Economists of the Austrian School of economics define inflation differently than much of the mainstream of the economics profession, writes By Gary Danelishen. The typical mainstream intermediate macroeconomics textbook defines inflation as “an increase in the overall level of prices.” Ludwig von Mises, suggested otherwise.
A recent exchange between Congressman Ron Paul and Ben Bernanke took place during Bernanke’s testimony before the Congressional Joint Economic Committee on November 8, 2007. Congressman Paul, instead of referring to either the PPI or CPI, referred to the MZM money aggregate. He likened the Fed to a price fixer. FULL ARTICLE
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Eric:
“i’m just not sure that people would be eager to use money backed by volatile assets when they could use money backed by gold. and i’m not sure what role a central bank has to play in real bills – it seems unnecessary.”
I agree on both points. People should be able to choose what money they want to use–backed by gold or by volatile assets, or by some bundle of commodities that might be more stable than gold. I also am unsure if a central bank accomplishes anything, but rather than calling for its abolition, I think the prohibition on private issue of paper money should be lifted. If the Fed serves no purpose then it will quietly become irrelevant. (I recall a recent post saying that the prohibition actually has been lifted, but so far no private banks have acted on it.)
a dollar is a dollar is, and only is, a dollar. it is only a promise to pay a dollar for a dollar. there is no need for the issuer to “pay back” anything after a dollar is printed. surely a college professor shouldn’t need me to explain such an obvious fact.
I would love to nitpick on the issues of stock values and credit cards, but for now I’ll stick to what seems to be the main point. Mr. Sproul, you don’t see a difference between somebody depositing an asset with a bank in exchange for receipts/notes/dollars or with the bank printing notes/dollars and buying assets? I would think it makes all the difference between “backed” or “unbacked”.
I still hold that anything people use for indirect exchange is money, but backed money is more stable and trustworthy for the economy, because it limits the amount of money that can be put into circulation. I’m afraid I don’t see how a bank would be limited when they can simply print money and buy assets with that money, short of a market in currencies where people can choose a different bank’s money instead.
“…..or by some bundle of commodities that might be more stable than gold.”
Good explanation for the success of todays paper currencies.( successful in the sense that people are willing to accept and hold on to them.)
There is some merit to RBD.Think of producers forming an umbrella organisation, and government
acts as issuer of claims against all the goods they produce.
Come up with a better mechanism for regulating the supply of money, demonetize gold forever.
Mike: “In a new issue of stock, the firm does get additional assets, so the stock price is unaffected.”
True, except that stock price isn’t determined by assets, but by profit. Analysts might take assets into account if the company is going under. If you use past earnings to figure stock value, then a new issue will dilute the price of the stock. If you use future earnings, the cash from the sale of stock will have to convince investors that it will generate greater profits, otherwise the price of the stock will fall.
the money supply “needs” to be regulated by the government as much as we “need” communism.
Michael Clem:
Start with a bank that issues 100 paper dollars in exchange for 100 ounces of silver. Then let that bank issue another dollar in exchange for another ounce of silver. Then another dollar in exchange for an equal value of gold, then another dollar in exchange for an equal value of copper, wheat, land, etc. Finally, another dollar for an equal value of government bonds, stocks, corporate bonds, private IOU’s, etc. In every case, the RBD says the value of the dollar will be unaffected as long as the assets received are worth one ounce of silver, but the physical form of those assets is irrelevant. After all, those assets could be sold for one ounce of silver if the bank chose, and then the banker would have full silver backing for every dollar issued.
Mike Sproul,
“Once again, Austrians have blinded themselves to the differenc e between a banker and a counterfeiter.”
I’m completely convinced that you’ve know true understanding of the Austrian position on inflation.
Eric and Juan, I’m convinced you know even less.
QM is not Austrian. It has never been Austrian,
“In spite of a tendency observable in some quarters to revert to more mechanical forms of the Quantity Theory, in particular to proceed by way of a multiplication of purely tautological formulae, it seems fairly clear that further progress in the explanation of the more elusive monetary phenomena is likely to take place along this path.”
The Theory of Money and Credit.
The objections you raise against Austrians are the exact arguments Austrians use against quantity theorists!
