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Source link: http://archive.mises.org/5886/free-money-against-inflation-bias/

Free Money Against “Inflation Bias”

November 14, 2006 by

Even under a regime in which government controlled central banks pursue deflation targeting there would be the risk of creating unsustainable debt levels for private households, firms and governments. A rising indebtedness (relative to income), in turn, would sooner or later tip the balance of societal preference in favor of debasing the value of money.

From the Austrian point of view, a government controlled money supply system, coupled with the price level stabilization idea, is inherently crisis prone, irrespective of inflation targeting or deflation targeting. That is why Austrians argue for an unconditional return to free-market money. They see it as a solution to the dangers emerging from today’s monetary regime. FULL ARTICLE


Person November 14, 2006 at 8:31 am

I think Polleit dodged the central complain here. In the Fig. 2 example, where nominal rates are zero … remind me why someone would buy that bond? Polleit claims that people would still save and lend in such a scenario, but why would they? They give $100 nominal now, and get back $100 nominal in ten years. So, the bond purchaser is giving up 10 years of possible use of that $100, in exchange for … nothing! Why doesn’t he just hold on to it, so that he has the opportunity to use it in any of those ten years? It seems to me Polleit still hasn’t explained why someone would lend in such a scenario.

John Bigelow November 14, 2006 at 8:46 am

Because the price level is falling, the $100 returned in 10 years is worth more (buys more stuff) than when the investor lent it out.

John Bigelow November 14, 2006 at 8:49 am

Sorry, ignore that comment. I shot first, thought later. I agree with the first comment.

RogerM November 14, 2006 at 9:01 am

John, I think you were correct. The inflation rate is negative, so actually there is deflation. $100 in the future would purchase more than $100 today because prices are falling each year.

But I have another question: Even with a gold standard, credit could increase dramatically if we allowed fractional reserve banking. And history bears this out for there were many periods of boom and bust under a gold standard. It could be argued that with fractional reserve banking, someone must place limits on the power of banks to create new money via credit expansion. In our case, the Fed performs that role.

More and more it seems to me that the main problem is fractional reserve banking. Fractional reserve banking seems to require a Fed-like group to rein the banks in.

Person November 14, 2006 at 9:07 am

Roger, you’re making the same mistake John did at first: Yes, $100 will be worth more later, but why do you need to buy the bond? A dollar in 2006 will (under deflation) transform into a more-valuable 2016 dollar, even if all you do is hold onto it. So why do you need to buy a bond to give you that same dollar back, when all it does is make you not able to use it for 10 years?

RogerM November 14, 2006 at 10:17 am

Yeah, you’re right. With no interest payment, he would have no reason to loan the money. But Fig 3 takes care of that by adding a 2% interest payment.

Person November 14, 2006 at 10:25 am

Roger: That still doesn’t matter. All that’s different in the Fig. 3 plan is that it repays the principle over several periods instead of all at the end. The total repayment is still $100. Check the first column: $2 + $2 + $2 + … + $2 + $82 = $100. All the bond did was give you your $100 back, and cost you the opportunity of spending most of it in the various periods. Still you’d be better off just holding onto the $100 and cutting out $2 as needed.

N. Joseph Potts November 14, 2006 at 11:02 am

RogerM: the Fed is a cartel that COORDINATES the inflationary activities of fractional-reserve banks. It INCREASES the capability of the banking system to do this FASTER. Notionally, it was established to do the opposite, but it constitutes merely another example of intervention aggravating the problem it was said to have been executed to solve.

WHY BUY THE BOND? There is no good reason anyone would carry out ANY of the investments illustrated in the article (unless his expectations were different from the outcomes shown). The illustrations are ZERO-SUM scenarios – they demonstrate that they all sum to zero regardless of whether the environment is inflationary or deflationary. Investors will invest in (expected) POSITIVE-SUM scenarios, which are equally attainable under either condition (inflationary or deflationary).

If he had used positive-sum scenarios, it might have been more realistic, but the essential conclusions would have been harder to make clear.

