We all know what inflation is, don’t we? Sure, we know, it is rising prices. Is it? Why? What is the reason for higher prices? And, more important, do the prices really rise? Compared to what?
Have I confused you? Good. Time to talk a bit about the foundation of money.
What do we mean with the term money? Easy one, it is what you give away when you buy goods and what you get for work. Yep, right. So, money is a medium of exchange. But now I need to confuse you even a bit more. Dollars, the nice printed paper bills, are money only since 1971, at least since than, they where backed partially by real money, which was gold at that time.
Hey now, what do you mean by “real money”? If I can go to the store and get T-bone Steaks in exchange for those bills, than it works for me and I call that money. Fair enough. I couldn’t agree more. But mind the “If” in your sentence. What is the reason for the butcher to hand you his valued tender T-bones for an ugly peace of paper showing always the same old men on them? Because, he believes, that he in turn can use them to get what he desires, maybe a fresh tasty bread and some tuna. This is the cool thing with a money (yes this is no grammatical error, it is a money, because there can be a lot of different moneys). Everybody accepts it as a medium for exchange.
Can you imagine how awkward it would be if you wanted to get 3 eggs and all you had is 1 pound of butter to offer? You might be lucky and the farmer could be in need for butter and is willing to exchange. But, what if not? In this case you have to find someone that has something the farmer could need and, at the same time, is willing to exchange this item for your butter. With a money, you are better of, you can exchange your butter for 1 unit of a money and buy those 3 eggs with the money you exchanged.
Money therefor is a commodity that everyone accepts for exchanges. It does not matter what the money is made of. In fact, all kinds of things have been used as a money. Iron bars, horse shoes, whiskey(yep here in the United States), cigarettes,mussel shells, gold, silver, grain and the like. The important thing for a money is that it is widely accepted for exchanges.
Agreed, some items are better suited to be a money than others. What if we would use eggs as a money? Well, risky thing to do. Eggs can easily break and broken eggs are hard to exchange. And if you would save for, say a new car, how long would it take for the eggs to rot? And even the car dealer I know wouldn’t accept rotten eggs for a new car (maybe for one of his used car occasions though).
So, bottom line, a money should have some attributes like durability, easy to divide, hard to counterfeit. Wait a minute. I understand the durability thing, even the requirement to be easy divisible, but why hard to counterfeit? Well, think about it, if there was a money price of one money unit (whatever the unit is let’s say a Taler) for an egg that would mean that one pound of butter (if we take the example above) would have a money price of 3 Taler(money units), because we exchange 1 pound of butter for 3 eggs. What would happen if all of a sudden there was more money in the market? Right you guessed it. You would have to pay more money units to get your butter or eggs or whatever you like to buy.
Say “bad Joe Counterfeiter” had a way to double the amount of money in a market. What would be the effect? Right, taking our example, all of a sudden you would have to pay 6 Taler for a pound of butter and 2 Taler for an egg, even if nothing else had changed. The value of the eggs compared to the butter has not changed at all, you still get 3 eggs for a pound of butter. Yet, you have to give more money units for this transaction.
Well, whats wrong with that? If the new money, “Bad Joe’s “ that is, comes on the market, it will equalize after some time. Right it will, but in the meantime, those having the new money sooner than the rest, benefit, for they buy to a price not already in sync with the amount of new money on the market.
This is the reason, why a good money should be hard to counterfeit. It prevents Inflation. Because this is how we call the process of pushing new money into a market. The rising prices are not the inflation, as coughing is not the cold. Rising prices are a symptom of Inflation. Inflation is the inflating of the amount of a money in the market. And it leads always to rising money prices. Yet, it does not lead to rising prices of a certain good compared to other goods, all goods rise only in money prices. So 3 eggs still go for 1 pound of butter but now the money price you have to pay is 6 Taler instead of 3.
Beside the raising of prices, how does this hurt the other participants in the market?
Well, you are a sober guy and you have saved some money every week from your paycheck for retirement. Say, 10000 Taler so far. Now, all of a sudden, your 10000 Taler can only buy half of what they would have bought before. Basically half of it is rotten. You sure are happy about that, are you?
And almost as worse, can you remember how long ago you received your last raise from your boss? If you earned 200 Taler a week before Joe’s coup, and you still earn 200 Taler now, you basically lost half of your salary. Ouch…
How can that be cured? Hmm, we could take money out of the market, can’t we? Yes we can, and guess how this process is called? Yes, you are right, it is called deflation. What will be the symptoms of a deflation? Right, falling prices.
So wrapping this thing up, Inflation is pushing more money into a market, thereby rising prices without changing the exchange ratios of the goods. Deflation is the removal of money from the market and has the opposite effect.
Not a really hard to grasp concept, isn’t it?
Now, we are a lucky bunch of citizens, because our good government makes sure Joe the Counterfeiter is caught quickly before he can do real harm to the economy as a whole. Really?
