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Source link: http://archive.mises.org/6828/the-principle-of-sound-money/

The Principle of Sound Money

July 10, 2007 by

Today’s national money regimes bear no resemblance to Mises’s sound-money principle. The quantity and quality of money is no longer a free-market phenomenon; it is determined by government-controlled central banks. From the Austrian point of view, today’s money regimes — even when taking into account the protections against government monetary mismanagement — would be incompatible with Mises’s principle of sound money. In fact, Austrians consider today’s monetary order a serious threat to the free societal order. FULL ARTICLE

{ 44 comments }

RogerM July 10, 2007 at 10:13 am

Very informative! Thanks!

Robin Anderson July 10, 2007 at 10:20 am

Thank you for the great article. Maybe this part went over my head, but I have a question: Why do the graphs shown use CPI to measure inflation? Earlier in the article you state that using CPI is deceiving.

Thorsten Polleit July 10, 2007 at 10:31 am

Mr Anderson, thanks very much for your comment. In fact the point I wanted to make is to show that central banks set interest rates by looking at changes in the CPI; that’s why the series have developed the way they did. By no means do I want to make a case for measuring inflation by consumer price indices.

Mark Brabson July 10, 2007 at 11:58 am

Good article.

I have dealt with this firmly in my proposal for an “Articles of Confederation” to replace the existing U.S. Constitution.

In the proposed Article relating to restrictions on State powers:

“No State shall emit bills of credit nor charter a central banking institution. Each bank under a State’s jurisdiction shall be required to maintain one hundred percent reserves on its demand deposits and one hundred percent reserves against any banknotes. All banknotes issued shall state particularly the commodity backing the note, the weight of the commodity and shall state the note shall be redeemable on demand. No State shall ever pass any legal tender laws. All money coined under State authority or privately shall be gold or silver and each coin shall state its content of gold or silver. All States shall only make disbursements in gold or silver coin or bullion. No State shall make any law prohibiting the use of money lawfully coined in any other state. This section shall not be construed to prohibit the coining of platinum money for collector purposes.”

Then in the Article relating to restrictions on the central confederacy:

“All payments and disbursements made by the Confederate States in Congress assembled shall be paid in gold or silver coin or bullion.

The Confederate States in Congress Assembled shall never emit bills of credit nor shall the Congress charter any central banking institution nor pass any legal tender laws nor coin money.”

I am also developing some language for the proposed bill of rights, which would permanently enshrine a Misean/Rothbardian view of commodity money into the document.

Mark Brabson July 10, 2007 at 12:00 pm

I would further state that no proposal for a minarchist state will last very long, unless the government’s power to inflate be totally destroyed.

Person July 10, 2007 at 12:28 pm

Thorsten_Polleit: If you think CPI is deceiving, name the specific basket of goods that you think is appreciating much faster. I want to buy financial derivatives of these goods so my money can predictably grow faster than inflation, or money market funds, as the case may be. Thanks.

Jacob Steelman July 10, 2007 at 4:46 pm

This is an excellent article. I have been involved with Austrian economics and the libertarian philosophy for 40 years. The older I get the less able I am to answer the question – why has the fiat currency system not collapsed when the fraud and Ponzi scheme that it is has been well known by so many for so long. When the price of gold soared to all time highs in the late seventies we were all sure the fiat system was dead. We thought it would collapse as had the German system in the 1920s. But it did not die and came back as strong as ever. Yes there are distortions and huge ones from the fiat system but it has not been discarded and abandoned. I have not seen any Austrian explanation for this – how can such a flawed system and an obvious fraud on the consumers continue for so long without any indication that it will be abandoned in the near future. Were a corporation in a similar situation (concern that it shares were valued on the basis of accounting entries with no real wealth being produced by the company as the basis for the share value) its shares would have been quickly dumped and become worthless. Why has this not happened with the global fiat currency system?

Mark July 10, 2007 at 5:52 pm

Why has this not happened with the global fiat currency system?

Because the government has continually run budget surpluses despite calling them deficits via devaluation.

How else can one explain a debt to GDP ratio that is half of what it was during WWII?

These budget surpluses have allowed generous transfer payments at the expense of a bunch of brain washed mice chasing a piece of cheese on a ferris wheel.