David C November 14, 2006 at 11:06 am

Hold on a minute here, am I reading this right. So the argument is that if my Gold is constantly going up in value, I would have no reason to invest – and therefore it would be an economic problem. Well, if gold is constantly going up in value, that would imply that productivity is constantly increasing while my costs are constantly going down. That sure doesn’t sound like an economic problem to me. (Or gold could be constantly going up because the fiat system is crashing, but that is certainly not a problem with gold either). I also doubt investment opportunities would ever dry up. Some ventrue capitalists make over 1000% apr on initial investments, gold going up would just change the dynamics of the market. Since we’re at the birth of the information age and not at it’s dusk. I suspect that plenty of worthy investment opportunities still exist. Also, if everybody hoarded gold, then eventually productivity improvements would level off and so would Gold’s rise – the market would find an equilibrium.

But one more thing, of course people would invest the gold. They would invest it in things that they want to do, rather than in things that preserve wealth or stay on the treadmill. To me things like deep sea, R&D, and exploring space come to mind. The people who invested the gold would be the first to reap the enjoyment of their investment, while the people who didn’t would pay out or end up living their life sitting on a pile of metal. Free people have more leeway to engage in high risk low return investments – to me that is not a problem.

Person November 14, 2006 at 11:15 am

David_C: So the argument is that if my Gold is constantly going up in value, I would have no reason to invest

Not quite. The claim is that people would have no incentive to invest via lending. That doesn’t say anything about investing via purchase of equity in a venture, and in fact, I’ve seen deflation proponents suggest that deflationary currencies would mean a shift from debt investment to equity investment, and that that would be a good thing.

Of course, I’m not sure even about that. While it’s true some people can make 1000% real APR, that wouldn’t fix the problem unless *on average* the ROR were high enough. But if products are continually declining in price, the average won’t be positive. You could, I suppose, get around this by only investing in the development of NEW, as-of-yet unpriced goods.

I also think that if there’s too much deflation, it becomes too hard for people to gain the currency, and it loses its network-effect advantage and thus its usage as a money, so on a free market, people would switch to a different currency when that happened.

RogerM November 14, 2006 at 11:24 am

Yep, you’re right! There’s no reason to buy the bond.

Joseph:”the Fed is a cartel that COORDINATES the inflationary activities of fractional-reserve banks. It INCREASES the capability of the banking system to do this FASTER.”

How does it do that? It seems to me that without the break on banks that the Fed uses, the reserves and overnight bank rate, banks would have the incentive to expand credit to the maximum. How does the Fed make it possible to expand more than that?

David, You’re right, too. History shows that production usually increases in periods of deflation, especially those before the 1930′s. This implies increased investments. All that is required for people to continue investing when prices are falling is that the return on the investment be greater than the increase in the value of money. So if money is increasing in value at 2%, then an investment that will return 10% will yield 8% in real dollars.

JIMB November 14, 2006 at 11:37 am

The article mixes the risk free rate of return with the total rate of return. Originary interest (risk free return) would be the advantage to holding money (savings) as prices fell, while any increment above that would require taking on risk and investment – which certainly would be done.

The issue at present is why an oligopoly of banks with the Fed is allowed to force everyone eventually to deal in debt (systematically increasing debt and prices relative to available cash by oscillating the increases in base money and buying up bonds), thus levying a “tax” (the portion of the interest illicitely earned by bankers as they diluting the supply of credit and money) on virtually every transaction in the economy …

Daniel M. Ryan November 14, 2006 at 12:22 pm

Here’s a tangent out of left field for you: in a regime where the money stock is fixed and there is productivity growth, the traditional Christian prohibition of charging interest for money lent makes some economic sense…provided that the price level is in fact declining at a rate roughly equal to the real interest rate.

Paul Marks November 14, 2006 at 12:36 pm

Plenty of people have lent out money in periods when prices were falling.

Sure they will make a gain just by leaving their money in a box under the bed (although there is the opportunity cost of not doing anything with the money), but they will make even more of a gain by lending out the money to someone who will pay interest (as long as the money is paid back).

Of course there is no such thing as “the rate of interest” – there are many different rates of interest (depending on who is doing the lending, who is doing the borrowing and on what terms). Thinking in terms of one big rate of interest can lead to mistaken ways of thought (as for institutions with central bank powers such as the Federal Reserve Board – they should not exist).

