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whereaminow (58.64)

Understanding the Basics of Inflation

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February 27, 2011 – Comments (51)

This will be an overview post, in a (probably futile) attempt to clear up confusion about inflation.

Two Definitions of Inflation

Price inflation - a persistent increase in the general price level.
Monetary inflation - an increase or overissue of currency

You can still find inflation defined in the second way (monetary) in college dictionaries in the 1940's. That's the traditional definition:

Inflation is an "expansion or extension beyond natural or proper limits or so as to exceed normal or just value, spefically overissue of currency." Funk and Wagnalls Standard College Dictionary (1941)

I can't explain how or why the definition changed. I can speculate but I won't. I will just point out that from the 1300's (at least) up until the 1940's, it was understood that overissue of currency caused price increases. Not even JM Keynes disputed this, as we will see below.  The modern definition leaves the cause unknown. So it's not nearly as helpful.

Inflation is a policy

We'll get to the reason inflation is bad in a moment.  Now that we understand what inflation is we will indicate the kind we are talking about as follows: (price) inflation and (monetary) inflation.

(Monetary) inflation is a policy. It is encouraged because it is believed that it encourages economic growth. We do not dispute that (monetary) inflation increases economic activity. 

Market Money and Fiat Money

Market money, such as the gold standard, operates differently than fiat money. The classical gold standard was not a government central planning project. Government's only role was to leave it alone, which it turned out was too much to ask.  With market money, demand for money drives the increase in money production. In other words, as money becomes more valuable (and hence, prices fall), production of money increases to meet demand (and therefore, prices rise.)  This is a built in balancing activity. Fiat money is not created because of a demand for money. More often than not, fiat money is created to pay for wars, pay for political promises, and stimulate economic activity.

How (monetary) inflation works

When new money enters the economy, the person (s) who uses it first gains a benefit. Let's look at it on a timeline. This has to be a rough sketch and I'm doing this roughly from memory so don't be too harsh. This is the basic outline of how money works its way through an economy:

T=0 - At this point, no money has been created. Prices are at X level.
T=1 - New money is created. Prices still at X level
T=2 - New money is givng to person (s). Prices still at X level. (The person(s) may be government, banks, government contractors, etc.)
T=3 - The money is spent in the market economy. Prices still at X level. Those who finally do spend this money get a benefit (if they don't spend it, they receive no benefit). They spend the money before it causes (price) inflation, at X price level. Governments are typically the first to spend money (in a pure fiat system, they are the only ones who get to spend it first.)  This is how government's growth becomes unstoppable.
T=4 - Those who exchanged goods/services for the new money are now flush with cash. They, in turn, begin to replace their stock (and may increase it to meet a perceived rise in demand). Prices are still at X level.

(At this point it is important to remmeber that resources are scarce and that this is an economic fact of life).

T=5 As the people who recieved the money in exchange for their goods start to work it through the economy, that money competes with existing currency to bid on economic resources.  This drives up the cost of those resources. Prices start to rise above X level.

T=6 Producers and businesses start to experience higher costs and must raise their prices to offset falling profits. Prices rise further.

T=7 Laborers experience a rise in the cost of living. By the time newly created money reaches them, prices have risen above the level that our first "spenders" at T=3 enjoyed. Workers are at an economic disadvantage. They must raise the price they are willing to accept for their labor. This in turn increases business costs. Prices rise further. Look what JM Keynes had to say about this effect:

"[A] demand on the part of the trade unions for an increase in money rates of wages to compensate for every increase in his cost of living is futile, and greatly to the disadvantage of the working class. Like the dog in the fable, they lose the substance in grasping at the shadow. It is true that the better organised might benefit at the expense of other consumers. But except as an effort at group selfishness, as a means of hustling someone else out of the queue, it is a mug's game …" - JM Keynes, How to Pay for the War (London: Macmillan, 1940)

In other words, the better organized may be able to keep their wages up with the cost of living, but in order to do so, it will be at the detriment of everyone else (consumers, non-union workers). In the end, the unions will be perpetually chasing a higher cost of living. Chasing inflation is a mug's game.

T=8 People on fixed incomes typically get the money last. They suffer the most. By the time their incomes are "adjusted for (price) inflation", everyone else has already touched the previously created money. At this point the competition for money has driven up nearly all costs so that when they finally spend it, they suffer an economic detriment.

T=9 Lather, rinse, repeat.

Here are the key points about (monetary) inflation:

1. The person(s) who spends first gains. The person(s) who spends last loses.
2. Government growth is inevitable and inescapable under pure fiat currency. There is absolutely NOTHING you can do to stop it. Talks of budget cuts are totally meaningless when the government can create and spend money before you can.
3. In the short run, prices can rise for a number of reasons (and you can list all the mainstream explanations like demand shock and bad weather here, and they would apply).  In the long run, prices rise due to (monetary) inflation.  This is irrefutable.
4. In a market economy, wealth is created by increasing productivity. Not by printing dollar bills. The fact that we are all wealthier today is in spite of inflation, not because of it. 

A Second Look at (Monetary) Inflation

Besides the problems listed above, there is a more serious charge against (monetary) inflation called the Austrian Theory of the Business Cycle.

This theory, attributed to Hayek but also the product of the work of Menger, Bohm-Bawerk, von Mises, and Rothbard, states that artifically low interest rates cause an unsustainable economic boom.

Let's look at a brief sketch. You can research ABCT more thoroughly with the links provided:

1. Artificially low interest rates increase the amount of borowing (and hence, indebtedness) particulary among producers in higher order goods  (Housing is a higher-order good.)

2. An increase in loanable funds must meet this increase in demand caused by artificially low rates. The money supply starts to expand as fractional reserve banks work their magic. This is (monetary) inflation. (Notice that the demand for money is not caused by the market, but rather by a central planner who manipulated interest rates.)

3. Economic activity increases. People feel wealthier than they really are. Furthermore, investment in new projects does not match consumer time preference. Consumer time preference is indicated by their rate of saving. Since consumers are not saving at all (or very little) thanks to artificially low interest rates, they have a very short time preference.

4. Projects started in higher-order goods industries are destined for bankruptcy. Consumers are not saving at a rate to justify expansion in higher-order goods.

5. The bidding for resources drives up the costs of production, starting a wave of bankruptcies.

6. Everyone gets bailed out. The free market is blamed. We start over again. =D

(Every boom in history can be traced to a expansion of loanable funds, even the Tulip Bubble.)

Austrian Business Cycle Theory: A Brief Explanation

Summary

Either way you look at it, as (price) inflation or (monetary) inflation, something isn't right. Does that mean if you study inflation, you are Nancy Negative? No. It's one facet of our world. Last night at work I got into a running six hour argument with my co-worker over who would be a better senior engineer on our shift, Jesus, Superman, or Colonel Nathan R. Jessup from A Few Good Men?  We both decided we'd rather hire the Sham-Wow Guy for comedic effect.  Yeah, I'm such a serious guy.

But when I look at the criticisms leveled against negativity, I'm flabbergasted by how little these people actually understand about the views they are criticising.

This is just a taste. There are more interesting things that can be said about inflation, but I don't have the time. I barely touched on fractional reserve banking, wars, central planning, or public deficits or the history of these schemes. All of these are features of an inflationary regime.

For more, please check out this previous blog:

Inflation: What is it good for?

For the historically inclined:

A HIstory of Inflation in Rome

John Law and the Invention of Modern Finance

David in Qatar

51 Comments – Post Your Own

#1) On February 27, 2011 at 12:25 PM, rofgile (99.10) wrote:

David,

 Before I go further, I enjoyed this blog greatly, it was well written, and it as well thought out.  

However, this post is itself another example facts vs theories that we could discuss. What you are talking about above is a theory. A theory is not a bad thing (I love theories but I understand that they have to be tested always - even Newton's great theories reach a point at which they no longer predict well). A theory is an idea with a predictive statement.  Theories are our tools we use to understand the world.  It is different than a fact. A fact is a measured observation of something in the world.  A fact does not predict things.

