Here's why the Fed is wrong about both inflation and deflation

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The majority of economists view deflation as a general decline in prices of goods and services. This is viewed as a major threat to the public’s well-being for deflation is seen as a major factor that plunges the economy into an economic depression. Most of them are of the view that central banks and governments’ worldwide must aggressively fight the possible emergence of deflation. This way of thinking stems from an erroneous view of what deflation is. As a result, it is overlooked that it is not deflation but rather monetary pumping which is the root of economic hardship.

Is Inflation about Price Increases?

According to Mises in Human Action, “What many people today call inflation or deflation is no longer the great increase or decline in the supply of money, but its inexorable consequences, the general tendency toward a rise or fall in commodity prices and wage rates.”

Once inflation is defined as a general rise in prices, then anything which contributes to price rises is called inflationary and therefore must be guarded against. It is no longer the central bank and fractional reserve banking that are the sources of inflation, but rather various other causes. In this framework, not only has the central bank nothing to do with inflation, but on the contrary: the bank is regarded as an inflation fighter.

A fall in unemployment or a rise in economic activity are all seen as potential inflationary triggers and therefore must be restrained by central-bank policies. Some other triggers like rises in commodity prices or workers wages are also regarded as potential threats and therefore must be always under the watchful eye of the central bank.

Most commentators hold that inflation is a general rise in prices that can be captured by the Consumer Price Index (CPI), but they disagree about the causes of inflation.

In one camp, the monetarists argue that changes in money supply cause changes in the CPI. In the other camp, we have economists who argue that inflation is caused by various real factors. These economists are having doubts about the proposition that changes in the money supply cause changes in the CPI. They believe that it is likely to be the other way around.

Contrary to the accepted view inflation is not a general rise in prices, caused either by money supply growth, or by real factors. It is simply an increase in the money stock.

There’s an important distinction to be made here. I don’t claim, as monetarists do, that inflation is an increase in prices caused by rises in the money supply. All that I suggest is that an increase in the money stock is what constitutes inflation.

Looking at inflation this way makes it very clear why it is bad news. When money is increased there are always first recipients of money who can buy more goods and services at still unchanged prices.

The second recipients of money also enjoy the new money. However, the successive recipients derive less benefit as prices of goods and services begin to rise. (Note that a price of a good is the amount of money paid per unit of a good.)

So long as the prices of goods they sell are rising much faster than the prices of goods they buy, the successive recipients of new money still benefit.

The sufferers are those individuals who get the money last or not at all. They find that the prices of goods they buy have increased while the prices of goods and services they offer have hardly moved.

On a closer inspection we can also establish that monetary injections give rise to demand for goods and services, which is not supported by the production of goods and services. It results in the transfer of wealth from wealth generators to non-wealth generating activities, or bubble activities.

While increases in money supply (i.e., inflation) are likely to be revealed in price increases registered by the CPI, this need not always be the case. Prices are determined by real and monetary factors.

Consequently it can occur that if the real factors are pulling things in an opposite direction to monetary factors no visible change in prices might take place. While money growth is buoyant, i.e., inflation is high, prices might display low increases. (Remember a price is the amount of money per unit of something.)

Clearly, if we were to regard inflation as rises in the CPI, we would be reaching misleading conclusions regarding the state of the economy.

On this, Rothbard wrote in America’s Great Depression, “The fact that general prices were more or less stable during the 1920s told most economists that there was no inflationary threat, and therefore the events of the great depression caught them completely unaware.”

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Is Deflation the Root of “All the Evils”?

So while inflation is an increase in the money stock, deflation can be seen as the opposite, which is a fall in the money stock. Or we can say that whereas monetary expansion gives rise to a bubble, the monetary contraction leads to the deflation of the bubble. It seems therefore that deflation in this sense must be preceded by inflation.

Following the views of the famous American economists Irving Fisher most economists regard deflation as bad news. Irving Fisher labeled deflation “the root of almost all the evils.”