The basic point is as has often been pointed out. All borrowing must be totally from real savings (not just “based on” real savings) real savings being people choosing to lend out rather than consume some of their income or wealth.

Any effort to finance borrowing by book keeping tricks (the inflation of the money supply) will end badly.

Nor should there be any special protection for the banking industry. No lender of last resort, no Fed, no “National Banking Act” (Civil War measure, but carried on after the conflict), and no protection from the normal principles of contract.

Murry Rothbard’s “The Panic of 1819″ shows how far back efforts at credit expansion go in the United States (of course the practice goes back much further than this) – and how all such credit money booms end with a bust.

Bankers (and the rest of the lending industry) must understand that they are money lenders (not Gods or Masters of the Universe). To lend out money they must have money (real savings) – they must not go in for book keeping tricks as a way of expanding credit.

And if they go in for these games they must accept that when they can not produce the cash which their drafts and other instruments are supposed to represent – well they should go to jail (the Rothbard line) or at least go bankrupt.

Ken Zahringer November 14, 2006 at 12:47 pm

RogerM: You need to read Rothbard’s “The Case Against the Fed”. In short, any individual bank that engages in fractional reserves is, at that moment, insolvent. Its liabilities exceed its assets. As soon as enough of its banknotes, checks, or whatever are deposited in other banks, and those other banks demand payment in cash, the insolvency is revealed and the bank goes under. Fractional reserve banking could still happen under free banking, but only with much higher risk and on a much smaller scale. The Fed coordinates credit inflation so that all banks inflate at roughly the same rate, and handles payments clearing to make sure everything comes out even. It is this coordination that makes FRB safe, and allows banks to inflate “to the maximum”. Given that the current reserve ratio for most banks is 0-3%, the Fed is hardly reining them in; rather, it gives them a safe environment to work in.

Daniel: I have thought of that myself in the past. Kind of ties in with the “let your measures be true” thing, doesn’t it?

Person November 14, 2006 at 12:51 pm

Paul_Marks: It is certainly true that people have lent at positive interest during deflation, and that interest rates for various transactions depend on many different factors. However, that doesn’t change the essential point. Deflation can be high *enough* such that people can’t earn a rate of return high enough to cover a loan’s transaction costs, making lending a losing game, and its in these cases that deflation would destroy the lending market. That’s not necessarily bad, of course — maybe equity investments are better, after all? But it is something to consider.

RogerM November 14, 2006 at 12:59 pm

Ken, Thanks! I was trying to remember what Rothbard had written on the subject, and it makes sense. However, that mechanism didn’t stop banks from expanding credit in the past. That may be because bankers know that they could bring the whole house of cards down if they force another bank to fail.

Recently I was reading about banking in Venice during the late middle ages when the only currency was gold and silver. Venetian bankers would inflate the money supply just by changing entries in their books. Of course, banks frequently failed.

It seems to me that if you’re going to allow fractional reserve banking, you have two choices: frequent bank failures or a Fed, because counterfeiting carries just too much temptation.

quasibill November 14, 2006 at 1:51 pm


I think there’s a natural limit (a feedback loop of sorts) that’ll prevent your deflationary spiral from occurring, and it’s in a previous comment by you:

“I also think that if there’s too much deflation, it becomes too hard for people to gain the currency, and it loses its network-effect advantage and thus its usage as a money, so on a free market, people would switch to a different currency when that happened.”

Remember that in this context, we’re talking about inflation and deflation in terms of price levels, and not money supply per se. And what is the price level, broadly speaking? The purchasing power of a given unit of money, which is in turn controlled by the relative demand for that unit of money. So, as you note, a truly deflationary spiral of a given money will be halted by the inevitable result of less people desiring the money, which in turn will decrease the purchasing power of the money (in other words inflated price levels).

It seems that this would be a very important distinction between competing currencies – you would have to have enough to be in the “window” of values where the money can take advantage of your “network effects”. Too much, and there’ll be too little demand, making it inefficient. Too little, and there’ll be so much demand that noone will use it as money. That’s how competing monies would be sorted out.

