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Source link: http://archive.mises.org/12767/deficit-financing-and-inflation-2/

“Deficit Financing” and Inflation

May 21, 2010 by

The best proof that inflation, the increase in the quantity of money, is very bad is the fact that those who are making the inflation are denying again and again, with the greatest fervor, that they are responsible. FULL ARTICLE by Ludwig von Mises and Bettina Bien Greaves

{ 12 comments }

Derek May 21, 2010 at 3:37 pm

Why is inflation at all time low, despite the stimulus and other government ‘inflating’ techniques?

Alvaro de Orleans-Borbon May 21, 2010 at 4:31 pm

To Derek:

Even if a lot of new money is being issued by most western central banks, inflation is currently low because of four reasons:

1. The real amount of inflation is concealed — see http://www.shadowstats.com — real inflation is currently around 8-10% pa.

2. Quite a bit of the excess creation of money is being offset by money destruction — every time you have a LCTM default, or an Argentinan bond default, or a subprime security default, etc, money is being destroyed and the central banker, with a satisfied smile, can correspondingly serve his political master by issuing new money. Of course, most of the destroyed money is in private hands, and most of the newly issued is in public hands — a little creeping nationalization, that is.

3. There is a time lag — some 12 to 24 months — between money issuance and price rises.

4. There is another BIG misunderstanding — the following statement is false:
ZERO money increase = ZERO inflation = ZERO price increases

The correct statement is:
ZERO money increase = ZERO inflation = DECREASING prices

Why? Quite simple: the yearly increase in productivity (some 5-7% pa) means that manufactured stuff costs less every year. This price decrease is being inflated away, so:
ZERO price increases = 5-7% pa inflation = 5-7% money increase

Call it an “Inflation tax on productivity”, if you wish — but it means that a “low” official inflation rate (say, 2-3% pa) is already taking away every year about 8-10% buying power from the citizen.

If you consider a true, undoctored yearly price increase of about 10%, and add about 7% pa productivity inflation, you get 17% pa, which is fairly exactly the constant increase in the value of a good constant money proxy like gold: since 2001 gold is appreciating, in US dollars terms, at a 16.8% yearly rate, and staying, amazingly so, 90% of those nine years within a +- 10% narrow price channel; since 2005 all other major currencies have joined this trend.

Why did we have such a “smooth” gold price appreciation in the last ten years?
Here I can only offer a guess: in the ’90 Ben Bernanke, in his well known Macroeconomics textbook, gave a nice explanation of why a central bank would maximize his seignorage — the profit it makes in real terms when it issues money — at an 8% yearly inflation rate, see:
http://www.nightfall.it/wp-content/uploads/2008/02/seignorage-and-inflation-tax.pdf

So, it makes sense for the Fed to run a monetary policy that optimizes its profit — actually, it appears that they are doing a very good job, looking at it from their own perspective.

So, inflation is not at an all time low, I’m afraid…

newson May 23, 2010 at 7:44 am

to alvaro:
regarding point 2): credit destruction, as per your examples, is not money destruction, the loss is borne by shareholders or bold holders. of course, credit destruction may be result in banks and financial institutions slowing down future money creation and people reigning in their borrowing, but it’s not a mechanical result.

of course you are quite right in the conclusion that the government intervenes to mitigate any slowing of the private money creation.

newson May 23, 2010 at 7:53 am
Smack MacDougal May 21, 2010 at 4:50 pm

In his lecture, Mises said, “The best proof that inflation, the increase in the quantity of money …” and thus Mises believed, wrongly, that an increase in the quantity of money is inflation.

Mises could hold this false belief only if he did not understand banking, which is quite clear that he did not.

You could double the number of dollars in circulation but if persons don’t increase their demand, prices are going to remain exactly the same. Why? Prices arise from demand in the face of supply and nothing else.

A banker is a trader whose business consists in buying money and debts by creating other debts. While the grocer buys food for resale, the banker buys money or debt and sells credit. A banker creates and issues credits payable on demand and in doing so puts money already in circulation to greater efficiency.

Inflation is a growth of credit. Inflation results in an expansion of credit. It’s a process undertaken by central bankers to let member banks buy money and sell credit contracts.

How do central bankers help out their commerical banker members with inflation? They lower interest rates. They lower reserve requirements. They loosen lending standards. They stop pay interest on reserves at a rate higher than interest in the markets for credit.

Inflation have NOTHING TO DO WITH CPI and hence prices. Prices for all things either rise or fall because of the Law of Prices (value arises from exchange, when money is involved in the exchange value gets renamed price, winning bids of demand for offered supply set prices).

Persons get mixed up about inflation and prices because they do not get economics; nor do they get money, credit and banking.