 1) The reason that there are two terms now for inflation is that realistically we can talk about monetary inflation and price inflation as two different things.  Otherwise we could not define them as separate terms.  You state that they are always connected - that is the theoretical idea.

 2) This is a theoretical idea in that you used vague T=n, time scale for the cause  (monetary inflation) to the effect (price inflation).  You cannot make a firm statement that price inflation will occur at a predictable time afterwards (say, definitely within 6 months, or 4 years).  This is a sign that this theory may lack predictable value. That is a bad thing for a theory.

---

 It is possible that price inflation and monetary inflation are not connected as they once were (or that the time delay between effect has grown so much that the increase in monetary amounts no longer can easily predict the price increases).  

 Why is this possible?

 1) Wages no longer rise with monetary supply.  Due to the loss of unions, global cheap goods/cheap global labor - we have not seen wages increase with the increase in monetary supply over the past several decades in the United States.  This should be the first warning bell about your theory of inflation.  In the 1970's, wages and monetary levels were connected.

 2) Prices of high tech goods have fallen even as their materials and quality have risen for the past two decades.  This is the second warning bell about your theory - it could not predict this.

 3) The most wealthy have gotten richer and the gap with everyone else has grown.  There is an accumulation of wealth at the top which is not reaching everyone else.  This has kept everyone elses wages low, and prices fairly low.  Even while some people do quite well.

 4) Materials are limited on this world while money is not.  I understand this.  However, unlike in previous centuries, there is almost no material that we cannot replace with a substitute that is more available or more reusable.  Instead of platinum, we can use silver.  Instead of copper, we can use aluminum.  Instead of rare elements for LEDs, we can use carbon-based organic LEDs.  We can maintain our high standard of living, even in a limited world, through improvements of technology.  And technology now moves quickly enough that it adapts as quickly as market pressures appear.  Ex. A high price for natural gas leads to replacement by cheaper wind power.

---

 I think the question has become, does the monetary theory of inflation presented above still have any predictive value in our current time period?  If it did, could you tell me when, exactly, we will see the price inflation that is only vaguely predicted by your theory?  If not, can you tell me why your theory has value at all?

 I believe your theory, which you deeply believe, has lost predictive value.  I believe there are complex reasons for this, some of which I have outlined above.  I think it makes sense that we now use different terms for monetary and price inflation. 

 -Rof 

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#2) On February 27, 2011 at 12:52 PM, whereaminow (58.64) wrote:

OH MY GOD. I just wrote a 10 page response to rofgile and the whole thing got eaten when I posted it. Forgot to CTRL-A, CTRL-C for once. F*******CK!

I'll be back in a few.

David in Qatar

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#3) On February 27, 2011 at 1:34 PM, whereaminow (58.64) wrote:

rofgile,

Before I go further, I enjoyed this blog greatly, it was well written, and it as well thought out.  

Thank you!

However, this post is itself another example facts vs theories that we could discuss. What you are talking about above is a theory. A theory is not a bad thing (I love theories but I understand that they have to be tested always - even Newton's great theories reach a point at which they no longer predict well). A theory is an idea with a predictive statement.  Theories are our tools we use to understand the world.  It is different than a fact. A fact is a measured observation of something in the world.  A fact does not predict things.

Agreed.

1)     The reason that there are two terms now for inflation is that realistically we can talk about monetary inflation and price inflation as two different things.  Otherwise we could not define them as separate terms.  You state that they are always connected - that is the theoretical idea.

In the long run, it is irrefutable that (monetary) inflation leads to (price) inflation. An overissue of currency must eventually lead to price increases. Theory based on deductive reasoning can be irrefutable. Arithmetic is all theory based on deductive reasoning. It is also irrefutable. 2+2 always equals 4. We could go out and measure every instance where 2 things were added to 2 more things. But that is also pointless. 

2) This is a theoretical idea in that you used vague T=n, time scale for the cause  (monetary inflation) to the effect (price inflation).  You cannot make a firm statement that price inflation will occur at a predictable time afterwards (say, definitely within 6 months, or 4 years).  This is a sign that this theory may lack predictable value. That is a bad thing for a theory.

Neither the positivist nor the theoretical approach to studying inflation can determine how long it will take for prices to rise. There is simply no tool available to humans to study money as it passes through trillions of transactions in a market economy.

That’s why it is important for economists to understand that there is a limit to their knowledge. It’s why Hayek warned against economic planning. Keynes loved planning, thought it was a great idea. Hayek was the party pooper (The Negative Nancy, if you will) that told him how his plans would fail. Hayek was right. 

It is possible that price inflation and monetary inflation are not connected as they once were (or that the time delay between effect has grown so much that the increase in monetary amounts no longer can easily predict the price increases).  

I don’t anyone could ever predict the exact level of price increases. It’s not that simple. For example, if you could predict that X amount of overissue would lead to Y amount of price increases, there would never be hyperinflation.  You have to remember that money has a subjective value to the money holder all its own. Subjective values are ordinal, not cardinal. Therefore, measurements of accuracy are impossible to ascertain. This is why interpersonal utility comparisons are meaningless.  One can only determine that an economic actor preferred one action over another. When all value in a currency is lost, economic actors reject it en masse. This is the crack up boom called hyperinflation. Predicting exactly when this would happen and by how much would require that you can see inside every actor's thoughts and measure their preferences before they act. This is also why central planning fails.

Why is this possible?1)     Wages no longer rise with monetary supply.  Due to the loss of unions, global cheap goods/cheap global labor - we have not seen wages increase with the increase in monetary supply over the past several decades in the United States.  This should be the first warning bell about your theory of inflation.  In the 1970's, wages and monetary levels were connected.

Agreed. Both collectively and individually, people have lost bargaining power. The corporate-state alliance has a great deal to do with this. This doesn’t refute the theory. It just means that people are losing purchasing power without being able to fight back. 

2) Prices of high tech goods have fallen even as their materials and quality have risen for the past two decades.  This is the second warning bell about your theory - it could not predict this.

Sure it does. An increase in goods relative to dollars will decrease the price of goods. If you had a stable money supply, the increase in high tech goods would decrease all prices. Butter is made more efficiently today, thanks to high tech goods. Yet it’s price is exploding.

An increase in productivity is the only way to increase the standard of living. More goods chasing fewer dollars. Prices fall, yet wages should not. Why is that? Because worker productivity is also increasing. This is theory backed up by fact. During the industrial revolution, wages rose slightly even as prices for goods were falling. The reason is because productivity was increasing.  This is how America exploded in overall wealth.  Americans should be enjoying another boom in overall wealth. Instead, they are stagnant.

Worker productivity exploded over the last 40 years as every industry has garnered some benefit from the technology revolution. The reason there have been minimal gains in the standard of living is because of (monetary) inflation. 

3) The most wealthy have gotten richer and the gap with everyone else has grown.  There is an accumulation of wealth at the top which is not reaching everyone else.  This has kept everyone elses wages low, and prices fairly low.  Even while some people do quite well.

Think about it this way. You need to hire a CEO for your corporation. Which skill is more important to you?

a)     Ability to anticipate changes in consumer preferences
b)     Ability to influence the government and keep corporate welfare rolling in? 

The reason that the rich get richer is because they get to spend the money first and they have been given tremendous influence by the goverenment in exchange for campaign money.  

4) Materials are limited on this world while money is not.  I understand this.  However, unlike in previous centuries, there is almost no material that we cannot replace with a substitute that is more available or more reusable.  Instead of platinum, we can use silver.  Instead of copper, we can use aluminum.  Instead of rare elements for LEDs, we can use carbon-based organic LEDs.  We can maintain our high standard of living, even in a limited world, through improvements of technology.  And technology now moves quickly enough that it adapts as quickly as market pressures appear.  Ex. A high price for natural gas leads to replacement by cheaper wind power.