It seems that there would be, in a free market, several different, independent levels of money, some highly valuable and therefore useful in large value exchanges, like say gold, while others would be very low value, like say shells, and therefore in more common use for everyday transactions, where in fact, gold may not be practical. Different kinds of money would “specialize” in different kinds of transactions. And if they’re independent (not all tied to a single standard) increases or decreases in the supply of any one money would have less large scale effect on the economy.

adi November 14, 2006 at 2:11 pm

Could Fisher’s theory of determination of interest rates be the reason why we have now disagreement over interest rates?

Fisher’s theory was something like this;
nominal interest = real interest + inflation premium,
and real interest rate = productivity of capital (economic growth) + market time preference.

Why not just suppose that there is a supply of loanable funds and demand for them in money market so that interest rate is determined by the market time preference.

Person, suppose that money stock is fixed (with gold regime very reasonable postulate) and there is no economic growth. Then every loan would still command a positive interest rate since agents would have a positive time preference. Loan could even be pure consumption loan and not connected to any productive activities.

Next situation would be scenario where entrepreneurs could loan from the money market to make productive investments. Given market interest rate, entrepreneur take so much loans that increase in the value of investment (marginal value of investment) is same as the market interest rate. Even in declining prices situation which Person so much feared would not be a problem; in Hayek’s world entrepreneurs take price differentials into account not absolute levels of prices.

Gasman November 14, 2006 at 3:34 pm

Is not Gibson’s paradox relevant here. Also pointed out by Mises but not called Gibson’s paradox. When society as a whole wants to save and the money stock is stable (like a stock of gold coin) then prices in terms of that money must be low and originary interest is also low because there is lots of money to lend. The point is that saving frees up the resources that would otherwise be consumed and these can now be invested whether or not the holder of money chooses to lend it. If most choose to hold the money the resources become available by being at a low price. In the case of the holder of money who chooses (or not) to buy a bond. She does not KNOW the future course of prices and therefore the choice is a speculative one. Some will choose to lend and others will hold cash and that is the market where the originary rate is revealed?

L.Baggiani November 14, 2006 at 4:49 pm

The discussion starts with the paper and always goes so far…

Polleit has effectively shown a should-be-common wisdom among the Austrians, but he simply did by a different point of view: the right working of the economic system winds down through inflationary and deflationary phases “per se”, prices signal scarcity or abundancy and do not affect the “natural” real growth (in Polleit’s explanation mirrored by the real interest rate which, in a pure free-market context, should equate the market’s intertemporal preference rate, as in wicksell’s stylised model).

It is simply another way to criticize the central banks’ “fear of inflation/deflation” by an Austrian point of view: instead of exposing how natural inflationary and deflationary phases are during the cycle (like Mises et al. did), Polleit has exposed how empty that fear,
given the “indipendency” of the “real side”, is (you gain a real 2% despite whatever inflation you experience, in the model).

Then the discussion has gone so far to including hate for Fed’s policy; but this is a step beyond Polleit’s work, e.g. when a Central Bank breaks the Fisher’s parity inflating prices beyond expectations (hence lowering the real rate) and this is where the natural equilibrium breaks, as Mises explained (and Hayek followed); back to Polleit’s model, this policy breaks the IRR-growth parity, and shows the perillous role of a central bank.

Good paper with simple and effective financial maths.

Björn Lundahl November 14, 2006 at 5:15 pm

” For instance, inflation would be needed to allow real wages and employment to adjust more smoothly to changing market conditions”.

If wages were determined by the free market (without union privileges and minimum wage laws), employment would adjust smoothly to changing market conditions.

“A more recent argument in favour of central banks pursuing positive “inflation targets,” or at least “zero inflation targets,” is the alleged necessity of preventing nominal interest rates from hitting zero. Such an outcome, it is widely feared, would run the risk of making monetary policy ineffective in terms of influencing real and nominal magnitudes”.

It would be a good thing if “monetary policy” would be ineffective. Expansion of the money supply means the creation of a business cycle.

“At the same time, deflation — understood as an ongoing decline in the economy’s price level — is widely believed to harm output and employment. For instance, if consumers expect goods and services to become cheaper in the future, it is feared, they would postpone their purchases, thereby setting into motion a vicious downward spiral: dropping demand, falling prices, declining output”.