And Eric, his brilliance as a budding economist is irrelevant, the most brilliant of economists have been morons in certain sub-categories of the science.
And again I agree with Niccolo.
and a huge gold bar could fall from the sky.
saying that the currency is backed because of what “could” happen is like saying i could pay you $100 tomorrow, therefore, you will receive $100 tomorrow. there is nothing about the dollar that says the bank must back it with real assets.
Getting back to a relevant topic, the problem with the conversation between Paul and Benanke is that they are talking about 2 different things. Paul is worried about the actual purchasing power of the dollar being decreased by the Fed printing more dollars (circular balance sheet transactions aside) while Bernanke is talking about the exchange value of the dollar versus other currencies. Now you can create lots of inflation by printing new currency and not affect the exchange rate at all, if all of the central banks around the world match the doallars created with more Euros, Yuan, Yen, etc., etc. In reality this is what happens. Central Banks around the world inflate uniformly, give or take a few percent which leaves the untrained eye with the impression that purchasing power is unaffected.
Of course Gold is the best (though not perfect) store of value and its value has increased immensely in any currency denomenated. So have commodities which are the first to reflect any change in the total amount of money in the world because they are traded worldwide and by their very definition their prices reflect pure supply and demand, not differentiation based on quality, features, appearance or any of the other factors that can make other goods respond to factors other than supply and demand.
Benanke is not evil, I think he honestly doesn’t understand this (he came from an Ivy leaugue university after all). Unlike Alan Greenspan who at one point in his life did understand this but decided that life on the other side was more glamorous.
So, in the absence of any govt intervention, what would re- emerge as money?
Here’s what Mises had to say about the German inflation of the 1920′s:
According to Mises elsewhere in the same book, the German central bank, and all other major bankers, followed the Banks School of monetary theory, which is just another name for the Real Bills Doctrine.
I agree that Bernanke is neither evil nor stupid. He wrote a thesis on the Great Depression and how the Fed should have handled the problem that has become the standard prescription for most universities. His problem is that he adheres to the wrong school of economics. As long as neo-Keynesian and neo-classical economics dominate, we will have poor economic policy.
mikey: “So, in the absence of any govt intervention, what would re- emerge as money?”
Predictions of any kind are risky, but those about the future are especially so. Nevertheless, I think gold would emerge as the only money once again because it is the only money that makes sense in a free market.
But quasi-money will always exist, too, because carrying around gold bullion or coins is simply to inconvenient. Quasi-money is anything that is not money but has the same effect as money. The old bills of exchange are an example. They were nothing but IOU’s that traded like money. Today, people might trade corporate bonds or notes as money. Quasi-money allows people to skirt the limitatiions imposed by gold. I don’t see how you can stop that in a free market.
Fundamentalist:
The German central bankers were lending at below-market interest rates. When private banks are charging interest rates of 100% and the central bank is charging 5%, then the central bank is not following the real bills rule of only issuing money in exchange for equal-valued assets. It was, in effect, lending 10 dollars in exchange for an IOU worth 1 dollar. But of course, the central bankers could claim that they were only lending money to legitimate businesses with productive uses for the money. This might have been what they understood to be the real bills doctrine, and it might have even been the way the RBD was understood by its critics. But the prominent adherents of the RBD (Bosanquet, Tooke, Fullarton) did not advocate that view. It’s easy to see how the RBD got an undeserved black eye at the hands of bankers who misunderstood it.
Mike: “When private banks are charging interest rates of 100% and the central bank is charging 5%…”
Are you saying that the German central bank was loaning money to member banks at 5% while the member banks were charging 100%? I’ve never heard that before. Are you sure that’s historical fact? I can’t imagine why anyone would continue borrowing at 100% interest rates. It seems that interest rates of even 25% would shut down all borrowing. If private banks were charging 100% interest for loans, how did the money supply expand so much?
Mike: “This might have been what they understood to be the real bills doctrine, and it might have even been the way the RBD was understood by its critics. But the prominent adherents of the RBD (Bosanquet, Tooke, Fullarton) did not advocate that view.”
That’s the same defense socialists use; it works great on paper, but so far, no one has ever emplemented it successfully. Doesn’t it make you wonder if anyone ever could implement it?