This is an argument that prices should be falling across the board. Agreed. But they’re not. Prices should always be declining. That’s rule #1 for understanding money in a market economy. If they are not always declining, something is wrong. 

I think the question has become, does the monetary theory of inflation presented above still have any predictive value in our current time period?  If it did, could you tell me when, exactly, we will see the price inflation that is only vaguely predicted by your theory?  If not, can you tell me why your theory has value at all?

We are already seeing (price) inflation, but it is in commodities and producer inputs. Not just gold and silver and oil. Butter is up 20% YTP, Lamb 19% YTD, Bacon 11% YTD, Potatoes 6% YTD.It hasn’t made its way into every facet of our economy. But (price) inflation is here and it’s real.

Also keep in mind that roughly 2/3rds of all dollars are held overseas. Countries with currencies pegged to the dollar are suffering from (price) inflation.

http://moneywatch.bnet.com/economic-news/blog/daily-money/food-companies-were-going-to-start-raising-prices/2138/ 

I believe your theory, which you deeply believe, has lost predictive value.  I believe there are complex reasons for this, some of which I have outlined above.  I think it makes sense that we now use different terms for monetary and price inflation               

No theory has been more predictive in economics than Austrian Business Cycle Theory. When focusing on (price) inflation, the resulting confusion makes it impossible to determine anyone’s prediction with any accuracy. There is no such thing as a “true price level”, making objective measurements of price increases relative to where they should be impossible. Economics is about acting humans making decisions based on subjective values. It is not about measuring price levels. 

Study of the phenomenon of price increases from a theoretical point of view leads to the irrefutable conclusion that all price increases in the long run are the result of (monetary) inflation.

The main difficulty in expressing my economic ideas to you is that economics is taught from a positivist framework today and I work from a theoretical one. Yet the positivists have failed miserably, while the theoretical schools have maintained a solid track record.  This is because economics is about action, not measurements. Humans have unlimited choices and ideas, working with scarce resources, in a division of labor. They must act on their subjective preferences.  Positivists treat humans like molecules in an experiment that can neither think nor act but in a predictable manner.  Theoretical economists and positivists end up talking past each other. The resulting confusion is left for us to sort out.

David in Qatar

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#4) On February 27, 2011 at 2:03 PM, rofgile (99.10) wrote:

David:
 

 Let me start by saying thank you for your response, even with your loss of effort due to the silly CAPS commenting system.  Really could use some work, TMFJake!!! 

 This has been a good discussion.  I think you make many valid points.  I am going to turn your logic around now on you in what might be an alarming manner.  

 You stated in response to my point about how technology can work around the limits of materials while maintaining our quality of life..

 "This is an argument that prices should be falling across the board. Agreed. But they’re not. Prices should always be declining. That’s rule #1 for understanding money in a market economy. If they are not always declining, something is wrong." 

 Increased effort is higher productivity. If the result is prices of your goods that will only fall, what is your incentive to pursue efficiency and productivity?  What would be the incentive to pursue better technology?  You own improvements in production would be a treadmill to your own inevitable bankruptcy.

 You say prices should always be declining, and that because they have not been declining we have truly been having price inflation.

 From my perspective, that would be called price stability. (Because we have avoided terribly falling prices of goods, while also avoid terrible inflation).

 And, it seems that the reason for the monetary increases that have lead to what I can price stability for goods has been a centrally managed Federal Governmental Bank.  The FED.

 From my perspective, the FED managed to keep us in high price stability.  This has in the above narrative continued to give incentives for businesses to increase their productivity, to find replacements for limited resources, to maintain our quality of life, and at the same time, maintain their quality of earnings for their efforts taken.

 That sounds like a happy story.  So, why don't we thus praise the FED for once and for all, which has maintained price stability and avoided the treadmill of bankruptcy supposed by constantly falling prices?

 -Rof 

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#5) On February 27, 2011 at 2:03 PM, Valyooo (99.81) wrote:

Great blog.  A few comments/questions

1) There is nothing worse than forgetting to hit control-a control-c.  Sometimes I make the longest post ever, go back to read it, and I think either a) I was dreaming that I posted that b) Something I said was offensive and it was reported....this is the only site that seems to eat my comments.  Another bad thing is when my computer decides it has stored my log in for too long, I make a post, then it asks me to log in, and then after i log in the comment is not there anymore.

2) Your theory is (obviously, to me at least) true.  You forgot to mention shoe leather and menu costs, but they probably are not very important to your discussion.  The worst part about inflation is that the state gets to abuse it. However, theoretically, if the state did not abuse their abilitiy to inflate (haha, good one) I don't think it has to be all that bad, because fractional reserve banking can produce some good results.  If we didn't use money, if we still bartered, the amount of "currency" (things we use to trade) would increase as economic activity increased.  So I think it makes sense to have money increase with production.  On a real gold standard (which seems nonexistant, because even the paper promises of gold backing are usually fake) there would be no incentive to invest, only to hoard cash.  If equities deflated over time, people would store gold.  Nobody would invest in property either, because the aggregate price level would fall.  There would be the benefit of less extreme busts, but economic growth would slow greatly.  If more people are willing to invest and expand production, FRB lets the money supply grow with it.  I think money printing is terrible, but money growth through the money multiplier makes sense to me...more money to match more production.  If a fisherman (like in Schiffs book) is now catching 3 fish instead of 1 fish like he used to, he will have 3 fish to trade now...so why should he still only have 1 dollar?  Unfortunately I have never seen a system of unchanged monetary growth coupled with fractional reserve banking.  What would be the incentive to invest when everything loses value except for gold?

3) This is a question.  In my international monetary economics class, I learned (With charts and everything) how an increase in the money supply drives down interest rates. This makes no sense to me.  If there is now more money floating around, shouldn't interest rates increase, because there is more money?  If the money supply falls, there is less money to pay interest with...so how can interest rates rise when the money supply falls?  

4) Would there be a system of interest rates in a fixed money supply, on the federal level?  I understand for small loans...but if the money supply didnt grow, where would the money come from to pay back municipal bonds?

 

I am probably going to ask you a few more questions like #3 throughout this semester, because I can't get all of my questions answered in class.  All the other students just want to get through the class so they can pass.  I just want to actually learn, but everybody else gets mad at me for asking questions that they can't even answer.  Great school system we have!

+1 rec

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#6) On February 27, 2011 at 2:12 PM, whereaminow (58.64) wrote:

rofgile and valyooo,

I will be back in a few hours to keep our discussion going, but I have to head out for a little while. I promise to give you guys, and anyone else who pipes in, as much of a response I can muster.

David in Qatar

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#7) On February 27, 2011 at 2:42 PM, Valyooo (99.81) wrote:

Cool.  Also, I think a lot of what I had to say is what rof said (but not all of what I had to say) in comment #4, which was not up while I was typing

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#8) On February 27, 2011 at 2:57 PM, rd80 (99.11) wrote:

I understand how gov't is the first to benefit from monetary inflation as it leads to price inflation, is the inverse true?  Would gov't be the first to be hurt by deflation? 

If so, that would partially explain the opinions that deflation is such an evil thing. 

I suspect inflation/deflation winners and losers are determined just as much by capital structure and duration of any outstanding debt as place in line. e.g., net debtors who don't have to roll the debt over or take on new debt any time soon will benefit from inflation.

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#9) On February 27, 2011 at 3:46 PM, Starfirenv (< 20) wrote:

Nice Davidsbeingcivil- This is why I still stop by here. Even with the "All praise and Glory to the FED" thing, which evoked visions of projectile vomit, I enjoy both sides. 