The game will end when obligations to the elderly can no longer be met.

Quenton July 10, 2007 at 6:00 pm

Jacob-

I believe you answered your own question when you said “global fiat currency system”. In the past, fiat systems have been fairly localized affairs. One government would try it out while another would stay on a commodity based currency. The fiat ones usually died a pretty quick death as there were better alternatives readily availible.

Now that there are no commodity based currencies among the major players on the international scene we are forced to choose between the various fiat systems. Will you put your wealth in Dollars, Euros, or the Rand?

When one fiat system starts to tank, move to the next one. Who cares if that next one is just as fundamentally flawed? Theres always another one just across the next border. See the current Zimbabwe situation for a good example. Zimbabweans have been trying desparately to switch out Mugabe’s funny money with US Dollars or the Rand for years at any chance they got. As bad as the US Dollar has become, it is still seen as a Godsend to these people.

Fiat currencies tank not simply because they are inheritly flawed, but because these flaws are eventually exploited by the Legal Counterfiters. A fiat system where the supply is stable almost never collapses. It is when the printing presses start working overtime does the collapse occur.

The Iraq War is finally starting to take it’s toll on our fiat system. Notice that the Euro is doing quite well against the US Dollar despite Europe’s crappy economy. They aren’t in a war so there is no need to inflate supply. They are a much better medium-term hedge beacuse of this.

Back to the main point. We don’t have much competition in the fiat/commodity currency market these days. Barring the return of a major country to a commodity standard then the only real hope is if a large corporation or other commodity holder issues their own redeemable currency. Seeing as how both governments and large corporations are the primary benefactors of the fiat system this isn’t too likely in the near future.

Mike Sproul July 10, 2007 at 7:11 pm

Jacob:

“why has the fiat currency system not collapsed when the fraud and Ponzi scheme that it is has been well known by so many for so long.”

The reason is that what we call fiat money is not fiat money. It is backed by the assets of the banks that issued it. See

http://www.csun.edu/~hceco008/realbillsintro.htm

Philemon July 10, 2007 at 8:26 pm

The global fiat currency is, in fact, backed by two things: U.S. withholding taxes, and the willingness of oil producers to accept payment in paper (in return for the ability to buy whatever the U.S.-backed rulers want in the same paper, of course).

Withholding tax takes earnings off the top via taxes on wages and other income collected by means of third parties. In order to hold a job, make an investment, save money, own property, U.S. citizens are forced to pay. And they are forced to pay for the enforcement of the payment. They’re even forced to take the paper in payment for debts to them.

The tax system is the foundation for the U.S. financial markets. Government paper backs dollars. More dollars, more securities. More securities, more taxes. More taxes, more government paper.

Oh, and oil is the basis for the U.S. dollar’s dominance over international trade. Maintaining that privilege is what the Pentagon is for. More tax dollars… See above.

Mark Brabson July 10, 2007 at 8:41 pm

But ya know what. They just can’t keep it up forever. The anvil of Social Security is hanging over their heads about 20 or so years ahead. And any major constriction in oil supplies will slit the belly of the beast. While I don’t think peak oil is as imminent as some suggest, certain developments will ensure that America’s share of the existing oil stocks will be reduced.

One thing is sure. Once one fiat currency goes, the remainder will fall like dominoes. But I am ready to pick up the pieces with my commodity money system as described above.

Mark Brabson July 10, 2007 at 8:44 pm

As an aside.

One thing that kind of irks me. Important matters, like the state of the money and banking system, seem to go unappreciated around here.

But just make an IP post, and you get 100+ responses in a single day.

IP may be important, but it seems the monetary and banking system should be a lot more important.

Mark Brabson July 10, 2007 at 9:04 pm

As another aside.

Irk wasn’t really the proper word. It puzzles me is what I meant to say.

RogerM July 11, 2007 at 2:36 pm

Jacob: “…why has the fiat currency system not collapsed…?”

