no real wealth.  Paper money can be manufactured at virtually zero cost and only yields some type of marginal utility when backed by legal tender laws of coercion by a monopolist of ultimate decision making otherwise known as the State.  Fiduciary media masquerading as money proper is always going to be problematic.

To the point about inflation given a gold standard, it is entirely plausible for an inflationary boom to occur if a large deposit of gold is suddenly found.  This would cause the purchasing power of gold to fall and the goods priced in gold to rise as well near the area where the gold was recovered.  But, this also means that material wealth has been increased as I’ve said above in the sense gold can be used for other purposes than a medium of exchange.  This incident would further my position that we cannot know what the supply of money or the demand for money can or should be in a society given sound money always has two purposes.

Last is the claim that it’s a straw man to say Neoclassicals think it’s disaster for price deflation in computers or coffee.  I think Jacob conflates genuine product development by an entrepreneur who seeks to refine and improve the factors of production for a specific product or product-line with Schumpeter’s concept of “Creative Destruction.”  Innovation and productivity improvements are necessary for entrepreneurs in all industries and not just in silicon valley or technology goods.  Businesses naturally want to provide the highest value and best bang for the buck to their customers.  This would occur in a deflationary economy just as it does in an inflationary economy.  The key difference is as Woods/Herbener explain is that price deflation rewards the better entrepreneurs while price inflation rewards those well connected who have access to getting the new money first.

Individuals after all desire goods and services and not necessarily money per se but the future purchasing power of the goods/services they hope to exchange for their money.  A characteristic of a free market economy is a naturally falling price level and not an price inflationary one.

In closing, I’d like to recommend two great podcasts produced by Radio Free Market with Michael McKay on Inflation, Deflation, and Money.

Mr Douglas French on Hurray for Deflation

Dr. Jorg Guido Hulsmann on Natural Money vs Forced Money: Legal Tender Laws


  1. I'd like to point out that Woods and Herbener directly claim that when economists are talking about deflation they are talking about price decreases. Not cuts in the money supply. Hence, I addressed this argument. I'd like to further point out is that you are doing the same thing. You are pointing of the benefits of price decline due to increased productivity. Of course this is good for the economy. Milton Friedman's theory allows for this. If we increase a targeted money supply each year by say 3%, if we have year of high growth this will cause mild price declines due to increased productivity. This is why I say Milton Friedman, and other economists are not afraid of mild deflation or price declines.

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

    To claim that fiat money and stable dollars is an oxymoron is truly confusing. I commend you for not being a believer in gold standards, but rather a fan of competing currencies. I as well believe we should allow competing currencies. And just to point out Milton Friedman was not in the favor of the federal reserve. All of his theorizing is given that it exists.

    But if we had these competing currencies, would people not swarm to the company that is providing stable money, as Hayek points out in his paper "A Free Market Monetary System". He even says the most desired dollar might even be fiat as long as it is stable. If it is not stable people will leave the dollar. Even Herbener points this out in the video. If deflation is all you make it out to be why would people be dumping this deflated dollar? It is because you did not address the consequences of cutting the money supply, but rather you address the benefits of falling prices due to increased productivity.

    Ah, Friedman wrote the book on monetary history of the United States, so if you want to see how he speaks about the 20's through the depression I suggest you do so. But in summation, what he says is that the crash of 1929 is a normal bust caused by the federal reserve. You would agree with that. What he goes on to say is that the severity of it is caused by a 33% decrease in the money supply over the next 3-4 years. If a third of the banks close is this good for the economy? No. So what Friedman argues is that we should have had less of a boom in the 20's which would have not caused as large as a bust in the 30's.

    You wrote very eloquently on the benefits of price decline caused by increased productivity and are obviously very knowledgeable on the subject. But the reason why mainstream economists don't adopt Austrian theory is because it is incomplete. There HAS to be consequences to cuts in the money supply. If deflationary policies were as much of the bees knees as Austrians point out, 1, people would adopt the Austrian Theory, and 2, we would constantly be using deflationary policies and the economy would be perfect all the time.

  2. Okay, let me try and refocus the conversation on money deflation since that appears to be what you're interested in.

    In a free market where the preferred medium of exchange is not issued by the state or controlled by a central government, the general stock of money would most likely grow since (as I've said above) the monetary unit would have two purposes - one as a means of direct exchange and one a means of indirect exchange. Like cigarettes in a prison - inmates can always use them as a money OR just smoke them if they want. Given you are a proponent of empiricism, we can see the evidence of this throughout history that civilizations migrated to precious metals in the form of coins. Now, this doesn't mean money HAS to be precious metals, but we can see WHY they have been money in the past.

    If the medium of exchange for whatever reason starts becoming scarce and falling in its quantity, that means the ratio between the money and other goods would become smaller and smaller leading to a higher and higher degree of purchasing power. This would only be a problem if the price of existing goods was not allowed to naturally fall and adjust to the whims of the market given supply/demand & marginal utility. People obviously might want to hold on to this money as savings if the did not feel the need to buy goods and wanting to prolong consumption. This would then lead to a larger pool of elgible savings for investment or future consumption down the road. Herbener raises an excellent point to your question about what individuals would do if they have outstanding debts they need to pay off and yet see a rising purchasing power of their money. But, again marginal utility would inform us that they are other substitute mediums of exchange (given no legal tender laws or fiat/mandates for what SHALL be money) and it would make sense for people to negotiate different payment terms with their creditors just as people who find themselves on the brink of bankruptcy when met with less purchasing power to pay off their debts. So, again the question of "what is the optimal amount of money for an economy?" can be answered with a different yet related question of - "what is the optimal amount of gold, silver, platinum, copper, zince, oil, cigarettes, etc for an economy?"

    Hopefully this is an exceptible answer to the issue of whether a falling money supply whether 2% or 50% would be problematic. My simple yet most likley unsatisfactory response would be - it depends.

    1. As for the issue of the Friedman and monetary history - I am well aware of his book with Anna Schwartz on monetary history as well as it's influence. But, sadly their conclusion that the Fed was to blame for the Great Depression is different than that of the Austrians. They claim the Fed didn't do ENOUGH to step in and pump money into the economy. As to whether a bank failure is bad - that is another entire blog post but I will say this. Yes, the bank failures obviously were bad in the same way all of the 2008 crash caused massive bankruptcy to mortgage lenders, real estate agents, wall street traders etc. Fractional Reserve banking and the mixture between Demand Deposit Banking and Loan Banking are fundametal problems to our current banking system that is prone to systemic problems.

      But, one thing that is not well known is what the Fed did in the aftermath of the crash in 1929. The Fed DID actually pump in a lot of liquidity from 1930 to 1931 and yet the standard answer from those follow the Friedman/Schwartz analysis is that the Fed didn't pump in ENOUGH money and was too timid - which is why Ben Bernanke fancies himself much more of a Friedmanite than people realize. Also, Friedman and Schwartz compliment Benjamin Strong (Fed Head until his death in 1928) for his competence and policies during the 1920s.

      I'm not advocating for a deflationary policy. Rather, I'm arguing from a free market economic analysis standpoint. Also, you confuse "people" accepting the analysis i've described versus the "State" accepting the laws and lessons we can infer from free market analysis. The argument goes, "If a totally free market is so great, why don't we have one?" To this I would point the inquisitor to Tom Woods brilliant reply.