On the contrary, deflation is the beginning of the process of economic healing. Deflation arrests the transfer of wealth from wealth producers to various nonproductive bubble activities caused by the prior monetary inflation. By arresting the transfer it arrests the process of economic impoverishment. Contrary to mainstream thinking then, deflation of the money stock strengthens the producers of wealth, thereby revitalizing the economy.

On this Rothbard wrote, “deflationary credit contraction greatly helps to speed up the adjustment process, and hence the completion of business recovery, in ways as yet unrecognized.”

Obviously the side effects that accompany monetary deflation are never pleasant. These bad side effects are not caused by deflation but rather by the previous monetary inflation. All that deflation does is to shatter the illusion of prosperity created by monetary inflation. Deflation removes various bubble activities thereby strengthening the process of wealth generation.

The popular belief that a fall in the money stock leads to general economic impoverishment emanates from a view that money can grow the economy. What however enables economic growth is not more money but more capital goods per capita. Furthermore, economists who regard a general fall in prices as an important cause of depression overlook the fact that what matters for business is not the general behavior of prices, but the price differentials between selling prices and costs.

A general fall in prices need not be always in response to monetary deflation. For instance, for a given money stock an increase in the demand for money can take place on account of a growing economy and rising living standard. This in turn will lead to a general fall in prices and hence will be labeled as deflation.

Should then this fall in prices be regarded as bad? In the market economy a fall in prices in response to an increase in real wealth is a mechanism through which wealth expansion permeates throughout the economy. With the increase in the purchasing power of money people can now secure for themselves a greater amount of goods and services.

Do Depressions Result When Money Disappears?

In his writings, Milton Friedman blamed the central bank policies for causing the Great Depression. According to Friedman, the Federal Reserve failed to pump enough reserves into the banking system to prevent the collapse in the money stock.

For Friedman, the failure of the US central bank is not that it caused the monetary bubble but that it allowed the deflation of the bubble. Murray Rothbard, while agreeing with Friedman that the money stock fell sharply, found that the Federal Reserve had been aggressively pumping reserves into the banking system. Notwithstanding this pumping, the money stock continued to fall. The sharp fall in the money stock, contrary to Friedman, is not indicative of the Federal Reserve’s failure to pump the money supply. It is indicative of the shrinking pool of real wealth brought about by previous loose monetary policies of the central bank and the resulting strong increases in the money supply rate of growth.

The existence of the central bank and fractional reserve banking permits commercial banks to generate credit which is not backed up by real wealth, i.e., credit out of “thin air.” Once the unbacked credit is generated it creates activities that the free market would never approve, i.e., these activities are consuming and not producing real wealth. As long as the pool of real wealth is expanding and banks are eager to expand credit various false activities continue to prosper.

Whenever the extensive creation of credit out of “thin air” lifts the pace of real-wealth consumption above the pace of real-wealth production the flow of real savings is arrested and a decline in the pool of real wealth is set in motion. The performance of various activities starts to deteriorate and bank’s bad loans start to rise. In response to this, banks begin to call back their loans and this in turn sets in motion a decline in the money stock. Remember that here we have credit that banks have created out of “thin air.” This type of credit never had a proper owner. Once it is repaid to the bank and the bank doesn’t create a new loan it must disappear. This is not the case when the loan is fully backed by real wealth — once it is repaid it goes via the bank to its original owner, i.e., lender. The bank here is just an intermediary.

We can thus conclude that depression is not caused by the collapse in the money stock as such, but in response to the shrinking pool of real wealth, which also causes the disappearance of money out of “thin air.” Even if the central bank were to be successful in preventing the disappearance of money, this would not be able to prevent a depression if the pool of real wealth is declining.

Also, even if loose monetary policies were to succeed in lifting prices and inflationary expectations, this couldn’t revive the economy as long as the pool of real wealth is declining.

We can conclude that it is the loose monetary policies of the central bank and fractional reserve banking that causes a persistent misallocation of resources, which in turn weakens the flow of real savings and hence weakens the process of real wealth formation. This in turn implies that the primary causes of depression are loose monetary policies of the central bank and fractional reserve banking. A fall in prices is just a symptom, as it were.

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