I didn’t say why I think Mike S. is amazing. Neither did I say : “I think Mike is right”
Fundamentalist:
I didn’t state the specific numbers, 5% and 100%, as historical facts. The historical fact is that the German central bank was lending at interest rates far below the market rate, even below the rate of inflation. (www.minneapolisfed.org/research/WP/WP158.pdf)
What I didn’t mention was that the central bank rationed credit–as it naturally would when its low interest rate made everyone want to borrow from it. Anyone who wanted to borrow on private markets would have had to pay a much higher rate, to compensate lenders for inflation.
The real bills doctrine has been implemented successfully every time a bank has lent money on good security. Inflations have happened when banks have failed to take good security for their loans.
I agree that Bernanke is neither evil nor stupid…His problem is that he adheres to the wrong school of economics.
The fact that he’s at the head of the biggest banking cartel on earh doesn’t influence his judgement ? His actions are not intended to achieve personal gain ? Is he human at all ?
Mike: “The historical fact is that the German central bank was lending at interest rates far below the market rate, even below the rate of inflation.”
According to the paper in the link you provided, Austrian banks loaned money at 6% to 9% while inflation raged at 10,000%. German banks did the same thing even though price inflation was higer there.
But what policy caused inflation to reach 10,000%? The paper you site states that in each country each government flooded the economy with paper dollars by borrowing from the central bank and spending on social programs. The central bank then used government debt as reserves and expanded the money supply further. But RBD claims that expanding the money supply doesn’t cause price inflation. The paper you cite contradicts that assumption of the RBD. It confirms Mises’s and Hayek’s principles that increases in the money supply cause price inflation.
The paper doesn’t explain why banks were lending at 6% when price inflation was running at greater than %10,000%. Any insight into that would be interesting. Were bankers in all four countries just stupid? I don’t believe I have ever read where banks didn’t at least try to match price inflation in the interest rate they charged.
Mises lived through, researched and wrote about the hyperinflation in Austria as a young economist. He is convinced that the bankers and government officials were strictly following the RBD. That’s the reason the price inflation surprised them.
Mike: “The real bills doctrine has been implemented successfully every time a bank has lent money on good security.”
Any historical examples you can provide? Because I have dozens where lending money on good security has caused price inflation. Rothbard’s book on the Great Depression offers many examples.
Mike: “Inflations have happened when banks have failed to take good security for their loans.”
I’m curious as to why making loans against poor security causes price inflation while making loans on good security doesn’t. I’m guessing that you will say that the value of the currency is based on what backs it. If what backs the currency has no value, then the currency loses value.
At the same time, good collateral is more scarce than bad collateral, or no collateral. So lending on bad collateral will also expand the money supply faster than loaning on good collateral. Could it be possible that what the RBD distinction between good collateral and bad collateral is nothing more than the greater and lesser expansion of the money supply?
I think it’s important to point out that with a gold standard, currency doesn’t retain its value simply because it’s backed by gold. Gold backing does nothing more than limit the amount of paper or digital money in circulation. We have had price inflation under a gold standard when paper currency was backed by gold because of fractional reserve banking.
Fundamentalist:
Empirical research in support of the real bills doctrine includes the Sargent paper cited above (“The Ends of Four Big Inflations”), Thomas Cunningham: “Some Real evidence in favor of rhe Real Bills Doctrine….”, and several papers on Colonial Currency by Bruce D. Smith.
The sargent paper concluded that the European hyperinflations were all ended by fiscal reforms, and that inflation stopped BEFORE the money supply stopped growing. Sargent concluded that the assets of the government backed the currency, which is consistent with a real bills view.
The RBD does not say that expanding the money supply does not cause inflation. It says that when the money supply expands relative to the assets backing it, then there will be inflation. Thus, when economists point to periods when the money supply grew relative to output of goods, and prices grew as well, and claim that as evidence in support of the quantity theory, I could respond that the inflation happened because the money supply had grown relative to the assets backing the money.