Prices will be adjusted to clear the markets. If consumers expect goods and services to become cheaper in the future, prices will fall today. Costs will also be adjusted to entrepreneur’s expectations and will keep businesses profitable.

For example, prices of computers fall every year and output and consumption increases accordingly. Original equipment manufacturers are very profitable.

From the book “America’s Great Depression”, by Murray Rothbard I quote:

“In a brilliant article on Keynesianism and price-wage flexibility, Professor Hutt points out that:

No condition which even distinctly resembles infinite elasticity of demand for money assets has even been recognized, I believe, because general expectations have always envisaged either (a) the attainment in the not too distant future of some definite scale of prices, or (b) so gradual a decline of prices that no cumulative postponement of expenditure has seemed profitable.
But even if such an unlikely demand arose:
If one can seriously imagine [this situation] . . . with the aggregate real value of money assets being inflated, and prices being driven down catastrophically, then one may equally legitimately (and equally extravagantly) imagine continuous price coordination accompanying the emergence of such a position. We can conceive, that is, of prices falling rapidly, keeping pace with expectations of price changes, but never reaching zero, with full utilization of resources persisting all the way”.


I also want to point out that the rate of interest, because of time preferences, never reaches zero. A quote from the book “Man, Economy & State”, by Murray Rothbard:
“The conclusive Mises-Robbins critique of Schumpeter’s theory of the zero rate of interest, which we have tried to present above, has been attacked by two of Schumpeter’s disciples.[43] First, they deny that constancy of capital is assumed by definition in Schumpeter’s ERE (the Evenly Rotating Economy); instead it is “deduced from the conditions of the system.” What are these conditions? There is, first, the absence of uncertainty concerning the future. This, indeed, would seem to be the condition for any ERE. But Clemence and Doody add: “Neither is there time preference unless we introduce it as a special assumption, in which case it may be either positive or negative as we prefer, and there is nothing further to discuss.” With such a view of time preference, there is indeed nothing to discuss. The whole basis for pure interest, requiring interest payments, is time preference, and if we casually assume that time preference is either nonexistent or has no discernible influence, then it follows very easily that the pure rate of interest is zero. The authors’ “proof” simply consists of ignoring the powerful, universal fact of time preference.[44]”.


“[44]As has been the case with all theorists who have attempted to deny time preference, Clemence and Doody hastily brush consumers’ loans aside. As Frank A. Fetter pointed out years ago, only time preference can integrate interest on consumers’ as well as on producers’ loans into a single unified explanation. Consumers’ loans are clearly unrelated to “productivity” explanations of interest and are obviously due to time preference. Cf. Clemence and Doody, The Schumpeterian System, p. 29 n”.


Björn Lundahl,
Göteborg, Sweden

N. Joseph Potts November 14, 2006 at 6:37 pm

One of several ways the Fed coordinates the extension of fractional-reserve banking is by managing (mostly preventing) bank runs by providing protection to both bank shareholders and depositors in the event of failure (e.g., Continental Illinois National Bank and Trust Co, 1984).

You describe the overnight funds rate as a “brake” on credit expansion, but the overnight funds – at ANY rate at all, represent the opposite of a brake: they are a safety net that permits banks to go further “out on the limb” of credit expansion than they otherwise could go.

These beneficent-seeming activites DO increase the extent to which banks can inflate on their reserves.

Person November 14, 2006 at 8:40 pm

quasibill: That’s a good point. I’d add that the two effects are not mutually exclusive. If a currency deflates too quickly, people will refuse to borrow in it, which would be the dominant mechanism by which other moneys “catch up”. But still, this would concede that to sustain itself as a money, it *must* be possible to inflate it. (Of course, gold meets this.)

Baggiani: what’s simple and effective about the paper? He’s “demonstrated” a market response that couldn’t happen, even under a HUGE number of helpful and simplifying assumptions.

adi: Easy now. I don’t “fear” falling prices — in fact, big savers like me quite like them. I just question whether business loans can exist for long with a currency that’s fixed-supply and/or significantly deflationary. I’ve previously accepted (in another thread on this matter) that consumption loans would probably persist — but I’d advise against getting one in such a scenario!

quasibill November 15, 2006 at 10:48 am


I don’t think “inflation” in the sense of increased supply of the money is necessary to achieve “inflation” in the sense of decreased purchasing power of the money. All that is needed is that less people desire it for it’s “medium of exchange” property, which, as you note, is a naturally occurring phenomenon as the money gains value.