THE STOCK MARKET, CREDIT AND CAPITAL FORMATION By
FRITZ MACHLUP will answer your question, I believe. You can find it on the Mises.org site. The system did collapse in the Great Depression, but then was rebuilt with a ton of regulations to avoid some of the mistakes of the past. However, it almost collapsed again in the 1970′s. Fiat currencies collapse when money creation gets out of hand. Central bankers have practiced much greater self-control in the last 50 years than have other fiat currency regimes in the past.

Also, by outlawing private ownership of gold for so long, people became accustomed to using only paper money. As late as the Great Depression, people would abandon paper money for gold when banks failed. But the guarantees by the federal government, and fewer bank failures due to regulation, have lulled people into a false security.

As Machlup writes, paper can substitute for gold as long as money creation doesn’t get out of control. In fact, when money creation stops, which is does periodically, prices rise to meet the new level of the stock of money and then stop rising.

I think the fiat system will collapse in the distant future. The cycle has been lengthened by the measures above, but the ill effects of excessive money creation haven’t stopped, just slowed down. In other words, instead of dying quickly from massive poisoning as fiat currencies did in the past, we’re dying very slowly from accumulating poisoning. But the current system will continue until the debt level gets too high and the Feds decide to inflate their way out of the problem.

mikey July 13, 2007 at 11:30 am

Person’s question tells me that he is confusing prices with profits.

Jesse July 13, 2007 at 12:02 pm

Mark Brabson: “Important matters, like the state of the money and banking system, seem to go unappreciated around here. . . . But just make an IP post, and you get 100+ responses in a single day.”

The number of responses is related to how controversial the position is, not how important it is. Most of us appear to agree on matters of currency and central banking, whereas there remain a large number who find themselves unable to give up the cherished, utilitarian notions of copyrights and patents despite all evidence that they can only exist through aggression.

Opposition to currency manipulation and central banking can be easily justified on utilitarian grounds as well as principles, and thus tends to unite the two major factions on this board, whereas the (dis)utility of copyrights and patents is far less clear, and debate between utilitarians and principlists results.

Aidan Stanger July 13, 2007 at 1:29 pm

I regard Austrian economics as deeply flawed, and this article is no exception. You seem to be starting off with the assumption that your pet theory is correct, and not giving adequate consideration to opposing viewpoints.

Your “important insight” that government paper money can only be established by a fraudulent act on the part of the government is actually an example of your misunderstanding of the situation. While it is probably true that the value of a currency must initially be fixed relative to a commodity (which could be another currency), there is no reason that they must give the impression that it will be permanently fixed.

Floating a currency is often a difficult process, and government intervention is usually desirable long after a currency’s unlinking from the gold standard. But ultimately it is better to leave it to the markets to decide the value of a currency. You seem rather worried about “misallocation of scarce resources” resulting from expanding credit and money supply – but keeping precious metals in bank vaults is a much bigger misallocation of scarce resources!

It is Mises, not Fisher, whose definition of inflation is “economically deceiving and erroneous”! You are correct in saying that even an unchanged (consumer) price index may well be accompanied by a loss in the exchange value of money, but if the loss in the exchange value of money is counteracted by domestic deflation so much that the CPI doesn’t even move, its significance is rather limited.

And has hyperinflation ever been the result of low interest rates?

David White July 13, 2007 at 2:02 pm

Aidan Stanger,

I’ll give this much: It takes some cojones to walk into an Austrian economics forum and declare Austrian economics “deeply flawed.” You’ve got along way to go, however, before you’re even close to backing up your assertion.

For one thing, commodities are sold on the commodities markets, and currencies are sold on the currency markets, the difference being that the former are goods that create real wealth via their use and exchange in the real economy, while the latter are merely irredeemable pieces of government-issued paper that only create the illusion of wealth.

After all, how else could the financial economy — which, in a sound-money regime, is limited by the size of the real economy that it exists solely to serve — now dwarf the real economy by a factor of at least ten?

But go ahead and invest in all the CDOs you want, and feel free to do so with the collapsing dollar. Me, I’ll buy commodities and stay out of the dollar as much as possible.

Time will tell who’s right.

RogerM July 13, 2007 at 4:32 pm

Aidan: “And has hyperinflation ever been the result of low interest rates?”

