A debate has been raging for some time among those in the finance industry about whether the United States is currently experiencing inflation, deflation, stagflation, reflation, hyperinflation, or maybe even some other sort of “-flation” that only Dr. Seuss could imagine. Given the confusion, this article will add some color to the debate by offering usable definitions of the terms inflation and deflation and then attempt to show what is occurring in today’s economy.FULL ARTICLE
Source link: http://blog.mises.org/8323/inflation-deflation-red-flation-blue-flation/
Inflation Deflation Red-flation Blue-flation
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Alex:
“So, Mike, do you mean that without the new silver coinage arriving the paper livres would be worthless, or just that their value would fall on news of the boat sinking?”
The paper livres were just like any other financial security. If the boat sank, or if there was news of the boat sinking, then the livres would lose some or all of their value. Exactly the same thing would happen to shares of stock in the company that owned the boat.
“But suppose the boat doesn’t sink and the 30,000 livres of silver coinage arrive and the French government in Quebec spends all the 30,000 of silver coinage. And, also suppose that some of the paper livres continue to circulate, so that the money supply has increased by 30,000 silver livres plus say, 5000 (paper livres). In this case, do you contend that the prices of goods and services in terms of livres would be higher, just the same, or lower than if the 5000 paper livres didn’t continue to circulate?”
Prices would be just the same. Before the addition of the 5000 paper livres, you could have bought a loaf of bread with 1 silver livre or one paper livre. Afterwards, 1 loaf will still cost 1 silver livre, and since 1 paper livre can be redeemed at the payroll office for 1 silver livre, 1 loaf will still cost 1 paper livre as well. You have to keep in mind that this assumes the payroll office would only issue the extra 5000 paper livres if it got at least 5000 livres worth of assets to back them. You also have to ask why the 5000 extra livres would circulate? The answer must be that economic activity increased to the point where people needed the extra 5000 lvs to comfortably conduct their business–otherwise they wouldn’t have been issued.
Mike Sproul: I’m sorry to keep asking you questions about your stance, but I would like to make sure exactly what you are saying.
You said: “Prices would be just the same. Before the addition of the 5000 paper livres, you could have bought a loaf of bread with 1 silver livre or one paper livre. Afterwards, 1 loaf will still cost 1 silver livre, and since 1 paper livre can be redeemed at the payroll office for 1 silver livre, 1 loaf will still cost 1 paper livre as well. You have to keep in mind that this assumes the payroll office would only issue the extra 5000 paper livres if it got at least 5000 livres worth of assets to back them. You also have to ask why the 5000 extra livres would circulate? The answer must be that economic activity increased to the point where people needed the extra 5000 lvs to comfortably conduct their business–otherwise they wouldn’t have been issued.”
Your original example, I understood, began with only silver livres circulating as money. Then, paper livres were issued in anticipation of the new boatload of silver livres arriving. So, I would like to keep those aspects of your example intact, so that we don’t argue at cross purposes.
1. Initially, only silver livres circulate. And, as you assume above, when the boatload of 30,000 new silver livres arrives and that money is in circulation, 1 loaf of bread sells for 1 silver livre.
For simplicity, assume that production consists only of loaves of bread (or we could replace your loaves of bread with identical baskets of goods and services). Anyway, I’ll stick the loaves of bread.
Assume the colony produces 200,000 loaves of bread each period (month, year, whatever). Assume the 30,000 new silver livres brings the money supply in the hands of the public up to 100,000 silver livres. So, as I said above, with this money supply, the price of bread is 1 liver per loaf.
Now, if the French government body in Quebec keeps 5,000 silver livres in storage to “back” 5,000 paper livres that are circulating as money (total circulating money=100,000 livres), I’m assuming we agree that the price per loaf of bread would be 1 livre per loaf (either in terms of silver or paper livres).
Now here’s the question I was asking you in my prior post: If, instead, the French government in Quebec prints 5,000 non-redeemable, non-backed, paper livres and uses them to pay their military, so that now the circulating money supply is 105,000 livres, do you not agree that the price of each loaf of bread would rise above 1 livre per loaf? I’m assuming you will agree that it will, because you will argue that the paper livres are non-backed.