Valyooo- re #3. Lets say you live in a town of 1000 and 998 of them want/need to borrow, but only 2 have money to lend (shortage of lendable money supply). Would interest be high or low?
Now lets say that in the same town of 1000 there are 998 who all just inherited a fortune and want to lend but only 2 who want/need to borrow (increased money supply). Would interest be higher or lower? And what do you think would happen to the price of goods?
Basic supply and demand.

I think the terd (not a typo- I was red flagged by the new "profanity Filter) in this punchbowl is that thru all this nonstop printing, very little "fresh fiat" actually makes it's way into circulation- other than food stamps and unemployment it seems it all goes to a few bankers to be used to speculate and bonus themselves. An entirely new phenom historically.  Best +1

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#10) On February 27, 2011 at 3:59 PM, Valyooo (99.81) wrote:

Starfire,

Good example, now I understand, thanks.

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#11) On February 27, 2011 at 4:03 PM, Starfirenv (< 20) wrote:

Since the thrust of this blog is"Monetary Inflation", I would like to share this short piece by Ellen Brown, "Restoring Economic Sovereignty". This piece may deserve it's own blog if anyone would like to run with it. Link provides more good reads.

http://www.webofdebt.com/articles/

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#12) On February 27, 2011 at 6:14 PM, whereaminow (58.64) wrote:

OK, I'm back. Before I get started I want to point out a way to read Austrian Business Cycle Theroy applied to current events. First is Thomas Woods' great book Meltdown, which I had Ron Paul sign for me when I met him. Another is a recent book you can read for free. It's called Deep Freeze: Iceland's Economic Collapse. The PDF is here. It's about 120 pages long. I've been skimming it the last couple of days and I highly recommend it.

David in Qatar

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#13) On February 27, 2011 at 6:33 PM, whereaminow (58.64) wrote:

rofgile,  

This has been a good discussion.  I think you make many valid points.  I am going to turn your logic around now on you in what might be an alarming manner.  

Ok, let’s do it!  It's been fun so far!

You stated in response to my point about how technology can work around the limits of materials while maintaining our quality of life.. 

"This is an argument that prices should be falling across the board. Agreed. But they’re not. Prices should always be declining. That’s rule #1 for understanding money in a market economy. If they are not always declining, something is wrong."  

Increased effort is higher productivity. If the result is prices of your goods that will only fall, what is your incentive to pursue efficiency and productivity?  What would be the incentive to pursue better technology?  You own improvements in production would be a treadmill to your own inevitable bankruptcy.

The free market is a great conspiracy to reduce all profits to zero. :)  But never fear, because there is no such thing as a perfect market. There will always be new ideas and new ways of improving upon existing production processes.  I cannot foresee a way in which entrepreneurial risk taking would no longer reward people.  Certainly no one can see these things in advance. Who knew that Facebook would come from a socially awkward kid dropping out of college? That it could be used to bring down tyrants lol???  It’s just an amazing thing, this market. It’s something I really cherish.

There’s another concept that you’re touching on that should be brought up. It’s called the disutility of labor.  When we talk about increased productivity in an economic sense, we don’t really mean “more sweat.”  We mean increasing produce by implementing cost saving and time saving technologies. That being said, as a person becomes more wealthy, in general, their incentive to engage in labor, in general, decreases. But so far, I don’t see any evidence that this reduces entrepreneurial spirit. I think I get what you are saying here, but I don’t see any reason to doubt new markets, new ideas, and new advances. Human ideas and wants appear to be unlimited.  

You say prices should always be declining, and that because they have not been declining we have truly been having price inflation. From my perspective, that would be called price stability. (Because we have avoided terribly falling prices of goods, while also avoid terrible inflation). And, it seems that the reason for the monetary increases that have lead to what I can price stability for goods has been a centrally managed Federal Governmental Bank.  The FED.

Remember what I said about a price level. I use “price level X” in the timeline example, for simplicity sake. In reality, there is no such thing as a true price level.  Keeping prices stable is therefore foolish and impossible. We also think it’s dangerous because it requires central planning. Central planning does not work because the planners cannot know the subjective values held by market actors. They have to guess.  They are probably going to guess wrong. The Fed almost always guesses wrong. 

From my perspective, the FED managed to keep us in high price stability.  This has in the above narrative continued to give incentives for businesses to increase their productivity, to find replacements for limited resources, to maintain our quality of life, and at the same time, maintain their quality of earnings for their efforts taken.

The Fed has kept prices stable, for now. Like the Japanese Central Bank has done for most of its two-decade recession.  But it is artificially low interest rates that are providing the incentive to increase productivity. Everyone has to borrow, because everyone is broke.  But, remember, artificially low interest rates simply create a boom that must bust. And we know what happens after that. More bailouts. More economic regulation. More central planning. What’s next? Negative interest rates? Paying us to hold their money?  At some point, you destroy your currency. The danger here is the Fed could make economic calculation impossible when businesses can no longer estimate future costs. 

That sounds like a happy story.  So, why don't we thus praise the FED for once and for all, which has maintained price stability and avoided the treadmill of bankruptcy supposed by constantly falling prices?

It’s important to remember that the Fed’s “solution” created this mess in the first place. It’s like praising the drug dealer for fixing the addict.  All he did was give him more drugs. Yeah, he’s stable now, but is he clean and sober or just on another artificial high?

David in Qatar

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#14) On February 27, 2011 at 6:50 PM, whereaminow (58.64) wrote:

Valyooo,

1) There is nothing worse than forgetting to hit control-a control-c.  Sometimes I make the longest post ever, go back to read it, and I think either a) I was dreaming that I posted that b) Something I said was offensive and it was reported....this is the only site that seems to eat my comments.  Another bad thing is when my computer decides it has stored my log in for too long, I make a post, then it asks me to log in, and then after i log in the comment is not there anymore.

THE WORST!!!!! I’ve paid for this many times in the past, which is why I ALWAYS ctrl-a ctrl-c, but this time of course, I forget… and pay for it. Thanks for the empathy.

2) Your theory is (obviously, to me at least) true.  You forgot to mention shoe leather and menu costs, but they probably are not very important to your discussion.  The worst part about inflation is that the state gets to abuse it. However, theoretically, if the state did not abuse their abilitiy to inflate (haha, good one) I don't think it has to be all that bad, because fractional reserve banking can produce some good results.  If we didn't use money, if we still bartered, the amount of "currency" (things we use to trade) would increase as economic activity increased.  So I think it makes sense to have money increase with production.  On a real gold standard (which seems nonexistant, because even the paper promises of gold backing are usually fake) there would be no incentive to invest, only to hoard cash.  If equities deflated over time, people would store gold.  Nobody would invest in property either, because the aggregate price level would fall.  There would be the benefit of less extreme busts, but economic growth would slow greatly.  If more people are willing to invest and expand production, FRB lets the money supply grow with it.  I think money printing is terrible, but money growth through the money multiplier makes sense to me...more money to match more production.  If a fisherman (like in Schiffs book) is now catching 3 fish instead of 1 fish like he used to, he will have 3 fish to trade now...so why should he still only have 1 dollar?  Unfortunately I have never seen a system of unchanged monetary growth coupled with fractional reserve banking.  What would be the incentive to invest when everything loses value except for gold?

A couple points here. First, you don’t have to choose between barter and FRB. You also don’t have to get rid of FRB. You just have to stop bailing them out.  Do away with legal tender laws. Now consumers can choose between currency backed 100% in 100% reserve banks or FRB.  There is a lot of historical precedent that shows consumers prefer sound money and 100% reserve banking. The Bank of Amsterdam’s near 200 year run as a 100% reserve bank (or darn close to it) stands at the top.

In regards to Schiff’s example, wealth isn’t about nominal amounts of money. It’s about the utility of the things you own and what you can afford to purchase with your money. It matters little if you have $10 or $1, what matters is what you can buy with the $10 or $1. So in Schiff’s example, the community’s supply of fish has increased by two. With an unchanged money supply, the price of all fish will eventually decrease. You can now buy more.