I couldn’t possibly list all of the instances of hyperinflation due to low interest rates. Start with the hyperinflation in France under John Law’s paper money regime in the early 1700′s, then go to the hyperinflation of the 1920′s in Germany, then look at the hyperinflation in Latin America during the 1960′s and 1970′s, then move on to present day Zimbabwe and the hyperinflation under Robert Mugabe. Hyperinflation has been common since John Law sold people on paper money. In every case, low interest rates and huge increases in the money supply go together.

RogerM July 13, 2007 at 4:50 pm

Aidan: “Floating a currency is often a difficult process, and government intervention is usually desirable long after a currency’s unlinking from the gold standard.”

Of course it’s hard, because it’s unnatural. Market processes established silver and gold as money with little effort millenia ago because people saw the advantages of using gold and silver and willingly adopted them. The government has to force people to use paper money by making it a crime to use any other.

Aidan: “…keeping precious metals in bank vaults is a much bigger misallocation of scarce resources!”

Milton Friedman and others used to ridicule gold as money by arguing that printing paper money costs so much less than does mining gold. That’s true, but Friedman didn’t calculate the cost of maintaining the paper money, such as the costs of maintaining the Federal Reserve and its army of bureacrats, or the cost of business cycles that destroy enormous amounts of wealth. I would much rather pay gold miners than Fed bureacrats.

Aidan: “…but if the loss in the exchange value of money is counteracted by domestic deflation so much that the CPI doesn’t even move, its significance is rather limited.”

Not at all. If new money reached all citizens at the same time, then you might be right. But, it doesn’t. It reaches some people first, who spend the money at lower prices. By the time the money filters through the system, prices have risen and the later receivers get the shaft. It doesn’t matter that prices didn’t rise according to some index, because prices will always end up higher than they would have been after the increase in the money supply. If an index (such as the CPI) doesn’t increase, it means nothing except that without the increase in the money supply prices would have fallen. A good part of the inequality of wealth and incomes in the US can be attributed to artificial increases in the money supply.

In addition, because the new money didn’t come from savings, consumers and producers will compete for the same scarce resources. There aren’t enough resources (labor and materials) to meet the needs of both, because consumers didn’t restrict consumption to save, so somebody has to go broke, and it’s usually producers. Enormous wealth is destroyed in the collapsing phase of each business cycle brought about by monetary pumping. The poor get hurt the most.

RogerM July 13, 2007 at 4:59 pm

Person: “If you think CPI is deceiving, name the specific basket of goods that you think is appreciating much faster.”

The 1990′s provide an excellent study. The CPI hardly increased at all, yet the stock market soared. After the stock market crash, the home market and commodity market soared. New money may go to consumer spending, in which case the CPI will increase, or it may go into the stock/bond market, commodities or real estate. The key to successful investing is to put your money in the market that is going to rise because of the new money. It will usually be the market that has been neglected for a while. With stocks, bonds, commodities and real estate at record highs, it looks as though the CPI, or consumer spending will be the next beneficiary of fiat money. But I could be wrong, so it’s best to have some money in all of the markets and readjust every quarter by selling in the markets that have risen and buying in the ones that haven’t.

Anthony July 13, 2007 at 7:00 pm

“I regard Austrian economics as deeply flawed”

My question, since others have answered your objections, is what exactly are your credentials in economics, if any? A lot of people assert that Austrian econ is flawed without having the foggiest idea of what it is all about. Even worse, they also lack any knowledge of neoclassical economics.

Aidan Stanger July 14, 2007 at 6:07 am

RogerM “I couldn’t possibly list all of the instances of hyperinflation due to low interest rates.”

Then how about you identify a single instance of hyperinflation that was caused by low interest rates rather than a government recklessly printing money in order to cover its own budget shortfalls!

RogerM July 14, 2007 at 10:00 am

Aidan: “Then how about you identify a single instance of hyperinflation that was caused by low interest rates rather than a government recklessly printing money in order to cover its own budget shortfalls!”

How can you separate the two? The only mechanism the government has for lowering interest rates is to “print” more money. Printing money and artificially lowering interest rates are opposite sides of the same coin. Technically, the central bank lowers its rate to commercial banks, which expands their reserves and in turn expands credit and the money supply. Or the central bank can purchase bonds from citizens and increase the money supply. These two methods of increasing the money supply are referred to as “printing money” because the effect on the money supply and the economy is the same as physically printing paper money.