Although I agree with what I think is your underlying point – an obsession with a fixed, single point money supply is unrealistic and not an economically efficient or robust system. As such, a truly fixed money supply is unlikely to ever arise, either naturally (through a free market) or artificially (through state interference).

adi November 15, 2006 at 12:04 pm

Quasibill, gold standard is not actually truly fixed money supply regime since there is powerfull incentive to mine more from the ground. Amount of mined though is usually small compared to existing supply of gold.

Main advantage of this standard in it’s pure form is it’s immunity from the governments machinations (Govt and money dont mix very well). Gold standard would also give an symmetric international monetary system where failures like Bretton Woods wouldnt occur. Also international trade probably could increase more (but only if present monetary system actually hinders it).

Gasman, Gibson paradox seems to be prevalent during the gold standard (positive correlation of nominal interest rate with the price level, not with the change of price level like in Fisher’s theory) since in some research papers it has seem to be vanished in post WWII era. Does anyone know
if Real Bills Doctrine and Gibson Paradox are somehow related ? I will not ask from Mike Sproul since he would preach several pages how Fed is not counterfeiter.. :)

Person, there is no problem with the pure consumption loans in deflation scenario since we must suppose that agents know that and are prepared to pay the price. This is just price of kind of intertemporal consumption choice. So definetly there is a role for expectations here…

quasibill November 15, 2006 at 1:18 pm

adi, I’m aware of the minimal inflation of gold supply, the argument I believe(d) person was making was one against a position many minarchist Austrians tend to espouse: namely, that any increase in the supply of money is wrong from a moral standpoint. I think Dr. Block has published a paper arguing against this position as well (my memory is that he argued against a Rothbard argument that increasing the money supply provides no social benefit.)

And for once, if I haven’t misinterpreted Person’s argument, I agree with Person. I further contend that a state enforced gold standard is in fact, not a good answer. Only a return to a truly free market with many different, competing, independently valued monies is a good answer IMHO.

L.Baggiani November 15, 2006 at 3:41 pm


“He’s “demonstrated” a market response that couldn’t happen”
what are you precisely referring to? the alternance of inflation and deflation phases as consequence of mere free-market behaviour? the real-interest-rate constancy? the use of the free-market paradygm? or something else I have missed?

I think it is not necessary (nor useful) to try deriving a whole-universe comprehending theory, or try deriving universe-wide consideration from any single comment to a precise concern (really marxist-style forma mentis); it can be useful to focus a limit set of variables to answer a precise concern: Polleit has stylised the free-market paradygm and shown again how it does not need any central bank’s intervention because, within this Austrianly so-longed pure-free-market economy, prices are an “effect” of the cycle which do not turn into its “cause”.

A paradygm can help to see what is it in the actual world which makes things work differently: should nominal interest rates fail in incorporating the right inflation rate, for instance, serious real consequences would follow, hence inflation magnitude would count.

If you think a paradygm-comparation and stylising is useless, you implicitly say that 99% of Mises books are useless too.

I hope I misuderstood your critique.

RogerM November 15, 2006 at 4:23 pm

Person made that comment not me, and I don’t have a clue about what he meant. Sorry.

Person November 15, 2006 at 4:56 pm

Baggiani: I was saying that, what “couldn’t happen” is people buying the bonds in Fig. 2 and Fig. 3. Polleit claims that the market response is for people to buy bonds with 0% yield.

They wouldn’t.

Even with an ironclad guarantee they’ll get it back, they’re still sacrificing the opportunity to spend that money in the intervening years. So they’d just hold on to the money rather than lend it.

True, $100 would be worth more in ten years than now. But as long as that $100 transforms on its own into a future-dollar, you gain nothing from lending at 0% interest.

Why is this so hard to understand?

Björn Lundahl November 16, 2006 at 2:22 am

Deflation (defined as increases of the purchasing power of money).

If the money supply does not increase and savings have not changed in an economy, total investments will not be less or more than compared to an economy in which the money supply increases.