Well, there is a little problem with that view. The problem is, that the government determines what a money is inside its territory. Ooops. You mean they can just print it up like Joe? Yep. And they do. They call it monetary policies. With our dollars we are completely dependent on the whim of our government. Thank god we have a democracy and they can’t do what they like, can’t they?
Naw, we have responsible politicians, that have the common good and the prosperity of the citizenship always before their eyes. And we have laws, haven’t we?
Ok, granted all super-altruists find their way into some government office eventually, let’s make a thought experiment anyway.
Suppose some real bad guys, selfish, reckless in short typical capitalists find a way to act like the altruists and convince the people to vote them into office. Just for the sake of the argument. I know it never can happen here. Now those folks had their fingers on the printing press and could spill the economy with money. What would that mean? Well first inflation, later more inflation and eventually hyperinflation(If you like to know what that means google up pre WWII Germany).
So those bad guys would be the first to get the new money and could spend it for good items while the rest of us would see how our savings and our wealth is vanishing.
But, sure that can never happen, can it?
Can someone explain, why new money in a market is needed anyway?
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Hi Norbert,
More money is required when more supply capacity is available. If you don’t add more money, then each money unit will be able to get more- conversely, the price of each good goes down. Thus, you have deflation.
So, when we’ve added billions of people to the labor pool, when technology is obviating commodities (think wireless for copper, solar for oil, highrises for land), when the greatest percentage of people live in peace in human history and negative supply shocks are minimized by better design and insurance, and there is a whole new cyberspace universe waiting to be monetized, it should be obvious that supply has increased tremendously.
Think of it this way- you have a poker game. 5 guys get 100 chips in return for a promise to mow your lawn. The games proceed, and one guy loses all his chips, another wins 100 chips, and the other three stay at 100. The guy who won decides to go home (don’t we all hate that guy?), pays you back your 100 chips, and takes 100 chips home (and tells you he’ll give them back if you’ll mow his lawn).
Now, 4 more guys come over. They’ll promise to mow your lawn for 100 chips too. So- do you get more chips? Or do you tell them that you only have 400 chips- you have to get 200 from the other guys, now the price of lawn mowing is only 50 chips.
Guess what happened to the guy who left? He now has TWO lawn mowings coming- FOR DOING NOTHING.
Now, if you think that’s a great way to run an economy- let people who are doing nothing other than hoarding chips (money) gain- well, hey, you must have lots of chips. And the ability to spend them to get control of monetary policy, to constrain the money supply. But guess what- someone has to provide the additional lawn mowings, and with fewer chips there is less “divisibility”. Also, as people see their chip values dropping (as more guys show up to play), they start sitting out more hands and taking fewer risks because they don’t want to run out of chips. And less playing, less risk taking translates to depression in an economy. Soon, people pay back what they can- if they can- take their chips home- and the losers have no chance to get their money back.
If money has time value, it should also have a half-life. Isn’t it clear why new money has to be created now?
BTW, is it a coincidence that every international financial crisis has been proceeded by an increase in Fed funds rates?…
Hi Dirk,
The source of the difficulty in understanding is that you misrepresent the economy in your version of the poker game.
If I have 100 poker chips, it is because they are my chips. That is a part of my wealth. It represents my production, my wages, my investments or my savings. I can do with them what I want to.
If I borrow those chips, from you or anyone else, I am bound by the terms of the contract, whether payment will be made in dollars, poker chips or lawn mowing services. Say I own 100 chips and owe 1 lawn mowing service. You or someone else owns assets called lawn mowing service obligations.
It is a given that there will be 500 chips and 5 lawn mowing obligations to start with. If you issue 500 more chips to new players without requiring them to commit to their own lawn mowing obligations, then there will be 5 lawn mowing obligations and 1000 chips. The very act of your issuing the new chips without any underlying lawn mowing obligations means that you, as the central banker of the game have just robbed me of half the value of my chips. Whether I play every hand or “hoard” my chips, the robbery is the same. The new players can use their chips to buy lawn mowing services too and will bid up the price of those services. My 100 chips will now only buy ½ of a lawn mowing service. In order to buy lawn mowing services to pay my contractual obligation, I will have to pay 200 chips. I will have to either borrow 100 more or earn them in some other way. Your issuing of those chips is theft from the original players.
Inflation in your poker game reduces the wealth of everyone except for those who got their chips for free. In real life, those who get the chips for free are the central bankers, the participants in the fractional reserve banking system and bond brokers. The further away from the issuance of the extra money, the more severely impacted the victim will be. That includes the poor, those on fixed incomes and those who own fixed income obligations. It also includes everybody who buys things, because the price of things will go up when the money supply increases without new production, or new lawn mowing obligations in keeping with the analogy.
The amount of money or chips in a market doesn’t matter in the least. There is no right amount of money and no wrong amount. What matters are the real goods in the market. Money is only a representation of the goods it can buy. If productivity and the amount of goods in the economy doubles over time without the money supply changing, prices will decline by one half, more or less. That doesn’t hurt or help anyone because the relationship is based on the value underlying the money.