Every period of hyperinflation has started with the state “printing” money in order to finance its spending. The state “prints” money by having the central bank lower interest rates or purchase government bonds.

Mike Sproul July 14, 2007 at 12:11 pm

Aidan:

“Your “important insight” that government paper money can only be established by a fraudulent act on the part of the government is actually an example of your misunderstanding of the situation.”

On the subject of money, Austrian economics is no more flawed than mainstream economics. They both wrongly believe the quantity theory and wrongly reject the real bills doctrine. Austrians are just louder and more reckless; for example, saying that fractional reserve banks are counterfeiters and the Fed is nothing but the head counterfeiter. There are a few people on this blog who agree that fractional reserve banking is not fraudulent, but they are a distinct minority among Austrians. Among econ. professors, the view that fractional reserve banking is fraudulent is, thankfully, fairly rare.

David White July 14, 2007 at 4:04 pm

Mike Sproul,

I am an Austrian who does not believe that fractional reserve banking is inherently fraudulent, only that depositors should be entitled to know — and be able to verify via an independent third party — whether and to what extent a bank engaged in this practice. Thus, a bank that promoted itself as being 100% reserve when it wasn’t, or lent a larger fraction than it advertised, would be engaging in fraud.

As for the RBD, I’m not expert enough in this matter to comment, other than to say that Robert Blumen, in his “Real Bills, Phony Wealth” series — http://www.financialsense.com/editorials/blumen/2006/0604.html — makes a compelling case against it.

Mike Sproul July 15, 2007 at 11:26 am

David White:

It’s nice to hear from an Austrian with a sensible view of fractional reserve banking. You realize, I hope, that this makes you a potential pariah among the more rabid Austrians.

If you’re interested in a compelling case FOR the RBD, start at the link below:

http://www.csun.edu/~hceco008/realbills.htm

ktibuk July 15, 2007 at 11:38 am

Some people actually think is the depositors know the bank is not a 100% reserve bank than this is ok.

The bank may vawe the safekeeping money on the terms that it wont keep %100 reserve.

But there is a major property rights and contract problem with this.

The problem is what the customer knows is a vague notion. He knows the bank is not carrying a 100% reserve but still he would demand his money when he wanted. Otherwise the customer would make a time depoist and earn more.

The most the customer would concede to is waiting a couple of days. And if there would be a bank run he would still ask for his money without bearing the risks of credit (in bankruptcy the people with irregular deposits, aka checking account people, would have the first claim and time depoists, aka savings account would have the last)

Fractional reserve banking is actually trying to eat your cake and have it too for both the customers and the banks. And what ever the customer says when asked when push comes to shove or realit bites he would act as if being defrauded.

If the customer doesnt care about availability there is a product for it and it is called time deposits.

RogerM July 15, 2007 at 9:58 pm

ktibuk: “Fractional reserve banking is actually trying to eat your cake and have it too for both the customers and the banks.”

That’s a great description of fractional reserve banking!

I was reading Hayek’s Monetary Nationalism and International Stability the other day and he had an interesting perspective on fractional reserve banking, or as he called it, proportional reserve. He detailed the problems it causes, but then asked whether similar practices in other areas would develop if we were able to eliminate fractional reserve banking. In other words, fractional reserve banking is so lucrative that, like the drug trade, it can’t be stamped out. It will reappear in other forms.

After I read Hayek, I was reading in a history book that the Dutch Republic experienced credit expansion and collapse (a typical business cycle) without fractional reserve banking. The cause was bills of exchange. Businessmen without the use of banks had expanded credit to a level over 15 times the value of gold in the country through bill of exchange, or I.O.U.’s. Then it all collapsed because of malinvestments. Go figure.

Maybe we’re asking the impossible by trying to stop fractional reserve banking. After all, many life insurance policies and mutual funds operate on the same principles as fractional reserve banking, as does much of the credit that a vendor company extends to a customer. Even de Soto admits that.

ktibuk July 16, 2007 at 3:39 am

The problem is vagueness of the contract of irregular depoists for the fractional reserve banking.