So why would I want to produce more? Well, reaching the largest amount of customers will always be the path to garnering the largest amount of wealth (well, besides printing money.)  Why did Rockefeller want to reduce the price of oil? The more people that could buy it, the more money he can make. It’s the old saying: “Sell to the classes, live like the masses. Sell to the masses, live like the classes.”

I see starfirenv got #3. Thanks star!

4) Would there be a system of interest rates in a fixed money supply, on the federal level?  I understand for small loans...but if the money supply didnt grow, where would the money come from to pay back municipal bonds?

That’s a good question. Whenever a government (state or federal) takes out a loan, it expects to pay it back with inflated dollars. Inflation is good for debtors, bad for creditors. So yes, if the money supply shrinks, it will increase the likelihood of not only muni bond defaults (they’re going to default anyway) but also the national debt.  Of course, not all creditors are stupid, and they try to figure in inflation to their interest payments, or look for other breaks (tax breaks are popular).

We pass from Austrian School Economics into libertarianism when I tell you that I simply don’t care. Public debt I find to be horribly immoral, as it requires an involuntary exchange at the point of a gun.  (As I’ve brought up in other blogs, most economic theories taught today have an implicit assumption of violence being present to force one or more parties into an involuntary exchange. Without it, their framework falls apart.)

I am probably going to ask you a few more questions like #3 throughout this semester, because I can't get all of my questions answered in class.  All the other students just want to get through the class so they can pass.  I just want to actually learn, but everybody else gets mad at me for asking questions that they can't even answer.  Great school system we have!               

That sucks. You can always go to the Mises Community forum and post these questions. They are much more reliable about giving you timely answers than I am!

David in Qatar

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#15) On February 27, 2011 at 6:52 PM, whereaminow (58.64) wrote:

Starfirenv,

Nice Davidsbeingcivil- This is why I still stop by here.

LOL, yep. Get in while the gettin's good!

David in Qatar

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#16) On February 27, 2011 at 7:06 PM, Starfirenv (< 20) wrote:

Hey David, see this- what do you say?

"Per my vow, I will buy drinks for an entire casino should the opportunity present itself.  I'd just as soon do it in Reno, as I've never been, and Starfire lives there."

From Checklist; From here:
http://caps.fool.com/Blogs/the-world-wont-end-for-real/546567
See comment 14. I'm thinking Qatar is no fun in the middle of summer.

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#17) On February 27, 2011 at 7:11 PM, NOTvuffett (< 20) wrote:

qatar smells like the poop of 1000 rams in summer, lol.

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#18) On February 27, 2011 at 7:17 PM, whereaminow (58.64) wrote:

Starfirenv,

LOL, I"m only a dick on paper (and if you happen to get under  my skin at work. I once kicked a guy out of my office for falling asleep near me. Mind you, I wasn't his boss. He just had to leave before I killed him.)

I should be back in the States this summer for good. We'll see. Once I move back to Amerika, I'll be looking to meet some of the good people here in person.

NOTvuffett,

So sad, but that kid was right.

David in Qatar

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#19) On February 27, 2011 at 7:51 PM, ETFsRule (99.90) wrote:

Good blog.

"Inflation is an "expansion or extension beyond natural or proper limits or so as to exceed normal or just value, spefically overissue of currency." Funk and Wagnalls Standard College Dictionary (1941)

...

The modern definition leaves the cause unknown. So it's not nearly as helpful."

Both definitions have some strengths and weaknesses, but overall I agree with you. The issue that I have with the old definition, is that it seems a bit more subjective and harder to identify. In order to identify an "overissue of currency", you need to be able to quantify exactly how much currency should have been issued. And I'm sure people will disagree on that. Personally I don't think we have had any monetary inflation at all over the past century.

Which ever definition people choose to use, I just wish everyone would approach the issue more quantitatively. I'm a numbers guy,  and numbers are usually the only way to convince me of anything.

So, for anyone who agrees with the monerary definition of inflation, these are the steps I wish they would take before they criticize the gov't for printing too much money:

1. Don't just talk about price increases.

2. Show me how much money the gov't has created, and then explain to me how much money the gov't should have created over that period of time. I would be interested to see how people arrive at their answer.

That's all.

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#20) On February 27, 2011 at 8:15 PM, whereaminow (58.64) wrote:

ETFsRule,

Thanks for the excellent comment.

Both definitions have some strengths and weaknesses, but overall I agree with you. The issue that I have with the old definition, is that it seems a bit more subjective and harder to identify. In order to identify an "overissue of currency", you need to be able to quantify exactly how much currency should have been issued. And I'm sure people will disagree on that. Personally I don't think we have had any monetary inflation at all over the past century.

There was a mechanism under the gold standard that let everyone know ex post facto that too much money had been issued, called the price-specie-flow mechanism.

Wars always require an overissue of currency, since there is no market for war funding (for better or worse). So WWI and II, Korea, Vietnam and Iraq required (monetary) inflation.

Now without the price-specie-flow mechanism, it is much more difficult to determine when an overissue has occurred and by how much.

Which ever definition people choose to use, I just wish everyone would approach the issue more quantitatively. I'm a numbers guy,  and numbers are usually the only way to convince me of anything.

I can sympathize with that point of view. I play poker. I love to gamble. I love the numbers game. Unfortunately, to understand subjective value scales, you have to let go of numbers for a while (but you don't have to discard them completely), because they don't help you in dealing with ordinal values.

2. Show me how much money the gov't has created, and then explain to me how much money the gov't should have created over that period of time. I would be interested to see how people arrive at their answer

Unfortunately, the only way we can know that is if the market sets the interest rate without interference. That's the price of money.  When the Fed purposely pushes down the interest rate, we can't know if it is necessary or not until it is too late. Action has to happen to reveal preferences.  Everything else is just fancy guesswork.

Sorry, but economists need to understand their limits. Precisely determining what the market requires is beyond their capabilities (they should never pretend to be mind readers.) In many cases, it is only after the fact that we find out what has happened.

David in Qatar

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#21) On February 27, 2011 at 8:50 PM, russiangambit (29.94) wrote:

> Sorry, but economists need to understand their limits. Precisely determining what the market requires is beyond their capabilities (they should never pretend to be mind readers.)

Exactly, this is one of my main gripes too. It is impossible to efficiently regulate the price of money. The system and activities is too chaotic and complex. It is even more difficult that central planning of an economy in my opinion. It is unexcusable that they continue to pretend that they can. There is not a single person who can predict the performance of a stock market 1-2 years in advance consistently. Yet, somehow economists think they can predict and shape and control economic activity a year or two in advance and take into account every possible unintended consequence of their actions.

I don't think there could be any argument that keeping real interest rates negative creates distortions and bubbles or whether it should be anacceptable monetary policy for longer than 6 months. In reality, we  already (not the FED) pay the banks to hold our money.

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#22) On February 27, 2011 at 9:58 PM, ETFsRule (99.90) wrote:

"Yet, somehow economists think they can predict and shape and control economic activity a year or two in advance and take into account every possible unintended consequence of their actions."

They're not perfect, but they're doing the best they can.

"I don't think there could be any argument that keeping real interest rates negative creates distortions and bubbles or whether it should be anacceptable monetary policy for longer than 6 months"

I'm not sure about a 6 month limit, but I agree that it would be a problem if we kept real interest rates negative over a long period of time. Since the late 1950's I think our policy makers have done a pretty good job of figuring out this problem, and since then, real interest rates have been positive the vast majority of the time. Even during the costly Vietnam War we were able to keep real interest rates positive.

There's not much we can do about an oil crisis, or other problems that cause temporary spikes in the inflation rate - but, for the most part I think the Fed's performance has actually been very good, especially for the flawed human beings that they are.

They should start to raise interest rates soon... but doing this prematurely would have been a big mistake.

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#23) On February 27, 2011 at 10:51 PM, russiangambit (29.94) wrote:

> They should start to raise interest rates soon... but doing this prematurely would have been a big mistake.