As for the gold standard: If the fed issues dollars that are each backed by 1 gram of gold, then those dollars will be worth 1 gram even if the private banks issue checking account dollars based on fractional reserves. The fed dollars are the fed’s liability. The checking account dollars are the private bank’s liability. The actions of private banks have no effect on the value of fed dollars, since they have no effect on the fed’s assets or its liabilities.
The quantity theory leads Austrians to think that if the money supply rises by 5% while output of goods also rises by 5%, then average prices will not change
Average prices for what? The entire economy? That’s obviously true: the average price is “the total money supplied divided by the total goods supply”, which (ignoring the division of apples by oranges) is thus unchanged. I think you believe that also means any particular subset of goods prices would be unaffected – you are wrong. (Some prices will even go down!)
Trouble is, what if the money supply rises 5% and the assets of the issuing bank also rise by 5%? The real bills doctrine says that the price level will be stable, since assets have risen in step with the money supply
Assets of the bank have risen: total goods supply is unchanged; you’ve just changed ownership of some of those goods from the non-bankers to the bank. You’ve got more apples and the same number of oranges – the ratio has increased!
I could meet that demand by first selling the bike for $40 and burning them
Selling the bike to whom? How do you know anyone will give you $40 for it?
No serious economist would deny that if GM issues one new share of stock, and sells it for its market price, then GM’s assets will rise in step with its liabilities, and the price of GM stock will not be affected
Really? The market price is based on GM being able to produce and sell goods, not merely hold a pile of cash – if they can’t make the new dollars equally as productive as their previous assets, the share price will ultimately fall; or if they can be more productive with the new money, the share price will rise.
Peter:
Assuming you believe MV=Py means anything, then P=MV/y, where y represents nothing but the amount of goods bought with the particular kind of money designated by M. So if M rises by 5%, all that has to happen is V falls, and/or y rises, and nothing happens to P.
The bank’s assets AND LIABILITIES have risen equally. Nobody’s net worth has changed, so the issue of new money (matched by new bank assets) does not have to increase Prices.
The bike was, by assumption, worth $40. That’s why I say it can be sold for $40. If it’s worth more the bank made a profit. If less, the bank has lost. If the bank loses more than its capital, the value of its money will fall.
The bank’s assets AND LIABILITIES have risen equally.
Yes, yes, you keep stressing that the BANK’s T account balances out, but we’re concerned with the overall economy–the bank’s actions have increased the supply of money in the economy without any increase in assets; the bank is creating something out of nothing.
And I still think there is a significant difference between a bank merely warehousing assets, and a bank purchasing assets (with newly printed currency), a point you have failed to acknowledge or even discuss, if only to refute my contention.
Michael Clem:
When a farmer borrows 50 checking account dollars from a bank, the bank places a $50 lien on his farm. The farmer has no additional wealth. It is as if his farm has been coined into money, so the money has not been created out of nothing. The banker has the $50 lien, but also the liability of the 50 checking account dollars. The bank has no additional wealth. The “extra” $50 in the economy could be offset by an increase in goods purchased, or a decrease in velocity, or by displacement of barter or other forms of money.
One bank issues checking account dollars as warehouse receipts for ounces of silver. Another issues them as warehouse receipts for a square foot of farmlend, and another for an IOU worth $1. No rational banker cares about the physical form of the assets he gets. He cares only about their value. And as long as he gets assets of sufficient value for every dollar issued, he can always trade those assets for silver, if silver is what customers want, or he can use those assets to buy back the dollars he issued.
Mike: “Empirical research in support of the real bills doctrine includes the Sargent…”
I didn’t ask for papers, but for historical episodes in which you think RBD actually worked. Besides, the theoretical and emperical evidence against the RBD is found in Mises, Hayek, Rothbard and the writings of many other economists.
Mike: “I could respond that the inflation happened because the money supply had grown relative to the assets backing the money.”
You couldn’t argue that for the periods when gold and silver were the only forms of money. RBD seems to work with paper money, but go back to real historical periods when only gold and silver coins were money and it falls apart because gold and silver are both money and assets; they have nothing backing them, but increases in their supply caused price inflation without any doubt.
Mike: “The actions of private banks have no effect on the value of fed dollars, since they have no effect on the fed’s assets or its liabilities.”