In a market, what is important are the lawn mowing obligations or any goods and services that people trade among themselves. If participants in your poker game produced more lawn mowing service obligations and offered them for sale at the table, nobody at the table would be hurt. The price of lawn mowing services would be bid down, but it also means that each participant would have to pay fewer chips to fulfill his obligation. They would, on average, have more left over to buy something else with. That is how a society progresses.
Artificially deflating or inflating the money supply are both bad and both hurt market participants because it distorts the relationship between the money and the underlying goods, just as adding more chips to your poker game without lawn mowing obligations distorted the relationship.
Production is what causes wealth and progress, not money. Money, as a policy tool, can only distort the economy and take from one pocket and put it into another.
BTW, is it a coincidence that every international financial crisis has been preceded by a massive credit and asset bubble? Is it a coincidence that those bubbles were accompanied by artificially low interest rates and massive monetary pumping? Is it a coincidence that consumer price inflation starts to take off at the end of each massive inflationary boom? You are right. They are not coincidences. The low rates and monetary pumping cause the inflationary asset and credit bubbles, the inflation inevitably starts to affect consumer goods, the central banks react by raising interest rates and the bubble bursts. It has never been a coincidence. It also cannot be different until the artificial manipulation of money and credit markets by central banks is stopped.
The economy doesn’t crash because the rates are raised. It crashes because there is a huge bubble that is caused by irresponsible monetary policy and artificially low interest rates to begin with. Central planning in the monetary markets is just as wrong headed and damaging as central planning in any other market.
Dan,
In my poker example, nowhere do I propose issuing chips for free. I do recognize the reality of price stickiness- that when you hold the money supply constant with increasing supply capacity, prices will fall, but not fast enough (we probably both agree that government contracts and minimum wage don’t help us here), and output will be negatively impacted.
What do you consider “false” economic activity? I understand the basic idea, as did Soviet/PRC economists, I’m sure. Do you consider bigger houses false? Feeding inner-city babies false? Investments in alternative energy? Internet postings?
One of the unintended consequences of deflation is cash hoarding and a rise in populism. I would refer you to Wikipedia for a more thorough discussion of deflation, and its destructive effects on economic activity.
Ultimately, this discussion will be settled either by voters, or guns (and at the moment the Fed is expanding its balance sheet at breakneck speed), because these decisions are ultimately directed by people’s views on economic growth and opportunity- more opportunity (and growth), or less.
Hi Dirk,
If you look at the references in the Wiki entry you suggest, you can see why our economy is in a shambles. Bernanke, Krugman, Central Bankers, ets. They are all apologists for monetarism, inflationism, or outright Keynesianism. Those are the theories and policies that have been followed and those are reasons for periodic devastation of the economy, the devastation we are living through now. That is my point. Things won’t change until we change the way we do things.
As far as the poker example goes, you are right, I didn’t use the exact example, so let’s try again:
Lawn mowing obligations (LMO’s) are the asset that arises when someone makes a legal obligation to provide lawn mowing services.
Before the game starts:
I own at least 900 chips if I am in a position to give them to the players, the original 500 plus the added 400. There are no lawn mowing obligations to start with.
I trade 500 chips to the original players and receive in return, 5 LMO’s, the promises of future production.
Beginning of the game:
Me – I own 400 chips and 5 LMO’s
Player 1 – owns 100 chips, owes 1 LMO
Player 2 – owns 100 chips, owes 1 LMO
Player 3 – owns 100 chips, owes 1 LMO
Player 4 – owns 100 chips, owes 1 LMO
Player 5 – owns 100 chips, owes 1 LMO
900 chips total, 5 LMO’s owned and 5 LMO’s owed
After the first round:
Me – I own 400 chips and 5 LMO’s
Player 1 – owns 200 chips, owes 1 LMO
Player 2 – owns 0 chips, owes 1 LMO
Player 3 – owns 100 chips, owes 1 LMO
Player 4 – owns 100 chips, owes 1 LMO
Player 5 – owns 100 chips, owes 1 LMO
900 chips total, 5 LMO’s owned, 5 LMO’s owed
Before next round
Player 1 sits out , pays off his LMO with 100 chips
Me – I own 500 chips and 4 LMO’s
Player 1 – owns 100 chips, owes 0 LMO’s
Player 2 – owns 0 chips, owes 1LMO
Player 3 – owns 100 chips, owes 1 LMO
Player 4 – owns 100 chips, owes 1 LMO
Player 5 – owns 100 chips, owes 1LMO
900 chips total, 4 LMO’s owned and 4 LMO’s owed
When 4 new players are admitted, I pay them 400 chips and get 4 LMO’s in return.