They should've raised them a year ago in my opinion,since liquidity crisis passed. When credit markets were frozen, I can understand pumping liquidity to unfreeze them. But they continued pumping liquidity for almost 2 years now, for a year longer than recession officially ended. There is no justification for it, it is irresponsible.

All this talk that keeping interest rates at zero  helps with unemployement has no basis, it simply makes no sense, and they don't believe it either. Yet they continue the pretense. US unemloyement can only improve via money pumping only after every qualified person if in the emerging markets is employed. The bubble will burst sooner than that happens due to inflation in emerging markets cause by hot money. 

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#24) On February 27, 2011 at 11:15 PM, whereaminow (58.64) wrote:

 rd80,

Sorry I missed your comment earlier.  

I understand how gov't is the first to benefit from monetary inflation as it leads to price inflation, is the inverse true?  Would gov't be the first to be hurt by deflation? 

Actually, yes. But for another reason. Since government is a huge debtor, it would prefer to pay back debts with devalued money.  The government would like an ever expanding money supply to pile up as large a deficit as possible. That's not planned, I don't think. It's just the way government "works." 

If so, that would partially explain the opinions that deflation is such an evil thing. 

Oh definitely. Politicians aren't that bright, but vested corporate/banking interests absolutely know what is going on. They determine allowed opinion on corporate media and advocating deflation falls far outside that narrow range. 

I suspect inflation/deflation winners and losers are determined just as much by capital structure and duration of any outstanding debt as place in line. e.g., net debtors who don't have to roll the debt over or take on new debt any time soon will benefit from inflation. 

That's an interesting question. I think you are right about net debtors with no rollover being big winners, but I'm not speaking from authority on that.

I think it goes beyond basics at this point, but I haven't even touched the subject of maturity mismatching and how the old golden rule of banking (that assets should match liabilities in both duration and quality) has eroded over time, and gets even further out of whack during an inflationay bubble. This also helps shape how drastic the bust will be.

David in Qatar 

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#25) On February 27, 2011 at 11:38 PM, Starfirenv (< 20) wrote:

Re #18- Davidisok- You passed the sense of humor test.

 "Once I move back to Amerika, I'll be looking to meet some of the good people here in person."

Sir, I would very much like to be on your list.  Best. 
MarkinNv

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#26) On February 28, 2011 at 12:17 AM, ETFsRule (99.90) wrote:

"If so, that would partially explain the opinions that deflation is such an evil thing."

Deflation is an evil thing. There is no need for theoretical guesswork from various sides of the political spectrum: all you need to do is look at history. Deflation results in economic catastrophes. That's just the truth.

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#27) On February 28, 2011 at 12:35 AM, russiangambit (29.94) wrote:

> Deflation is an evil thing.

It seems to be the deflation resulting from a bust, such as housing is an evil thing. Natural deflation resulting from progress such as in tech gadgets doesn't seem to be all that bad. Should we then discuss that may be we should avoid busts if we don't like the deflation so much? Instead of trying to reinflate bck, which inevitably result in another bust? In other words, the aftermath of  bust is an evil thing, and it is not necessarily true that inflation is  proper cure for it.

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#28) On February 28, 2011 at 12:40 AM, whereaminow (58.64) wrote:

ETFs,

Please give this non-Austrian, positivist study on deflation and depression a look.

Atkeson and Kehoe utilize panel data on inflation and real output growth for seventeen countries including the United States, the United Kingdom, France, and Germany. The data set for each country encompasses at least 100 years. The authors focus on medium-term fluctuations by breaking the time series on inflation and on economic growth for each country into periods of five years and calculating the average annual rates of real output growth and inflation for each such period or "episode." 

"Deflation" is then defined for each episode as "a negative average inflation rate" and "depression" as "a negative average real output growth rate." The five-year episodes are selected so as to begin and end with years ending in "9" or "4" so that, for example, the years of the Great Depression (1929–1933) and the depression of 1921–22 are grouped together in single episodes, 1929–1934 and 1919–1924, respectively.

----

As Atkeson and Kehoe conclude: "The data suggest that deflation is not closely related to depressions.  A broad historical look finds more periods of deflation with reasonable growth than with depression, and many more periods of depression with inflation than with deflation.  Overall, the data show virtually no link between deflation and depression." (Emphasis added) The authors caution, however, that their study "characterizes the relation in the raw data between deflation and output growth, with no attempt to control for anything" and "perhaps a link between deflation and depression could be teased out of the data with a well-motivated set of controls." 

Though Atkeson and Kehoe cannot be said to have "proven" there is no link between deflation and depression (also, that would be called a Negative Proof, and logically impossible,) their conclusions differ vastly from the mainstream view that deflation results in economic catastrophes.

David in Qatar 

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#29) On February 28, 2011 at 12:57 AM, Valyooo (99.81) wrote:

David,

Where in the states are you from?

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#30) On February 28, 2011 at 1:08 AM, whereaminow (58.64) wrote:

Valyooo,

I grew up in Chicago, but I have only been there off and on for the past 15 years.

I'm not sure where I will end up. We are torn between East and West Coast opportunities.  And when I say "we", I mean "she", because I'm a Californian at heart.

We'll see...... 

David in Qatar 

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#31) On February 28, 2011 at 9:10 AM, XMFSinchiruna (28.54) wrote:

Just a drive-by comment to remind Fools to distinguish between demand-pull and cost-push inflation. The dynamics of each are unique, with cost-push inflation representing the more relevant challenge to our current predicament.

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#32) On February 28, 2011 at 9:55 AM, djemonk (< 20) wrote:

Excellent post and even more excellent thread.

Thanks!

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#33) On February 28, 2011 at 12:46 PM, Melaschasm (89.97) wrote:

O.P.  Great discussion of inflation.  There isn't much I can add.

Monetary inflation has been intentionally created by the Fed.  Ben has specifically said that he will print as much money as it takes to avoid deflation, even if he overshoots creating a little more inflation than desired.  The Fed has targeted a long term inflation rate of 2%, and has maintained this inflation rate by printing money.

I do not claim to understand why people do not believe that increasing the money supply reduces the value (price) of money.  Imagine if the USA printed and spent $1,000 trillion dollars this year.  Do you think prices would go up or go down? 

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#34) On February 28, 2011 at 1:00 PM, binve (< 20) wrote:

David,

This is an excellent post! Sorry I missed it this weekend. I haven't read through all the comments yet, but it doesn't look like there is much to add. Thanks for taking the time!

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#35) On February 28, 2011 at 1:06 PM, ETFsRule (99.90) wrote:

David: I read the study and they conceded that there was a link between deflation and the Great Depression.

I had a few issues with the rest of the study:

1. Regarding Japan's lost decade they said, "More reasonable, we think,
is that much of the slowdown is the natural pattern for a country that was far behind the world
leaders and had begun to catch up."

Well, the lost decade is now the lost 2 decades. That sure doesn't seem like a natural pattern to me... so they need to re-visit the situation in Japan and come up with a better explanation.

In table 4, I'm not sure why they didn't just plot both of these data sets on the same graph, but you can see that the trend is clear: since 1960 Japan's real output growth and their inflation rate have moved in synch with each other (except for the brief spike in inflation around 1970). The relationship looks pretty clear to me.

2. Most of their other examples seem to be from the 1800's, and they don't give us any background information, so it's hard to look more closely at those periods of deflation. I don't even know how accurate the statistics were at that time. I can only find CPI data going back to 1913, so I'm not sure how they studied deflation before then.

I am also aware of this study by Mises, but I disagree with it. They say:

Federal Reserve Bank of Minneapolis data show CPI was negative for 13 years in the twentieth century, including 1922, 1928, 1939, and 1955. The NBER chronology shows the economy was in expansion for 12 months in each of these years.