That’s simply not true on any level. All you have to do is remove the paper dollars and talk strictly about gold coins. If the Fed or the private banks suddenly come into ownership of a greater quantity of gold coins and loan them out, price inflation will follow. That has been proven time and time again without question. Adding paper or digital money to the scenario doesn’t change anything. If an increase in gold coins will cause price inflation, so will an increase in paper money, whether it has backing or not.
Mike: “The bank’s assets AND LIABILITIES have risen equally. Nobody’s net worth has changed, so the issue of new money (matched by new bank assets) does not have to increase Prices.”
Why do you keep repeating this nonsense? Net worth has nothing, repeat NOTHING, whatsoever to do with prices. Have you read Adam Smith? Do you understand that prices are determined in the marketplace by supply and demand, both of which are determined by the subjective valuation of the participants? So where does net worth fit into that equation? It doesn’t!
Any commodity in the marketplace obtains its price by the subjective valuation of individuals. No objective value exists for anything, not even money, but especially not for money. You are trying to force an objective value on money by claiming it is worth the assets backing it, which is the same thing as denying everything we have learned in economics since Ricardo. The classics like Smith and Ricardo tried to force objective values on all commodities. The great insight of economics was the subjective nature of value. This holds for money as well, but especially money.
The backing behind paper money means nothing to the value of paper money. It cannot under any circumstance fix the value of paper money or any form of money. Paper money is a commodity in the market place like any other commodity. Subjective valuation in the supply-demand tug-of-war determines it price. If RBD denies this, it denies over a century of the best economics in existence.
And according to subjective valuation, an increase of the supply of a commodity, all else held constant, the subjective valuation of that commodity will fall and its price will fall. This happens with gold coins and it happens with paper and digital money. To accept that it happens with gold coins but claim an exception for paper/digital money is to attribute magical properties to the paper/digital money.
“And I still think there is a significant difference between a bank merely warehousing assets, and a bank purchasing assets (with newly printed currency), a point you have failed to acknowledge or even discuss, if only to refute my contention.”
I am hardly an expert, but it seems to me that your two cases are the same.
A Warehousing bank: People voluntarily deposit assets at the bank, accepting notes in return. They can return the notes and get back what they deposited.
An Asset-purchasing bank: People voluntarily sell assets to the bank, accepting notes in return. They can buy back the assets with notes.
You are assuming that the asset-purchasing banks wildly “print” notes, forcing them on an unsuspecting and passive public in the form of purchases, whereas a warehousing bank is not guilty of this. But there are two sides to every transaction. Greeted with offers to exchange assets for notes, the public appraises an asset-purchasing bank’s reputation. They don’t have to exchange their assets for notes if they think the notes or the bank are suspect.
Because both a warehousing bank and a asset-purchasing bank are based on the idea of mutual and voluntary exchange, they are the same. You single out the asset-purchasing bank as a guilty of benefiting from newly printed currency, but a warehousing bank also prints new currency in order to take deposits. No?
With legal tender laws, things break down.
Fundamentalist:
1) My analyses of historical periods when the RBD worked would be too long for a blog post. And why bother when they are right there in the papers I cited? (I didn’t mention Bomberger and Makinen on Greece and Hungary, which also supported the real bills view.)
2) I’ve never denied than an increase in the quantity of gold will reduce the value of gold. The RBD relates only to paper and credit money.
3) When a dollar is convertible into 1 ounce of silver, that dollar will be worth 1 ounce no matter how many are issued, and the issuing bank will always be able to pay 1 ounce (or something of equivalent value) for each dollar as long as new dollars are only issued in exchange for assets worth one ounce. If convertibility is suspended, the same result holds–a result you can read about in “There’s No Such Thing as Fiat Money”.
4) I posted above, on this thread, why supply and demand works fine for actual goods, but is not applicable to paper or digital currency.
Mike: “The RBD relates only to paper and credit money.”
So paper money has magical powers that enable it to violate all principles of economics?
Mike: “When a dollar is convertible into 1 ounce of silver, that dollar will be worth 1 ounce no matter how many are issued…”
Again, violates all known laws of economics.
Mike: “…supply and demand works fine for actual goods, but is not applicable to paper or digital currency.”