Me – I own 100 chips and own 8 LMO’s
Player 1 – owns 100 chips, owes 0 LMO
Player 2 – owns 0 chips, owes 1 LMO
Player 3 – owns 100 chips, owes 1 LMO
Player 4 – owns 100 chips, owes 1 LMO
Player 5 – owns 100 chips, owes 1 LMO
Player 6 – owns 100 chips, owes 1 LMO
Player 7 – owns 100 chips, owes 1 LMO
Player 8 – owns 100 chips, owes 1 LMO
Player 9 – owns 100 chips, owes 1 LMO
900 chips total, 8 LMO’s owned and 8 LMO’s owed
When player 1 sits out, he doesn’t hurt anyone. He is only preserving the wealth he accumulated. Player 2 is not hurt by player 1 sitting out. He was hurt by playing the game and losing. Player 1 doesn’t owe him or anyone else anything at all. He won it fair and square. The players remaining in the game each individually owe an obligation to mow my lawn. Playing the poker game changes nothing with what they owe. If they choose to gamble again, they may make some more chips or lose some chips, but either way, they will still owe the LMO. They may be able to negotiate with me or with player 1 or among themselves for some kind of deal with the LMO’s but that does not change the makeup of the game.
A real free market economy is not like a gambling game. It is not a zero sum game. Each of the players can improve their own standing by being productive and offering their productivity to other players to bid on. Their productivity adds to the well being of all. The more productivity, the lower the prices of each item will be, as the same number of chips are spread over a larger array of goods. Productivity should absolutely result in lower prices over time and, historically, has always done so, except where there is a monetary policy that steals money from the producers and gives it to the inflationary money makers.
Look at the period of the late 1800’s. It was significantly deflationary because of the vast increase in productivity. It resulted in a massive surge in our society. We haven’t seen a beneficial deflationary period like that since then because the Federal Reserve, established in 1913, makes sure that we don’t. It has, instead, devalued our money to a very small fraction of what it was when it started. It is currently inflating away 1/3 of our wealth every decade. People need to be 1/3 more productive just to keep up with the devaluation.
Hi Dan,
Thank you very much for taking the time to understand the detailed transactions for the case of what I’d like to see- adding more chips when more players show up (i.e., increasing money supply when economic supply- not demand- is increased).
Now, if you take the same time to think through my original example where NO CHIPS are added when the second group of 4 people show up.
If you don’t add more chips, you either have to constrain their output (to 1/2 LMOs) OR deflate the cost of LMOs, in which case the fellow who left with 100 chips doubles his “wealth” just for leaving.
Hi Dirk,
Lets look at it. We will assume a starting point after the end of the first round where player 1 sits out.
I think I get your point. So let’s start with only 500 chips total, then add the 4 new players with no new chips.
Before new players:
500 chips total, 4 LMO’s owned and 4 LMO’s owed
Admit new players – There are only 500 chips and 9 players. The new players will have to bargain with the existing chip owners to get chips. They can each get 25 from me, because I have 100 left over. I will, however, require them to commit to 1/4 of a lawn mowing commitment. They can bargain with player 1, because he won’t need chips if he sits out. They can each get 25 from him, but of course will have to commit to 1/4 LMO each to him if they want him to bargain with them. That is only fair. So each of the new players owns 50 chips now and owes 1/2 LMO.
If you assume that all 8 remaining players want to have the same number of chips to start the round with, then the new players will have to negotiate with the original players for chips, just like in the real economy. But in order to get them to relinquish their chips, a new player will also have to assume a proportional amount of the LMO debt or bring something else to the table to negotiate with. We will assume that player 2 wants to get back in the game and negotiates with the chip holders for an equal share, and increase his LMO debt. Assuming that everyone at the table acts rationally and that there is no new production, the result before the start of the round will be:
Me – I own 0 chips and own 5 LMO’s
Player 1 – owns 0 chips, owns 1 LMO from new players
Player 2 – owns 62.5 chips, owes 1.375 LMO
Player 3 – owns 62.5chips, owes .375 LMO
Player 4 – owns 62.5chips, owes .375 LMO
Player 5 – owns 62.5chips, owes .375 LMO
Player 6 – owns 62.5chips, owes .875 LMO
Player 7 – owns 62.5chips, owes .875 LMO
Player 8 – owns 62.5chips, owes .875 LMO
Player 9 – owns 62.5chips, owes .875 LMO
500 chips total, 6 LMO’s owned and 6 LMO’s owed.
Player 1 has 100 chips before the 4 enter, worth 1 LMO. After the negotiations, he has 1 LMO worth 100 chips. I, before, during and after every one of the rounds, will own 500 chips worth of either chips or LMO”s. The value of chips in relation to LMO’s does not change, no matter how many players are added.
The fractional chips are like pennies, nickels and dimes. They are fractional representations and are merely an accounting process which doesn’t affect the reality of the game. Chips could be cut up into parts to make the distribution and accounting easier. The process could continue adding new players and the result would be a further distribution of the assets (chips) and liabilities (LMO’s) in proportion because nobody is going to give up chips unless the chip receiver agrees to a portion of the obligation that arose from borrowing the chips. The only issue may be that with a very large increase in players, you would have to divide the chips and LMO’s into very small parts. That doesn’t affect the reality of who owns what and owes what. It is a very rational process. It is merely an accounting process that has no effect on the overall chip supply. At the end, 1 LMO will be worth 100 chips. Player 1 only gains from playing. He gains absolutely nothing by sitting out.