Well, from looking at the data I can see that we had negative CPI in several years which coincided with recessions. In addition to the great depression, 1921, 1938, 1949, and of course 2009 all match this description.

There may have been years where we had very brief periods of deflation, which did not cause a recession. But every time there is an extended period of deflation, it always results in a depression or lost decade. I've never seen a long period of deflation in any country which coincided with a healthy, growing economy.

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#36) On February 28, 2011 at 1:29 PM, Slider08 (42.18) wrote:

David,

You have a way of easily explaining the core issues of Austrian economics that most (armchair) Austrian economists lack. Some comments, though:

- I'm not sure everyone knows the difference betweena higher order good and a lower order good, though you hinted at it.

- Good luck sufficiently explaining and comparing theoretical/positivist economics :p

 

I think the question has become, does the monetary theory of inflation presented above still have any predictive value in our current time period?  If it did, could you tell me when, exactly, we will see the price inflation that is only vaguely predicted by your theory?  If not, can you tell me why your theory has value at all?

 David did a good job answering this one, but I'd like to point out that this is the reason Hayek (and Austrian economics) lost out to "Keynesian" ideas in the 30's and 40's. Mainstream economists became disenfranchised with the Austrian Business Cycle Theory (ABCT) when the economy failed to recover from the Great Depression within a normal/predictable time period. Economics never happens in a sandbox, and the ABCT alone isn't enough to predict exactly when a recession will hit or to what extent it will affect the economy, especially in an interventionist market.

Previous depressions/recessions to the Great Depression typically saw both price and wage deflation, which were necessary to correctly reallocate resources away from the artificially-low-interest-rate-induced, falsely demanded markets to the proper markets. Popular opinion at the beginning of the Great Depression, championed by Hoover and Henry Ford, was that higher wages created more demand and a better economy, though. (This is absurd.) For the first time in American history, industries tried to keep wage rates stable in the middle of a recession, the obvious results being much, much higher unemployment rates in those industries and a complete hampering of reallocating resources between falsely-demanded goods and actually-demanded goods, leading to a much longer depression than normal. There's no formula the ABCT (or ANY economic theory) could have used to predict or account for this or countless other interventionist policies or just-plain-poor entrepreneurial vision. Any economic theory/framework that claims to have what you term "predictable value" is suspect at best.

I'll leave with a F.A. Hayek quote from his Nobel prize lecture (entitle The Pretense of Knowledge):

 

Of course, compared with the precise predictions we have learnt to expect in the physical sciences, this sort of mere pattern predictions is a second best with which one does not like to have to be content. Yet the danger of which I want to warn is precisely the belief that in order to have a claim to be accepted as scientific it is necessary to achieve more. This way lies charlatanism and worse. To act on the belief that we possess the knowledge and the power which enable us to shape the processes of society entirely to our liking, knowledge which in fact we do not possess, is likely to make us do much harm.

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#37) On February 28, 2011 at 6:07 PM, whereaminow (58.64) wrote:

Thanks for all the comments, everyone. I've been away for a few hours and I see that the discussion continued. 

Starfirenv,

Sir, I would very much like to be on your list.  Best.  

MarkinNv  

Thanks Mark! I really appreciate it. I'll do my best to make it happen. Who knows, maybe I'll take the summer off and tour the country. I deserve it. I've been overseas for like 12 of the last 15 years.

russiangambit,

Thanks for the comments. As usual, I agree with your ever-reasonable points. 

TMFSinchiruna,

You are more than  invited to make a drive-by or lenghty commentary on any of my blogs. I always love seeing your name pop up in my comment thread.

djemonk,

Thanks!

Melaschasm,

Thanks and I appreciate the reductio ad absurdum approach.  I think people believe that the Fed has tools to control (price) inflation if they "overshoot."  I'm trying to help people understand that there is no such tool and no idea to know if they are overshooting.

binve,

Thanks binve! I have a surprise for you coming up this week :)

ETFsRule,

Thanks for looking at the study(s). I simply wanted to show that it's not a rock-solid case that deflation always means terrible things. But in terms of the pain of a deflationary crash after a bubble pops, you will get no argument from me. It's a horrible thing. We just disagree on how/why we ended up there and how to fix it.

Slider08,

Thanks for the comment! That could have been a good blog on its own.  Hayek's Pretense is one of the finest, humblest speeches you are going to find.  

- Good luck sufficiently explaining and comparing theoretical/positivist economics :p 

I think you'd be pleasantly surprised. I know that I have been. I have done some blogs here dedicated to that topic alone and had very nice responses and great discussions. CAPS members consistently exceed my expectations, which is why I love blogging here.

David in Qatar 

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#38) On February 28, 2011 at 7:28 PM, rfaramir (30.46) wrote:

David,

Awesome blog!

"Talks of budget cuts are totally meaningless when"

No, I believe budget cuts are always a good thing. When the government is in surplus, they have no reason to print, which is a good thing. Lowering taxes is also always a good thing, but not always effective in lowering spending, especially when the state can print. Cuts first, lower taxes second.

As far as "Housing is a higher order good," I'd disagree with Doug French, because of his own words in the fine article: "The fact is that homes include the land they are built on, and land is certainly a higher-order good." I.e., housing itself is NOT a higher-order good, though it requires the higher-order good(s) to exist. This is not much different from "I, Pencil" where you touch on myriad higher-order goods to fully trace the origins of a lowly consumer good. Or the iPod (consumer good) includes (necessarily requires) the higher order goods in order to exist, e.g., assembly factories in China, chip factories in Oregon and Texas, bulk shipping, etc.

rofgile, 

"You say prices should always be declining, and that because they have not been declining we have truly been having price [sic] inflation.

From my perspective, that would be called price stability. (Because we have avoided terribly falling prices of goods, while also avoid terrible inflation).

And, it seems that the reason for the monetary increases that have lead to what I can price stability for goods has been a centrally managed Federal Governmental Bank.  The FED."

You put a word, "price," into David's mouth. If prices are stable, that is not price inflation, it is price stability, by definition. But since we usually have price deflation due to technological progress and stable money supply, when there is price stability there must be *monetary* inflation.

Normally, there is slight price deflation, so everyone gets richer. When there is not, some few get richer, and it is no mystery who: the printers of the money! And their co-conspirators the bankers, and lackeys in government. Instead of all of us being richer due to technological progress, the Fed and the banksters are richer, because they have confiscated our purchasing power by counterfeiting the currency.

ETFsRule, 

"you need to be able to quantify exactly how much currency should have been issued. And I'm sure people will disagree on that."

The exact amount is easy to quantify: exactly one twenty-dollar bill for every (unencumbered) troy ounce of .9999 pure gold in the Treasury's inventory. Plus one replacement bill for every damaged bill surrendered. (Actually, I think it was $20.67 ask and $20.00 bid, the spread funding the upkeep of the gold vault.)

There was no disagreement for decades! Any fixed amount of money in a market is sufficient for all transactions. A proper money (gold, silver, 100% backed paper) is indefinitely divisible for small transactions, and dense enough for large ones. There is no need for "more money" to be supplied, and never a shortage or surplus of any commodity, only goods and services that need to be repriced to fit the market realities.

When there is a 'shortage' (e.g., frost-bite crops), the price rises locally, bidding up remaining crops from warmer/luckier climes, so the goods travel from far to near guided by the invisible hand. When there is surplus, prices fall, producers cut back or shift out of that line of business (if they were on the margin of profitability).

Deflation is a good thing: everyone feels richer since they have more purchasing power. Debtors hate it, bankers fear it (fractional-reserve ones, at least, as it can bankrupt them). But it is good for the people, especially those on fixed incomes. 

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#39) On February 28, 2011 at 8:29 PM, whereaminow (58.64) wrote:

rfaramir,

Great comment. Wow.  