So, let’s say that the price of each loaf rises to 1.05 livres in the above case. After this happens, suppose the French government in Quebec subsequently inks some French bonds and then announces, “There are 5,000 paper livres circulating as money in the colony, but they are all backed by French government bonds.” Do you think that this will reduce the price of bread to 1 livre?
Alex:
I suppose that I would distinguish between fraud as would be adjudicated by a legal system and fraud for practical purposes in making economic predictions. For instance, if a Ponzi scheme had a 100-page offering document and page 57 had one sentence in fine print that said “you will be receiving interest payments out of your principal account and your account balance will be overstated, as if these payments were not being so made,” who knows…perhaps a judge would deem that to be adequate disclosure and not be fraud. However, I think it’s likely that that investors wouldn’t notice it and they would be angered when they realized that they had been swindled. Although not legally, it would be economically tantamount to fraud.
In the same way, whether you want to call fractional reserve banking fraud or not, or if you think that general consumers have sufficient information to make the determination on their own that it’s a bad idea, I personally think it’s all but certain that people are making poor decisions and don’t truly understand what they’re doing. To the extent that that sends a faulty signal on current vs. future consumption, it will tend to cause malinvestment and business cycles.
I also wonder how you explain the behavior of banks in making loans. Presumably, banks are competent and understand the implications of fractional reserve banking. So when they extend a loan to someone, why not place some covenant on it requiring the recipient to keep their deposits somewhere other than a fractional reserve bank. From the bank’s perspective, there’s nothing to be gained by allowing the borrower to take unnecessary risk with the funds they’ve been given. The bank wants to see those funds protected.
On a related point, I probably part company with other Austrians, but I feel similarly about MMMF holdings. They clearly aren’t fraudulent in that legal title is transferred to the borrower and holders of MMMF shares presumably assume the risk that their holdings will decline in value, but I speculate that a lot of people view them as demand deposits for practical purposes, and I wonder if and to what extent this sends a faulty signal on current vs. future consumption.
The late Scholastics discussed the morality of fractional banking back in the 16th century and could no more come to an agreement back then than people can today.
Yes, I think fundamentalist’s point is well taken.
What I fail to understand, though, is whether or not we agree to call fractional reserve banking ‘fraud,’ why it is that some argue that fractional reserve banking is responsible for any malinvestment that would occur from a significant monetary expansion. The total responsibility for whatever degree of monetary expansion that takes place lies with the central bank. The central bank management can do arithmetic. For example, they would know if a $100 expansion in the montary base would lead to a $1,000 expansion in the money supply. Focusing on fractional reserve banking for any malinvestment that monetary expansions may cause, therefore, seems to me to be inappropriate.
Alex:
I think your understanding may be incomplete in distinguishing between inflation (money creation) that gets funneled directly into the supply of loanable funds vs. money that just gets added to the money supply and spent by government. It is only the former that tends to cause business cycles. By its nature, fractional reserve banking is the former in that money which is not intended to be loaned out (we’ll assume that much, let’s ignore our other conversations for the moment) is added to the supply of loanable funds.
That is distinct from the Fed “printing” bills, handing them to the Treasury, and Treasury buying up and consuming commodities. Although it would be expanding the overall monetary supply, that would not tend to cause economic miscalculation. It would just be the appropriation of wealth from one party to another. It is only the type(s) inflation that systematically manipulate the natural rate of interest which cause business cycles.
Alex: “Focusing on fractional reserve banking for any malinvestment that monetary expansions may cause, therefore, seems to me to be inappropriate.”
There’s plenty of blame to go around. The Feds can influence the money supply two ways. 1) Buying bonds from banks will raise bank reserves and give them more money to lend. 2) Lowering the rate at which banks can borrow from the Fed or from other banks can increase reserves.