Another scenario could be that we start as before, but one of the new players actually mowed my lawn and I paid him 100 chips that he could bring to the table. The other 3 new players would then have to negotiate with the lawn mower, with me and with player 1 for chips. I don’t think we need to go through the entire scenario, but I hope you understand the point. If a player actually produces a lawn mowing service, he will get paid for it and not have to incur a lawn mowing obligation.
Of course in the real economy, we don’t deal in just chips and LMO’s. People produce all sorts of stuff that they bring to the table. That real productivity is the stuff that people negotiate with and for. They bring their stuff to the table and try to deal with the chip holders. The more valuable the stuff they bring to the table, the more chips the chip holders will give to them.
If, instead of incurring an LMO to buy the original chips with, the players all brought something of value, the players could negotiate with me and each other for chips. If player 9 put his Rolex watch on the table, he could probably get someone to cough up a chip or two. If other players put their Xboxes and snowmobiles and their other possessions on the table, they might have to cut up the chips into pieces to be able to accommodate everyone’s sense of proportional value, but the game could function just the same with the chip pieces that total up to the same 500 original chips. Once everyone was satisfied that their contribution to the table was appropriately satisfied in proportion to value, then the game could begin. There would be more individual fractional pieces being used, but the original number of chips can satisfy any level of goods that are brought to the table.
If instead of cutting up the chips, you decided to double the number of chips in proportion to the number of chips held to make it easier, nobody would be better of worse off, because each person’s proportional share would be the same. The prices for LMO’s would double, however. After the distribution of new chips, each LMO would cost 200 chips.
In the real world, there is not a proportional distribution of chips to all of the players. The chips are all distributed for free to a few of the players, who are able to buy LMO’s at the old 100 chip price. But as the chips filter out to the other players and the doubling of chip supply equilibrates, the net result is that those who got the chips for free increased their wealth at the expense everyone else. Their original 100 chips will only buy 1/2 of ah LMO.
Inflation of the money supply always, without exception, transfers wealth to those who get it originally from those who get it later, after prices are inflated. There is no other way it can be.
Hi Dan,
I think we’ve reconcilled our views, save one last factor- inflation is ALWAYS required. Now, let me explain that rather startling statement.
In any economy- especially one as complex and dynamic as ours (compare to caveman and 80% of the world prior to 1980)- the scarcity of any resource relative to others can shift. Supply and demand shocks create imbalances that can cause price changes in oil, or gold, or carpentry services in Galvaston. Thus, at any one time, the price of one resource will INFLATE relative to other resources- unless you have price controls, and then you get shortages and other nasty effects that eventually starve people to death.
In order to create these price shifts in a fixed money supply economy, something else must then deflate- deflation is the necessary outcome to achieve resource inflation with no changes in money supply. BUT, since people don’t like to reduce prices, what really happens is economic activity drops as prices are kept too high- again, minimum wage laws, government and corporate contracts, etc. And total economic activity drops, creating negative psychology and creating a downdraft in economic activity.
The last two asset “bubbles” arose from violently displacive technology (internet) or major changes to capital/housing gains tax rates (housing). These changes created the inflation in internet stocks and housing just as much as expansive monetary policy- when you can get 2X capital gains tax free in a home, (not to mention homes are bigger now) the value is going to increase, more money or not.
I do understand your concern for general inflation, and the loss of wealth by those on “fixed” incomes in an inflationary period. I am not in favor of creating permanent 15%+ inflation, and understand this will mean slowing the growth of money in the future. But
But, if money has time value, why shouldn’t it have a half life? Shouldn’t money invested today be more valuable than money invested tomorrow?
Hello, mind if I butt in here?
While I’m relatively new to the austrian vs Keynesian debate, I have a question that seems relevant yet which seems to get little discussion in the endless to and fro between the two schools.
Austrian adherents say abolish Fractional Reserve Banking (FRB) and adopt a gold standard. The argument always seems to come down to gold rather than FRB. It seems to me that FRB is a greater evil than fiat money.
Given that private FRB means that most of the money supply bears interest and thus requires growth to remain stable regardless of whether the growth is of sound nature, why is the middle ground of a full reserve banking system based on fiat money created through national seignorage (i.e. created by government and spent rather than lent into existence) not discussed more?
While such a scheme does not preclude inflation at least it does not require it, so particpants in a democracy would in theory be able to choose via their elected representatives whether policy should favour borrowers or savers at any given time. This proposal is outlined by James Robertsone at jamesrobertson.com.
Why is this not an acceptable middle ground? What am I missing?
Thanks
(another) dan
Hi Dirk,
It is a little long again, but I don’t know how to discuss it any more briefly. Please bear with me.