Or as Murray Rothbard puts it in his book “What Has Government Done to our Money?:

Money in a Free Society

8. The “Proper” Supply of Money

“An increase in the money supply, then, only dilutes the effectiveness of each gold ounce; on the other hand, a fall in the supply of money raises the power of each gold ounce to do its work. We come to the startling truth that it doesn’t matter what the supply of money is. Any supply will do as well as any other supply. The free market will simply adjust by changing the purchasing power, or effectiveness of the gold-unit. There is no need to tamper with the market in order to alter the money supply that it determines”.


Björn Lundahl,
Göteborg, Sweden

adi November 16, 2006 at 6:07 am

Do we all agree about following?

1) That amount of money in circulation is not important. Any amount of money suffices. There is no need for monetary policies of central banks.
2) That increase in the money supply, ceteris paribus, will increase “price level”.
3) That price of loans is always positive, even in the declining prices situation since people have time preferences. Price of loans thus is sum of two components; appreciation of value of money + nominal market interest rate.
4) Marginal productivity of capital has nothing to do with the interest rate. Entrepreneurs will maximize their value of investment when the marginal increase of value of investment is same as the given market interest rate. Market interest rate is given by the time preference.

Björn Lundahl November 16, 2006 at 6:20 am


“Do we all agree about following?” etc.

Yes, at least I am in agreement with your comment.

Björn Lundahl

Björn Lundahl November 16, 2006 at 6:27 am

Deflation (defined as increase of the purchasing power of money)

If the money supply is constant and prices on the average fall and this is also expected, the factors of production, land and labour will be discounted accordingly throughout the production structure (various stages of production) and capitalists will earn interest on their investments.

For example:

If a capitalist makes an investment of 100 million dollars (in gold) in real estate, and is happy with 5% net profit yearly when the purchasing power of money in society is zero, this happiness will be maintained, logically, if the same capitalist makes an investment with 5% net profit yearly plus a premium of the value lost per year of the initial investment in real estate when the purchasing power of money in society is increasing. This premium is brought about by purchasing the real estate in question for a price of 90, 80, 50 million dollars etc or whatever price that fully compensates him for the value lost because of deflation.

Björn Lundahl
Göteborg, Sweden

RogerM November 16, 2006 at 8:55 am

adi:”1) That amount of money in circulation is not important.”

While that is true, the real question is whether the amount of money in circulation is increasing or decreasing. That does make a difference. If the money supply grows at exactly the rate of the increase in production, which it never does even under a gold standard with 100% reserve banking, the world would be perfect.

But if it grows faster than production increases, prices rise and people favor debt. Also, it transfers wealth to the first receivers of the new money at the expense of the late receivers.

If the money supply increases suddenly, malinvestment and waste occur, which cause boom and bust business cycles.

But if the money supply increases more slowly than the growth in production, prices fall and people favour saving.

adi November 16, 2006 at 9:44 am

RogerM wrote; “If the money supply increases suddenly, malinvestment and waste occur, which cause boom and bust business cycles.

But if the money supply increases more slowly than the growth in production, prices fall and people favour saving.”

That is true, but you could infer from my points 1) and 2) same idea. I just ment that there is no good reason why the amount of money should be larger or smaller than it’s presently. There is no need for monetary policy other than hands-off from the money supply.

As for the stability of price level, there is no need to have a stable level of prices. We know from the history of gold standard that there has been large findings of gold and prices have fluctuated a lot.

RogerM November 16, 2006 at 10:35 am

You’re right! But I think people are underestimating the role of fractional reserve banking, which I think is the main problem. If we allow fractional reserve banking, then a Fed is necessary in order to prevent bank runs and failures. Those would take place, and have taken place, under a gold monetary system with fractional reserve banking. But if we think restoring the gold standard is hard, it will be a cake walk compared to eliminating franction reserve banking.

I’ve come around to the idea that the Fed does permit more credit expansion than free banking would because, as Rothbard and I think ME Hoffer noted above, banks that expanded credit too much would fail. But we must remember that it was the bank failures and panics of the 19th century that persuaded Americans (who were far more free market oriented than Americans today) to accept a Fed.