Both the bank, and knowing customer (not knowing is being defrauded no question) sign a contract but terms are so vague if there is a problem a third party couldn’t decide about the property rights. Mainly in the case of a bankrupcy.

If the depositor doesnt want constant availability
why wouldnt he put his money in a time deposit and recieve more profits?

I cant think of an answer.

TLWP Sam July 16, 2007 at 7:20 am

Oh dear, criticism from folks such ktibuk and RogerM about fractional banking are such that it look as though we’re back to the drawing board with people exchanging gold coins, no?

Alex MacMillan July 16, 2007 at 11:02 am

A bank has assets consisting of $10 of gold and $15 of loans outstanding and due for payment in one year. The bank’s deposit liabilities are $25. I take it that those against fractional reserve banking would be happy if the breakdown of deposits were no more than $10 in demand form and the rest time deposits.

But, what if the time deposits had 6 months maturity? Would this be evidence of fraud on the part of the banks, because the time depositors expect to be able to demand their funds 6 months from now, with no guarantee that the bank will have their funds at that time?

adi July 18, 2007 at 7:50 am

We have had this discussion with Mike many times..

I thinkt that FR banking is not fraudulent when customers know that they have just purchased a call option on assets of bank when they have put some real metal on its vault. When bank defaulst option is worthless.

Bank expects that its assets earn high enough return to compensate for owners equity and customers loans (or “deposits”, call as you like it).

Otherwise Austro-Swedish monetary theory is perfectly valid.

Aidan Stanger July 18, 2007 at 11:04 am

David White -

Sorry for the delay in responding.

The reason I came here is because on another blog I was arguing with someone who wanted a return to the gold standard, and was sticking to the claim that inflation is equal to total money supply increase, despite all the evidence to the contrary. This site was one of the links he gave in support of his argument, but the quality of the articles here seems to me to be generally poor. I don’t deny there are some good ones, but there’s an overreliance on dubious assumptions, and some of the articles could best be described as lunatic fringe!

Your comparison of commodities markets and currency markets is quite a good example of the dubious assumptions that can be found here. Currencies are not just sold on currency markets, but also on commodities markets and nearly every other kind of market – they’re so much more convenient than bartering! They’re not creating an illusion, they’re enabling real wealth to be created more easily.

Your question “how else could the financial economy — which, in a sound-money regime, is limited by the size of the real economy that it exists solely to serve — now dwarf the real economy by a factor of at least ten?” is a good one. I think the answer lies mainly in the way it is measured. Turnover in the financial economy is very high, but the profit to turnover ratio is very low for most transactions. The exceptions (such as the headline-grabbing private equity deals) usually relate directly to activities in the real economy.

I don’t intend to buy any CDOs – especially as the American dollar is indeed sliding – but that’s not because of any inherent flaw in fiat currencies. The Australian dollar’s doing fine, and will probably soon be worth as much as yours!

Aidan Stanger July 18, 2007 at 1:09 pm

RogerM -

[floating a currency] “Of course it’s hard, because it’s unnatural. Market processes established silver and gold as money with little effort millenia ago because people saw the advantages of using gold and silver and willingly adopted them. The government has to force people to use paper money by making it a crime to use any other.”

I’d rather go with what’s efficient than what’s natural! Besides, different people have different ideas of what’s natural. I’ve heard someone advocate having different currencies at the local, regional, national and international level, because she considered it to be natural!!! I don’t dispute the advantage that silver and gold had millennia ago, but a lot has changed since then. Physical portability of the commodity is no longer necessary – its value can be stored electronically now! As for the restrictions imposed by governments, didn’t that vary from country to country?

Milton Friedman and others used to ridicule gold as money by arguing that printing paper money costs so much less than does mining gold. That’s true, but Friedman didn’t calculate the cost of maintaining the paper money, such as the costs of maintaining the Federal Reserve and its army of bureacrats, or the cost of business cycles that destroy enormous amounts of wealth. I would much rather pay gold miners than Fed bureacrats.

Business cycles would still occur with a gold standard, so there is still the risk of destroying wealth. But because of the reduced flexibility, there is much less opportunity to create wealth. And how many orders of magnitude more than the Federal Reserve’s “army of bureacrats” would the gold standard cost?