I believe that you are right that prices of some goods change in relation to the prices of other goods when there are supply and demand shocks. If the price of gasoline doubles, that means that people have less money left over for other goods. The prices of those other goods have to decrease, given a constant money supply. Those decreased prices will require sellers to reduce their various costs, including labor. If all we are talking about is just how money works, then that really is the whole story. Over time, the prices of all goods and services adjust to the new reality of supply and demand.
As you say, though, in reality, things are not that simple. There are minimum wage laws and long term contracts that everyone has to deal with, so let’s look at the implications. In the case of minimum wage laws, say the prices for the employer’s products go down. In order to remain profitable, wages must decrease. The marginal revenue product of each employee has decreased, so the marginal wage needs to decrease. If the employees were at minimum wage levels before the adjustment and the wages are now stuck above the marginal revenue product, the only alternative is to lay workers off.
The unemployment is not due to the lack of money supply. It is due only to artificial floors on wages. The other side of the coin is that employees in the industry that is doing well because of the high prices may get raises and have extra money. The businesses themselves have profits that add to the economy in other ways. The economy is never static. It is in a constant state of flux as it adjusts to shocks and to new technology and tastes. The lesson is not that money needs to increase, but rather that government needs to quit manipulating supply, demand and prices for goods, services and wages, and just let the markets adjust as they need to. It is the manipulation that causes the unemployment, not the markets themselves.
In the case of business contracts, one of the purposes of contracts is to mitigate risks of things that will happen in the future. While both sides would presumably profit from their agreement at the time it was made, any time there are changes in prices or conditions, it may hurt one side or the other. Being an entrepreneur is inherently risky. Those that are able to predict customer demands and market conditions better than others will be more profitable. If a company commits to a long term contract and later is badly hurt by rising or falling prices, the other side is that someone else is helped by the rising or falling prices of the same commodity. Inflating the money supply to help those who had bad judgment only introduces moral hazard and distorts the markets, so that successful entrepreneurs will not be able to predict as well. The manipulation only helps the political entrepreneurs who try to use government to their advantage, and to the disadvantage of everyone else. That is our current stimulus package being discussed by our political entrepreneurs and politicians.
With regard to the tech bubble, think about the violently displacive technology. Where did it come from? Someone had to develop the various technologies to make it work. If the money supply remained constant, where would those entrepreneurs have to get their capital to build and develop? It would come from savings, wealth that people actually possessed, wealth that represented people’s prior production. It would be in limited supply and as that supply was used, interest rates would rise.
If the financial markets had actually been allowed to work, interest rates would have reflected savers’ and investors’ and entrepreneurs’ actual preferences. Rates would not have been artificially lowered to induce credit expansion. The higher rates would have induced more people to save, creating a greater pool of actual wealth to invest. The higher rates would have prevented foolish dreamers from believing that money was cheap so they might as well go for it. Higher rates would have put the brakes on explosive growth in a natural way that would not have caused distortion and dislocation.
The way that it did work, for the tech and housing bubbles, and every other credit inflation bubble, is the Fed artificially lowered rates through open market operations, making vast new reserves for the fractional reserve banking system. Because a bank only has to keep, at most, 10% reserves, for every dollar of reserves that the Fed created, the banks created ten more dollars of new money by lending out demand deposit money that was owned by someone else.
The easy credit, low interest rate policies encouraged entrepreneurs to jump in head first When investors saw the increase in prices of financial assets, due to credit expansion, they took money from savings and plopped in into the stock market. Why earn a measly few percent on your savings account when you can earn 30% playing the market. I remember people saying “why pay off our credit cards. We are only paying 15 or 18%. We can take our cash and make 30% on the market. Even those businesses without a business plan could get millions of dollars to play with. It was an incredible time. I could only shake my head in wonder.
The explosion of the technology markets had nothing to do with the inherent economics of saving, investing or technology. It had everything to do with artificially low rates and rapid expansion of money and credit. Without the expansion of money and credit, there would not, could not, have been the stock market bubble.
Without the artificially low rates and the expansion of money and credit, there would not, could not, have been a housing bubble.
As we agreed at the beginning of this discussion, with a constant money supply, an increase in the price of one thing is offset by a decrease in the price of other things. In the housing market, if the price of housing increased, the price of everything else should necessarily have decreased, because housing is such a large expenditure. Without new money, mortgage interest rates would have been driven up as the pool of savings that supported it started to dwindle. The high rates would have put the brakes on the bubble before it got started. That did not happen because money and credit expansion worked with the incentive of artificially low mortgage rates to induce irresponsible buyers to engage in a bidding war in a game of “who is the greatest fool.”
In the discussion of time value and half life, the issue is that it is not money itself that has a time value, but rather wealth that has a time value. Money is only a representation of wealth that someone has accumulated. If you were going to inherit a million dollar mansion from your rich uncle, would you rather receive it today or would you rather receive it 10 or 20 years down the road? Today, of course. That is time value.