Matthew Swaringen May 21, 2010 at 5:46 pm

Mises wasn’t wrong, he was just simplying and establishing that the end result of new money is an overall increase in prices. Increases in the supply of money will entail later inflation, because by giving cheap credit banks crowd out resources that would otherwise go to market-chosen purposes. This new money doesn’t create real wealth.

It is also true that decrease in the supply of a resource or product will increase it’s price, but that’s not what why we are regularly experiencing inflation. The primary cause is credit being extended through the injection of new money into banks.

BioTube May 21, 2010 at 9:18 pm

You’re both missing the point – Mises defined inflation as an increase in the money supply(the classical definition), making this thread a complete non sequitur. Matt, the idea of inflation-as-price-increase probably originated with Keynesianism(if it didn’t create it, it certainly displaced the earlier definition).

Beefcake the Mighty May 21, 2010 at 9:34 pm

Awesome name, BTW.

Ivan May 23, 2010 at 3:52 am

“You could double the number of dollars in circulation but if persons don’t increase their demand, prices are going to remain exactly the same. Why? Prices arise from demand in the face of supply and nothing else.”

This makes absolutely no sense. If you double the supply of money in circulation you will, ceteris paribus, see prices double (this is merely tautological). If the demand for cash holdings doubles, then you will, ceteris paribus, see no change in the over-all price level, ect.

Inflation is the result of an expansion in the supply of money (in the broader sense), and nothing else. This can be done through OPO, or by a defunct banking system that lacks adequate competition. In a free-banking system, the supply of credit and bank notes cannot exceed the demand for credit and bank notes.

Shay May 24, 2010 at 6:45 am

I think his point was that if everyone lived in a utopia and was already fully satisfied and had no further desires, then doubling everyone’s money supply wouldn’t alter prices, because nobody would do anything with the excess money. They’d just continue to buy things at current prices, and not buy any more than they were before. Or if everyone was dead, doubling their money wouldn’t increase prices. Therefore, monetary inflation doesn’t necessarily lead to price inflation.

Graeme Bird May 23, 2010 at 4:21 am

“This makes absolutely no sense. If you double the supply of money in circulation you will, ceteris paribus, see prices double (this is merely tautological). If the demand for cash holdings doubles, then you will, ceteris paribus, see no change in the over-all price level, etc”

Right. I think though that people tend to get confused if they miss out some things in the process. The way things unfold. I appreciate the ceteris paribus, meaning one supposes that Q (always misleadingly defined as GDP by the way. Thats where a lot of confusion starts.) stays the same. And that therefore your statement would hold true.

But normally I would recommend that people think in terms of money supply increase affecting spending, and then the spending flows affecting the prices. If money demand increases in the face of money supply its the quantity of SPENDING that is invariant. Normally speaking this would be associated with falling prices. Not with a steady price level.

The main reason why one has to think this way is that spending doesn’t just mean consumer goods spending. Prices don’t just mean consumer goods prices. And Q isn’t just GDP. What is the money spent on? Not just GDP. We spend the money on Gross Domestic Revenue, in the Reisman sense, PLUS investment goods that are not all included in GDR.

This is why people get skeptical of the quantity theory of money. Since they go to look at the statistics and they can no longer always make the MV=PQ deal seem to work. They have the metrics all wrong for M …. V …. P and Q. So whilst its a tautology in one sense for some reason we are looking at all the wrong metrics for the concepts we are trying to put together tautologically.

People aren’t happy with the idea of inflation as being defined by monetary growth alone. Since if monetary growth was zero the demand for money would surge, and prices might take years and years to stop falling, if they ever did stop. From our starting point such a money would be untenable to the purpose. I think you really want the money supply growing at least enough to keep Growth Domestic Revenue from falling, but not enough to keep prices from falling. So zero monetary growth, people see as inherently deflationary. You would rather want to say that its excessive monetary growth. But then how much is excessive? Rothbard at one time thought you could define inflation as monetary growth above the rate at which gold and silver supplies are expanding. That may seem lame but its about the best definition I’ve seen so far.

You might define it in terms of monetary growth, in excess of what would have appeared to be needed to keep Gross Domestic Revenue from falling. Thats a hard one to figure. But it could be as high as 7% in some years. And 0% in others. Or negative in some potential situations. Our monetary situation is so unstable its just a hard thing to define how much monetary growth ought to be considered neutral and the extra bit inflationary. I still think the gold and silver definition is the best. However we don’t want to get into this jive where we consider that there must be one metric only, when we are trying to take a measure of something we are defining conceptually. Better to define inflation by two or three fair-sounding methods and then present them all.

Will Richardson September 8, 2010 at 1:01 pm

But increased demand will mean increased supply especially with an output gap of unemployed labour and capital, and if velocity of money circulation falls as there is more money so it doesn’t have to be used so rapidly, prices would be stable anyway?

Another way of looking at things is this

http://bilbo.economicoutlook.net/blog/?p=10895 specifically or here generally

http://bilbo.economicoutlook.net/blog/

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