At the same time, if the Fed commits neither of the above two crimes, banks can expand credit, and therefore the money supply, on their own through the ponzi scheme of fractional banking. (Hayek has a great analysis of this in “Monetary Theory and the Trade Cycle”) Hayek shows a number of things that can cause an increase in the demand for loans. One is new technology. If the new demand comes when a state of equilibrium has been reached, the bank will need to raise interest rates in order to attract the new savings that it will loan to the entrepreneur with the new technology. But that will put him at a competitive disadvantage with other banks, so he lowers his reserves and makes the loan anyway which sets in motion the money creating aspects of FRB.
Also, reserves tend to increase during recessions as companies build cash balances and don’t take out loans. When business confidence returns and demand for loans increase, banks will on their own (without Fed prompting) lower their reserve ratio to make new loans.
Fundamentalist, you said: “banks can expand credit, and therefore the money supply, on their own through the ponzi scheme of fractional banking.”
Hold it. Let’s assume the banking system has $10 of reserves consisting of $2 of paper currency and $8 of deposits at the Fed. Explain to me how the banks’ (in totality) can acquire $1 more in new reserves that the Fed cannot sop up (for example, by engaging in open market bond sales.) Therefore, explain to me how the banks can expand the money supply without the Fed letting them do so.
Matthew: Each time the monetary base increases through an issuance of currency or a central bank purchase of government bonds, there is a tax involved, that is a transfer of wealth from the private sector to the government. Here is a numerical example of each of your two cases.
Case 1. The Fed purchases $100 government bond on the open market. This causes the banks’ reserves to increase by $100 (suppose the desired amount of currency in the hands of the public is unchanged). The bank’s expand their loans by, say, $900 and the money supply expands in total by $1000.
Case 2. The Fed prints up $100 of currency and gives it to the Treasury Dept. The Treasury would normally give $100 government bond for these funds (though that bit of nonsense is irrelevant). The Fed’s balance sheet has $100 more government bonds on the asset side and $100 more liability for the currency on the liability side. The Treasury, as you say, spends the money on goods and services. At this point, the private sector has been taxed by $100, as in case 1. Also, as in case 1., assuming unchanged desire for currency in circulation, the $100 in additional currency will be deposited in the banks. The banks’ reserves thus increase by $100 as in case 1., and the banks expand their loans by $900. The money supply thus expands by $1000, as in case 1.
In each of cases 1 and 2 there is an expansion in bank loans of $900, an expansion of the money supply by $1000, and a tax of $100 imposed on the public.
Alex:
Both of your cases involve the expansion of money through fractional reserve banking, so don’t juxtapose the distinction I was trying to draw. Let me try again:
Case 1: The Fed buys $100 on the open market. Banks expand credit with the additional reserves, resulting in a $1000 increase in the money supply.
Case 2: The Fed buys $1000 of debt directly from the Treasury. Treasury spends the money.
In both cases, the money supply increases by $1000, but only in the first one is it sending a false signal about current vs. future consumption preferences.
Note: whether or not the $1000 that Treasury spends in Case 2 ends up in bank deposits and is expanded to $10,000 is a completely different matter and does not enter into the above analysis.
Matthew: Thank you for your latest reply and the clarity of your example. I didn’t realize from the wording of your prior post that you wanted a ten-fold increase in the amount of government bonds purchased directly by the Fed in Case 2 relative to Case 1 (though qualitatively it doesn’t change comparisons of the two cases).
You said: “Note: whether or not the $1000 that Treasury spends in Case 2 ends up in bank deposits and is expanded to $10,000 is a completely different matter and does not enter into the above analysis.”
Of course the $1000 that the Treasury spends in Case 2 will end up in bank deposits since there is no reason that the public’s demand for currency would be different in the two cases. So in your case 2 (using your figures) the banks’ loan portfolio will end up expanding by $9000 and the money supply by $10,000. You can’t say that in case 2, you want to stop the analysis in the middle of the process (that is without considering the final effect on bank’s balance sheets, while considering the final effect in case 1). Of course, if you do that you will end up with different scenarios. Matthew, both cases 1 and 2 have the same effect on loan portfolios of the banks and the money supply if you use the same quantitative amounts in both cases (either a $100 open market purchase of government bonds by the Fed and a $100 purchase of government bonds from the Treasury. OR $1000 figures in both cases.)