…but if the loss in the exchange value of money is counteracted by domestic deflation so much that the CPI doesn’t even move, its significance is rather limited.Not at all. If new money reached all citizens at the same time, then you might be right. But, it doesn’t. It reaches some people first, who spend the money at lower prices. By the time the money filters through the system, prices have risen and the later receivers get the shaft.”

Firstly, that assumes that there’s a single deflationary episode to counteract a single inflationary episode. In practice, it’s rather different, as there would be an ongoing process of both inflationary and deflationary activity.

Secondly, do you agree that the same argument is valid against the claim that commodity price rises are not inflationary?

It doesn’t matter that prices didn’t rise according to some index, because prices will always end up higher than they would have been after the increase in the money supply.”

But what makes you think that every price rise matters equally? Many goods have substitutes that are unaffected by the inflation, so the economic effects are limited – if there’s a shortage of money, it could just cause a shift back to the cheaper brand.

If the inflation is the result of money supply increase, it’s likely to be self correcting when the money supply decreases. But if the inflation is the result of an increase in commodity prices, counteracting it is much more difficult.

If an index (such as the CPI) doesn’t increase, it means nothing except that without the increase in the money supply prices would have fallen.

True. Do you deny that deflation would be problematic?
If not, do you deny this is deflation?
If so, what feature of deflation would cause problems that this would not?

A good part of the inequality of wealth and incomes in the US can be attributed to artificial increases in the money supply.

If so, that goes to show how different poverty and inequality are!

As for the cause of hyperinflation, how can you not separate a genuine attempt to stimulate the economy from a desparate decision to plug a hole in its budget at the expense of economic stability?

Alex MacMillan July 18, 2007 at 5:40 pm

Aidan: Perhaps you could elaborate on a few of your comments.

What do you mean by the following phrases:

“But because of the reduced flexibility, there is much less opportunity to create wealth.”

“Many goods have subsitutes that are unaffected by the inflation…” and “if there’s a shortage of money, it could just cause a shift back to the cheaper brand.”

“if the inflation is the result of an increase in commodity prices” How do you get anything but a transitory inflation without a money supply increase?

RogerM July 18, 2007 at 8:41 pm

Aidan: “I’d rather go with what’s efficient than what’s natural! Besides, different people have different ideas of what’s natural.”

If you understood true economics (Austrian) you wouldn’t consider paper money to be so efficient, mainly for the reasons I gave above. Also, people can disagree about what’s natural, but who would say that something is natural (paper money) when the state has to put a gun to your head to make you use it?

Aidan: “But because of the reduced flexibility, there is much less opportunity to create wealth. And how many orders of magnitude more than the Federal Reserve’s “army of bureacrats” would the gold standard cost?”

A gold standard would not reduce flexibility at all. Why would it? In fact, a true gold standard (which would include 100% reserve banking) would cause mild price deflation. Mild deflation would encourage savings and discourage consumption, thereby increasing money available for research and R&D and investment in new businesses. Therefore, a true gold standard would increase wealth at a much faster rate. Such a regime would cost must less to administer than does the current army of bureaucrats.

Aidan: “Firstly, that assumes that there’s a single deflationary episode to counteract a single inflationary episode. In practice, it’s rather different, as there would be an ongoing process of both inflationary and deflationary activity.
Secondly, do you agree that the same argument is valid against the claim that commodity price rises are not inflationary?”

Generally, when economists talk about a price index, such as the CPI, or price inflation, which the indexes measure, they mean the net increase/decrease when all prices increases/decreases are considered. Obviously, some prices increase and some decrease in a given period of time. If the net result is a general increase, the CPI will increase and we say that prices have inflated. Are commodity prices inflationary? Not at all! Commodity price increases are the result of monetary inflation and just part of the general rise in prices.

Aidan: “- if there’s a shortage of money, it could just cause a shift back to the cheaper brand.”

Prices can rise for reasons besides an increase in the money supply, for example, and shift in tastes, or newer technology. But those price increases occur in specific industries, not the economy in general. If the price of oil rises because of a shortage of oil, then consumers of gasoline will be forced to spend more of their income on gasoline, leaving less income for other products. With less spending on other products, their prices should fall, so you won’t see a general price rise and the indexes won’t be affected. Indexes rise only when a general price increase, across the board, takes place. When indexes rise, there are usually no cheaper substitutes because the price of substitutes rise also.