It happens that we often think in terms of money, because that is the most tradable form of our wealth. There is nothing special about money, though. The implications of what you are saying is that all of our wealth should have a half life just because we would like to receive it now rather than later.
The short answer is no, neither money nor any other form in which we hold wealth, should have a half life. Our wealth will change in value, depending on economic conditions, but it is not right that our wealth should be systematically decimated because we tend to prefer to have any good now rather than later.
Hi Other Dan,
I think that the overall discussion is not so much Austrian versus Keynesian, but rather Austrian versus central planning. While Keynesianism is at the heart of many of the issues, other schools, such as monetarism, assume that someone in government should be in charge of making things work.
Mainstream economic thinking has, in most respects, become a repudiation of economic laws in favor of economic control by authorities. Central banking, minimum wages, price gouging laws and price controls, windfall profits taxes and on and on. You can find support for thousands of these policies in mainstream economics, even though they ignore the markets and the importance of prices and profits in directing economic activity.
There are a couple of related questions regarding money and banking : 1. Should there be a monopoly in the creation of money or should there be competition in money, and 2. Should banks be bound by the normal laws of society or should they be able to create money and profit from it by lending assets that don’t belong to them.
When Austrians promote a gold standard, I believe they are, at the root, really promoting a free market in the creation of money. The assumption is that, in a free market competition among competing currencies, gold would be the winner because it has all of the qualities that make a stable money that is less subject to arbitrary devaluation. It has, historically, been the choice of money where free people have been given the choice.
I have not read James Robertson’s proposal yet, but the middle ground you describe would maybe make it somewhat harder to inflate as rapidly. History shows, however, that money monopolies will always inflate because they benefit directly from it.
The only reason that it would be harder to inflate rapidly with what you describe is because it also includes the 100% reserve requirement for banks. That has always been an important issue in Austrians economics. New money can’t be leveraged to many times the original about by bank inflationary credit.
I am not sure what you mean by “most of the money supply bears interest and thus requires growth to remain stable”. The Fed carries out its interest rate policies by buying or selling government debt (and now toxic investment assets). The money itself, however, doesn’t bear interest. If new money wasn’t created, interest rates would be market rates under any monetary regime.
The whole idea that the system would make it easier for people in a democracy to affect whether policy should favor savers or borrowers is a very significant weakness. The markets are held hostage to the endless manipulation for political advantage. It is a similar weakness to the present system.
Democracy is not freedom in any sense of the word. In a free society, people participate by being a part of the market. They vote for what products and services they prefer with their dollars. The problems we are having at this very moment with the housing bubble and meltdown are the result of manipulation of the relationship between borrowers and savers.
Normal market signals would have raised interest rates years ago before the bubble began. Those signals would have favored savers and discouraged borrowers. That is, in fact, exactly what was needed. Instead, the central planners thought they knew better and favored borrowers at the expense of savers. Less money was saved as a result, and massive amounts were borrowed. The inevitable result was the bubble market.
The point is not finding a middle ground. It is rather to establish a monetary system that, to the greatest extent possible, lets markets decide rather than politicians and central planners.
To take this in another direction, money may be a means of exchange, but nowadays it is a commodity in itself. People deal in trading and buying and selling different monies everyday. What kind of effect does inflation have on these markets? Or does it have any effect? It seems to me that inflation would have a similar effect on money markets. The more there is available, the less valuable it is. I have read reports of countries in Africa whose dollar is so devalued that all of the assets of that country for just a few billion dollars (strictly on asset value, not reality). Is it inflation that caused this?
Also, is it necessarily inflation that is driving up the price of goods or does policy drive up inflation and the need for more money? If we are going to increase the minimum wage every couple of years it seems that it would be necessary to increase the amount of money in the market (supposing that the number of workers in the work force remains constant). Some might say unemployment has increased so we don’t need to pump more money in for a minimum wage increase, but unemployment will not remain high for forever and I have never seen a minimum wage decrease. Don’t these changes increase the need for inflation?
Ray
Hi Ray,
I think there is some general confusion in discussions about inflation because there are different definitions of it. Inflation is the increase in the money supply, but it is also thought of as the general increase in prices in an economy.
If the money supply is held constant, a rise in prices of one set of goods must necessarily cause decreases in the prices of other sets of goods. The higher prices on one set means that there is less money left over to buy the other goods and the price of the other goods will decrease.
Without an increase in the supply of money, there cannot be a general, overall rise in prices. If the money supply does increase, there are more dollars with the same set of goods. On average, the prices of the goods have to rise. That is the observable inflation that we can see as consumers.
Inflation affects everybody, because everybody buys things. The money traders are more like speculators, hoping they can predict the price relationships between the different types of currency with which they deal. The monetary policies of the countries has a lot to do with the relationships, so their doing well or poorly depends more on their predicting policy changes rather than in the actual performance of monetary units, at least as speculators.