In both instances, then, the interest rate will be artificially lowered by the same amounts and whatever malinvestment will occur, it will be the same in both cases 1 and 2.
Alex:
“So, let’s say that the price of each loaf rises to 1.05 livres in the above case. After this happens, suppose the French government in Quebec subsequently inks some French bonds and then announces, “There are 5,000 paper livres circulating as money in the colony, but they are all backed by French government bonds.” Do you think that this will reduce the price of bread to 1 livre?”
You can’t just blithely assume that new money is issued without any existing money refluxing to its issuer, any more than you can assume that you can stamp bullion into coin without somebody, somewhere, melting coin back to bullion.
But if, as you say, the government issued 5000 new paper livres while getting no new assets, then yes, the value of paper livres would fall by 5%. If the government then dedicated 5000 livres worth of assets (newly inked bonds, as you say) to back those livres, then yes, the value of the paper livres would rise by 5%. But I have a feeling you have not asked yourself the important question of whether the french government has sufficient net worth to back those new bonds. If it does, the bonds, and the money, will hold their value. If not, the bonds and the money will lose value.
If you’re still unclear on my position, click on my name above to read about the real bills doctrine.
Alex: “Therefore, explain to me how the banks can expand the money supply without the Fed letting them do so.”
You’re right. Banks can only expand money if the Feds do nothing. If the Feds decide to stop banks from expanding credit, they can.
Mike Sproul said: 1. “You can’t just blithely assume that new money is issued without any existing money refluxing to its issuer.”
2. “But if, as you say, the government issued 5000 new paper livres while getting no new assets, then yes, the value of paper livres would fall by 5%. If the government then dedicated 5000 livres worth of assets (newly inked bonds, as you say) to back those livres, then yes, the value of the paper livres would rise by 5%. But I have a feeling you have not asked yourself the important question of whether the french government has sufficient net worth to back those new bonds. If it does, the bonds, and the money, will hold their value. If not, the bonds and the money will lose value.”
1. One of your favorite terms is “refluxing” and it somehow seems to be critical to your thinking about the money supply. The word means “flowing back,” so you are saying that when new money is issued existing money somehow flows back to the issuer (the French government in Quebec, or in modern day terms the central bank). So, to answer your point 1.: Of course, I can assume the normal thing that money does not flow back to the issuer. Explain why when the French government in Quebec issued the 5000 paper livres, these paper livres would naturally flow back to the French government.
When the Fed issues $5,000 dollars more currency, how does this automatically flow back to the Fed? In fact, it doesn’t; the liability for currency grows and grows over time.
2. I’m glad you answered my question with regard to the effect of “inking” some government bonds by the French government in Quebec and the fact that you believe this announcement would raise the value of the previously issued currency. Can you explain why the announcement by the French government in Quebec that they have printed up some big pieces of paper (government bonds), which they intend to hold in a cupboard indefinitely somewhere in the fort, is going to reduce the price of a loaf? After all, nothing has happened to the quantity of money and it is never naturally going to flow back to the cupboard in the fort. Instead, more boatloads of silver money will come or the French government in Quebec will issue more paper livres as time goes on.
Suppose the French government finds 5000 of silver livres in a cupboard in the fort that they had forgotten about, and redeems the 5000 paper livres for 5000 silver livres. In other words, suppose the 5000 paper livres do flow back into the fort (to be ripped up), there is no change in the money supply by this flow back and issuance of new silver livres. How then will there be any change in prices? The only way a flowing back of the paper livres into the fort could change prices is if the French government in Quebec taxed the people 5000 livres and then permanently kept the 5000 livres out of circulation (buried them in that hard to find cupboard or something). Such action would lower the money supply.
By the way, I shall read your real bills stuff at my earliest convenience. I’m sure the topic will come up again.
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