I agree with you on the proper amount of money required for an economy, but I can't express it like you can. So instead I try to focus what the Fed can't know. I like to tackle their claims of knowledge. That's my lane :)

Thanks for coming on this blog and sharing your insights. You are one of the most knowledgeable commenters I've ever come across. 

David in Qatar 

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#40) On February 28, 2011 at 10:09 PM, Valyooo (99.81) wrote:

David,

I know we have had our differences but if you're ever bored in NY I would be down to  buy you a beer.

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#41) On February 28, 2011 at 11:57 PM, whereaminow (58.64) wrote:

Valyooo,

Differences schmifferences. I forget these things in 5 minutes. I just need to realize that there are people out there that aren't as forgetful.

if you're ever bored in NY I would be down to  buy you a beer

Thanks! It's looking like I need to go on a stateside tour!

David in Qatar 

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#42) On March 01, 2011 at 8:31 AM, ETFsRule (99.90) wrote:

"Deflation is a good thing: everyone feels richer since they have more purchasing power. Debtors hate it, bankers fear it (fractional-reserve ones, at least, as it can bankrupt them). But it is good for the people, especially those on fixed incomes. "

Are you sure you're not just saying deflation is a good thing, because you want to believe that it is a good thing? Can you show us some historical examples of economies that have prospered during a deflationary environment?

I don't have any theoretical problem with deflation... but, from looking at the numbers, it seems that deflation is very bad for the economy.

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#43) On March 01, 2011 at 12:09 PM, whereaminow (58.64) wrote:

ETFsRule,

For (price) deflation, where productiivity is increasing faster than the money supply causing prices to fall, that's easy: America 1787-1913.

For example in 1896, the price level was lower than 1834.

There were instances of (monetary) inflation leading to (price) inflation during the 1800s. War of 1812, money printing by the Bank of the United States (1816-1836) and the Civil War. But despite that, the overall price level quickly fell again once the printing stopped.

There are rare instances of a declining money supply in American history for any length of time. A contraction in 1873 turned into a sharp, but brief recession. (Original historians called it the Long Depression, but modern econ historians of all stripes generally agree that it wasn't very long at all and the growth that followed it was tremendous,)

You can see some of the same events played out in the 1800s that you see today. The panic of 1819 was a housing boom that crashed. The housing boom originated when the BoUS printed money to pay off the War of 1812 debts.  

(Price) deflation was the rule of thumb before the Federal Reserve.

(Monetary) deflation is a rare occurence. Without a central bank or government first printing excess money, I don't even know how it would be possible. Theoretically, yes, people could hoard all the gold, but on a scale to shrink the money supply? I don't think it could ever happen. 

David in Qatar 

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#44) On March 01, 2011 at 1:09 PM, rfaramir (30.46) wrote:

ETFsRule,

Price deflation is a good thing by definition. It means that the market has produced more goods, which are being chased by the same quantity of money, so prices fall. More goods means we are wealthier, as goods are wealth.

Money supply deflation is theoretically as bad as money supply inflation in its disruptions of the economy. It is a manipulation (upwards) of the value of everyone else's dollars by destroying some of your own. That's why it hardly ever happens, few are stupid enough to do it. It's why you don't have to police those nasty uncounterfeiters, LOL!

But the Fed on rare occasions has been known to sell some of its assets and "soak up liquidity," which means that the dollars tendered to it for those assets it causes to disappear (electronically). Since they were "fiduciary media" anyway (counterfeit but indistinguishable from legitimate media), destroying them is not theoretically doing wrong, it is righting a wrong already done (the previous counterfeiting). The sudden disappearance of currency can cause a shock to the markets similar to, but in opposite direction from, money supply inflation, so the usual Austrian remedy (as I understand it) for money supply inflation is not deflation but just stopping the inflation, permanently. Unfortunately (to me), this lets the counterfeiters keep their ill-gotten gains to this point, but if less damage is done, then maybe it is justifiable?

I don't know of the jury is still out on that question, or, what's more likely, I just haven't fully understood their answer, yet. I'm still learning, via mises.org (I recommend getting their Daily Article and subscribing to their podcasts in iTunes) and fee.org (I recommend The Freeman, their free publication).

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#45) On March 01, 2011 at 3:20 PM, ETFsRule (99.90) wrote:

David: Thanks for the response.

I was finally able to find CPI and GDP data going back to 1790. Overall there was a very slight increase in the CPI from 1790-1913. I would call this a period of constant prices, rather than a period of deflation.

There were a lot of ups and downs along the way though. I'm going to run some statistical analysis on the data, and I'll bear in mind the explanations that you have provided here. I'll post the results in my blog later this week.

"(Monetary) deflation is a rare occurence. Without a central bank or government first printing excess money, I don't even know how it would be possible."

Maybe a sudden increase in population? Say, from the slaves being freed and entering the economy (thereby increasing the demand for currency)? Or hypothetically, from refugees fleeing one country and entering another?

rfaramir (99.63) wrote:

"I'm still learning, via mises.org (I recommend getting their Daily Article and subscribing to their podcasts in iTunes) and fee.org (I recommend The Freeman, their free publication)."

My advice is, don't listen to experts on either side of the spectrum. Most "experts" have an agenda that they are trying to push. It's best to figure these things out for yourself... after all, this isn't rocket science, it's just economics.

What really worries me is that when I asked if you had any historical data to support your position, you replied back with more theory and more rhetoric. That makes me sad :-(

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#46) On March 01, 2011 at 3:41 PM, mtf00l (47.94) wrote:

I'm glad to see everyone is ok with interest on money that doesn't exist...

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#47) On March 01, 2011 at 4:10 PM, Starfirenv (< 20) wrote:

"after all, this isn't rocket science, it's just economics." #46

I just fell out of my chair...     :o)

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#48) On March 01, 2011 at 8:41 PM, whereaminow (58.64) wrote:

ETFsRule,

It took me a while. I had to finally download the CPI numbers from a site called measuringworth.com

I count 124 years from 1790-1913

I count 51 years where the CPI went up - (price) inflation.

I count 72 years where the CPI went down - (price) deflation

It is a bit too much to say (price) deflation was the rule of thumb before the Fed, but it was more common than (price) inflation.

Now comes the interesting part. I can pull the GDP numbers from the same time set and compare the increase/decrease in GDP paired to years whether there was inflation/deflation.

That'll take some time. But I think that's the empirical analysis you are looking for right?

David in Qatar 

 

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#49) On March 01, 2011 at 8:46 PM, whereaminow (58.64) wrote:

(CPI 1982-1984 = 100) 

I also think it's interesting to note that the CPI in 1900 was 8.14. In 1800 it was 12.17.

There was a massive run up in prices during the Civil War. No surprise there. CPI went from 8.06 in 1860 to 15.79 in 1865. A near doubling of prices in 5 years.  From 1865-1900 prices nearly halved back to the 1860 level. 

David in Qatar 

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#50) On March 01, 2011 at 9:30 PM, ETFsRule (99.90) wrote:

That'll take some time. But I think that's the empirical analysis you are looking for right?

Exactly. That's the same site I found. You can just copy the data into Excel and from there do whatever you want.

I plotted the yearly % change in CPI vs the % change in nominal GDP as a scatter plot, and there's a pretty strong correlation (decreasing CPI generally = decreasing GDP, and vice-versa). I haven't done the same with real GDP yet, but obviously that's something I need to do. And there are a lot of other things to consider like causation vs correlation, etc. But it's interesting that this correlation was even stronger for 1790-1913 than it was for 1914-2009 (0.72 versus 0.44 if I remember correctly). The CPI was also a lot more volatile back then.

I have a lot more work to do... this will consume my lunch breaks for the next few days.

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#51) On March 03, 2011 at 3:47 PM, FracturedVision (23.24) wrote:

A lot discussed here is explained by the Cantillon effect, all of it true.  I think the most important thing is to identify which part of the timeline we're in right now - T6 to T7, judging by the rise in the price of commodities that you have already shown.

 Thanks for the great read

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