The hyper-inflation that you are talking about in African countries is caused by those countries creating massive amounts of money, inflation in the technical sense, which causes the inflation in the popular sense, the rise in prices. It is not a new phenomenon and is not limited to African countries. Germany followed the same course after WWI. It eventually took a wheelbarrow full of German Marks to buy a loaf of bread. Argentina went through it. Zimbabwe is being devastated by it now. It arises from government policy of using inflation to finance itself and is an insidious form of tax. As massive amounts of money are pumped into an economy, the value of each existing monetary unit declines rapidly. Normal incentives and markets are extremely distorted.
Unfortunately, no country is immune to it if they follow the same policies. If America follows the path it is on, it, we, will bear the same result at some point in the future. American politicians seem intent on setting us up for disaster.
In a free market, any amount of money is as good as another. There is no right amount of money. If the price of oil or labor or anything else increases, it will affect the prices of everything else. Given a constant money supply, there will be less left over and the other prices must necessarily decrease.
If prices are prevented from decreasing to adjust to the new market conditions, whether through minimum wage laws, regulations or price controls, the result will be unemployment of either people or resources. It is the regulation and price controls that cause the problem, not the supply of money. If you want to alleviate the results, you must remove the cause.
Just to be clear, I’m firmly in the monetarist camp. I think it’s rediculous to think that a global, complex, dynamic economy has some kind of “natural” eight year long “business cycle” that leads to necessary recessions. And I’m not a fan of government spending and stimulus, as I feel political considerations are usually not economically optimal (especially here in Illinois).
While I totally understand the invisible hand of the market, price stickiness and people’s inability to correctly comprehend deflation (for example, they prefer a 2% raise with 4% inflation over no raise and 2% inflation) seem to lead to a reduction in economic activity EVERY TIME the Fed increases interest rates and constrains the money supply. These reductions have led to global recessions and financial crises, which cause much more trouble than any benefit.
Again, if we have excess unmet demand, and excess supply, what is constraining economic activity? The only business cycle I see is the one created by monetary policy shifts at the Fed.
Insolvency in the leveraged financial system is constraining economic activity, not liquidity.
Artificial liquidity injections at specific dosages will not prevent mis allocations nor could it solve insolvency.
Hi Dirk,
I heartily agree with you that it is ridiculous to believe that there is a natural business cycle of any length. I heartily agree with you that the only business cycle is that which is created by monetary policy shifts at the Fed. That is the whole point. If the Fed did not abuse the interest rates by lowering them below the market rates, the inflation/credit bubble could never get started.
I agree with you that the Fed should never, ever raise interest rates. By the same token, the Fed should never, ever lower interest rates. Interest rates are market phenomena. Fed policy is merely price controls in the financial markets and can only lead to the distortion of normal market incentives.
If you believe that economic phenomena, such as supply, demand and prices, are subject to immutable economic laws, then if there is excess demand, there must be either artificial price ceilings or artificially restricted supply. If there is an excess supply, it must be either an artificial price floor or artificially restricted demand. Some type of manipulation of markets is occurring.
Free markets tend to clear when prices and quantities are allowed to adjust. While a market is never at equilibrium, it always tends toward equilibrium. If markets are continually out of balance over the long term, then look for the laws and regulatory restrictions that are causing the disruption and remove them.
Minimum wage laws, agriculture bills, import/export restrictions, and on and on. Government never seems to run out of ways to impede rapid market adjustment. The massive stimulus bill has as it ultimate motive to prevent asset prices from falling from their absurd heights to an equilibrium level. We are in for a long, painful adjustment.
The economy will never adjust if it is prevented from adjusting. The Japanese central bank has followed a low or 0% interest rate policy for more than a decade and a half. Instead of stimulating growth, they were in recession for a decade and still only progress in fits and starts. If they would just let the market decide, the rates would increase, the Japanese banking house of cards would crumble, all the bad debt held for many years would be cleared and the economy would be free to assume a normal path.
Dan M,
Sorry for some delay in replying to your reply!
I guess the problem I have with your position is that it assumes that the central money issuing authority would be corrupt, since it is the nature of human beings to be so due to man’s fundamental will to power.
We try and address this in society by recognising our weakness and designing institutions to protect us from ourselves. A market is just an institution.
The problem is that even if free markets are used to issue and control money, someone still has to create laws, rules and definitions for these markets. I fail to see why the market governance institutions in a market fundamentalist economy would be any less prone to corruption than in any other system. By your argument, some people will always try to effect corruption to suit themselves
Furthermore, institutions that are necessary even in a market fundamentalist economy such as the police and law courts would by definition be relatively more powerful in a libertarian system than in a more centrist system since the number of officially chartered institutions would be relatively low.
One could perhaps argue that the market fundamentalist system is more resistant to chronic corruption, while being more at risk from complete failure, and thus less robust.
The trouble with this of course is that now we enter the areas of ideologies and politics. It seems to me that to subscribe to the assertions of austrian economics one must first make a number of assumptions about these matters before arriving at the purported benefits.
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