Aidan: “Do you deny that deflation would be problematic?”

Yes, I deny that mild deflation would be problematic. As I responded above, mild deflation would increase the wealth of the country much faster than mild inflation. Rapid deflation is just as bad as rapid deflation.

Aidan: “If so, that goes to show how different poverty and inequality are!”

I don’t understand your comment. Inequality assumes poverty.

Aidan: “As for the cause of hyperinflation, how can you not separate a genuine attempt to stimulate the economy from a desparate decision to plug a hole in its budget at the expense of economic stability?”

Sorry. Don’t understand what you’re trying to say.

Aidan Stanger July 20, 2007 at 12:48 pm

Alex MacMillan and RogerM -

My comments about reduced flexibility relate to the fact that if you are tied to a gold standard, it’s far more difficult to get out of a depression. Austrian economists might not like to admit it, but Keynesian recoveries can work!

I will discuss inflation later, as I am too tired to write a sufficiently detailed explanation at the moment.

RogerM, while I don’t entirely agree with your attitude to deflation, I do regard it as more sensible than that of many economists. And I find it interesting that you have switched from the Austrian to the Conventional definition of deflation!

Inequality does not assume poverty. In theory, capitalism increases inequality and reduces poverty! In practice it’s more complicated, of course, but poverty relates mainly to people’s standard of living, whereas inequality relates only to their wealth or income relative to that of everybody else.

Regarding hyperinflation, there is a very big difference between reducing interest rates in order to stimulate the economy and increasing the money supply in order to cover a budget shortfall. I’m having trouble seeing how you can’t see it!

Alex MacMillan July 20, 2007 at 3:16 pm

Aidan: Since the Federal Reserve came into existence 1913, its policies to ‘aid’ the economy have caused a total CPI increase of 1936%. The justification for this inflation would have to be made on the basis that without the Fed’s active short run monetary policy, the U.S. economy would have been worse off over the years.

Anthony July 20, 2007 at 5:42 pm

“Austrian economists might not like to admit it, but Keynesian recoveries can work!”

Wait – work in what sense? Short or long term? If they simply avoid recessions and push them back, so to speak, the risk is that in the end the eventual recession concluding the business cycle may be far worse than what it would’ve been otherwise.

RogerM July 20, 2007 at 7:19 pm

Aidan: “Austrian economists might not like to admit it, but Keynesian recoveries can work!”

When have Keynesian recoveries worked? Certainly not in the 1930′s when Keynes proposed his theories. Keynesian econ was responsible for the stagflation of the 1970′s, but that’s about all. Severally analyses of the Fed’s attempts at applying Keynesian policies show that the Fed has been procyclical, that is, Keynesian policies have made every recession worse than it should have been. Besides, Austrian econ proves that recessions end more quickly when the government does nothing.

Aidan: “In theory, capitalism increases inequality and reduces poverty!”

Socialist theory. In reality, capitalism reduces inequality. No nations on earth have ever had greater inequality than the USSR and Communist China.

Aidan: “Regarding hyperinflation, there is a very big difference between reducing interest rates in order to stimulate the economy and increasing the money supply in order to cover a budget shortfall. I’m having trouble seeing how you can’t see it!”

I’m having trouble seeing why you think they’re so different. Sure, the intentions are different, but we know what road good intentions pave. The primary method for increasing the money supply is through Fed induced lower interest rates. Lower interest rates increase the money supply and cause price inflation. It doesn’t matter whether you intended to increase jobs or cover a budget shortfall, the effect is still exactly the same.

Anthony July 20, 2007 at 9:02 pm

“Socialist theory. In reality, capitalism reduces inequality. No nations on earth have ever had greater inequality than the USSR and Communist China.”

Indeed. Living standards increase, and so long as markets are competitive profits will tend to zero.

Dan August 10, 2007 at 2:21 pm

Let me leave a link of a site that gives a great report on Fiat Currencies like this one.

http://dailyreckoning.com/rpt/fiathistoryWP.html

-cheers!

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