If anyone believes that, I have a bridge I’d like to sell you. Someone has said that gravity isn’t a suggestion, it’s a law. Similarly, some laws of economics are inviolable. Any suggestion that any item in the free market is not subject to the laws of supply and demand is like claiming that someone can ignore the law of gravity. I would be very suspicious.
Keep in mind that the RBD was developed over 400 years ago and hasn’t kept up with progress in economic science. As classical economists thought they could fix prices to objective costs, so RBD thought it could peg the price of money to assets. Austrian econ advanced price theory by introducing subjective valuation (Actually, Austrians revived the pricing theory of the Scholastics from the 16th century.) Had the RBD kept up with advances in economics, it would have given up on fixing the value of money to assets even as Austrians freed prices from costs. And RBD enthusiasts would realize that money is just another commodity in the free market; it has no magical powers to violate the laws of economics, especially the laws of subjective value and supply and demand.
Fundamentalist:
The laws of supply and demand apply to actual goods, not to pieces of paper, bookkeeping entries, and computer blips that can be costlessly created and retired in infinite amounts in an instant.
Start with the simple idea that if I issue 100 mike dollars that are each a claim to 1 ounce of silver, and if I keep 100 ounces in my vault, then each mike dollar must be worth one ounce. Then take a small step and suppose that someone offers me an equivalent value of gold in exchange for another mike dollar. Then suppose someone offers to pay me 1.10 ounces next year, in exchange for 1 mike dollar today, and I accept because I can profit from it. In both cases, the value of the mike dollar will remain at one ounce. This is not to say that the mike dollar might not fall if I lose some of my assets, but if my depositors understand this and accept it, I am only making a voluntary trade. That aside, ask yourself what is the upper limit to how many mike dollars I can issue in this way, and you might realize that the only upper limit is how many mike dollars the public wants, always understanding that I only issue mike dollars to people who bring in at least a dollar’s worth of stuff.
Mike: “The laws of supply and demand apply to actual goods, not to pieces of paper, bookkeeping entries, and computer blips that can be costlessly created and retired in infinite amounts in an instant.”
Absolutely nothing in economics is exempt from the law of supply and demand.
Mike: “Start with the simple idea that if I issue 100 mike dollars that are each a claim to 1 ounce of silver, and if I keep 100 ounces in my vault, then each mike dollar must be worth one ounce.”
Wrong! Each dollar is worth what individual actors value it for, regardless of how much silver you claim backs it. For all the participants in the economy know, you could be not telling the truth about the backing of your money.
I repeat, nothing has an objective price, especially not money. It’s all subjective. You’re trying to set monetary theory back 150 years.
Mike: “The laws of supply and demand apply to actual goods, not to pieces of paper, bookkeeping entries, and computer blips that can be costlessly created and retired in infinite amounts in an instant.”
The fact that paper and digital money are easy to create and destroy does not exempt them from the law of supply and demand; it simply makes the supply easier to manipulate that a commodity like gold.
But overlooked in all of the smoke and mirrors about asset backing is the fact that the RBD violates the ABCT. The crucial point about the money market is whether the loans a bank issues reflect money saved or money created. The RBD obsession with what backs paper/digital money is just a red herring. It doesn’t matter. RBD is like a pick-pocket distracting your attention with silly arguments about asset backing while lifting your wallet.
If bankers loan money that has been saved by others, then that savings reflects a reduction in consumption equal to the amount of savings. So when a businessman borrows the money, he will use the money to pay wages and buy materials. The workers receiving the new wages will spend most of their wages on the consumer products that the savers gave up, so prices don’t changes. The collateral offered by the businessman matters not at all, except for the solvency of the bank.
On the other hand, if the funds loaned don’t come from the reduced consumption of someone else and the bank creates the money, as RBD suggests, then the workers who received the new money in wages will spend it on consumer good and compete with other consumers for the same goods, thereby driving up consumer prices and setting the ABC in motion.
If you’re a Keynesian or neo-Classical economist, you’ll love the RBD. But if you thing Mises, Hayek and Rothbard are right about the Austrian Business Cycle Theory, you’ll hate RBD for the damage it causes to long term wealth.
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