L.Baggiani November 16, 2006 at 4:32 pm


ah ok
sure, no one sane would ever buy such a bond!
but I want to tell you that, in the way I have approached the reading, I am not interested in whether such a bond would ever be bought: that bond simply stands to show that the real side of the question is independent on direction or magnitude of prices movement.

it is simply an example of a situation stretched to the limit, sort of a paradox to mark how empty are fears for inflation/deflation, at least at the consequences that Fed ECB and other institution tell about.

and I sincerely think that Polleit did not aim to describe an actual financial market just with those few bonds!

hope to have been clear, now I understood your concern

M E Hoffer November 17, 2006 at 6:00 am


This: “The Fed coordinates credit inflation so that all banks inflate at roughly the same rate, and handles payments clearing to make sure everything comes out even. It is this coordination that makes FRB safe, and allows banks to inflate “to the maximum”. Given that the current reserve ratio for most banks is 0-3%, the Fed is hardly reining them in; rather, it gives them a safe environment to work in.” found above, was from: Post by Ken Zahringer at November 14, 2006 12:47 PM. Just to clarify.

Though, for my own account, I completely concur.

Further, you state: “If we allow fractional reserve banking, then a Fed is necessary in order to prevent bank runs and failures.”– I wonder why you believe that to be true(?) Banks, surely, like other enterprises, can and should be ‘allowed’ to fail, no?

You note: “19th century…Americans…were far more free market oriented than Americans today…”. Would you not expect that they were more vigilant, than their latter-day counterparts, because they lacked the blinders of socialized risk?

Otherwise, you stated that ~noone would buy the zero % Bond~. Doesn’t that happen everyday? How would that transaction be different from the one that ‘collectors’ enter into? I mean, who would have thought that a specifically pixelated prepaid (phone)card would have been bought by speculators as an “investment”? As well, there are myriad non-financial rationales for lending at 0% v. stuffing the mattress, no?

RogerM November 17, 2006 at 9:13 am

MEHoffer:”Banks, surely, like other enterprises, can and should be ‘allowed’ to fail, no?”

I agree, they should fail in theory. In practice, such failures caused the populace to accept the Fed. I don’t disagree with you in theory, but in the practicality of it.

“Would you not expect that they were more vigilant, than their latter-day counterparts, because they lacked the blinders of socialized risk?”

Based on the history of bank failures and panics of the 19th century, I’d say no.

“How would that transaction be different from the one that ‘collectors’ enter into?”

Collectables, such as antiques, are valued today for the joy of ownership and for their ability to appreciate at a rate greater than the inflation rate. I don’t see the joy in holding a bond, and a bond won’t appreciate faster than the increase in the value of money. It’s hard to say what collectables would do in a regime of deflation.

Michael Robb November 18, 2006 at 6:32 am

It is heartening to see this level and extent of quality comment on so important a subject matter as proper analysis of a sound money system. There should be no lack of scholarship ready and waiting when public preference for concluding transactions in a gold payment mechanism is found to be widespread. There is a refreshing display of good manners at work too, which seems appropriate considering the importance of the matters under discussion.

M E Hoffer November 19, 2006 at 11:03 am


“Based on the history of bank failures and panics of the 19th century, I’d say no.”

Would you agree that there are differences between the 19th and 21st C. ‘s?

Simply, during the 1800′s the only low-cost systems of communications amounted to yelling over the hedgerow to your neighbor or geographically co-locating, at the nearest Inn, to swap highlights and hearsay.

No wonder “panics” were afoot.

Given the stew of information that today’s counterparts have been fricasseed in and their access to low-cost worldwide communications, I would think that they could readily bear the increased responsibility.

And: “I don’t see the joy in holding a bond…”

It isn’t the “bond” itself, though, Ripley’s, there are collector’s of those, too, rather the organization, receiving the “investment”, that is better able to utilize the funds v. mattress stuffing.

As I stated above, I think this type of investment rationale is, in various permutations, employed everyday.

DS December 5, 2006 at 12:54 pm

Great discussion. I’ve found two articles that have helped me understand quite a bit on the subjects brought up here. Maybe they’ll be of benefit to someone else: Honest Money and Fractional Reserve Banking. It was interesting to learn that our Constitution and the Coinage Act of 1792 actually established us on a silver standard, NOT a gold standard.

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