Comments (28)

• Dr. Vitor

  I am discussing in the Austrian Economics Forum topic linked in the URL bellow a system where governments can print new money but with that they still don't cause change in the money stock and don't create inflation. Please, go there and read the entire discussion with all my replies. It is not monetary manipulation, as the monetary base is kept constant all the time. It is indeed, a system intended to free markets from all traditional taxation, substituting the governmental bill by a cost embbeded in a special parallel currency that makes temporary holders use it faster. The "taxation bill" is substituted by the "increase of the speed of some transactions bill". Is seems strange but I believe it works and it is a step toward freedom from governments. The link is http://austrianforum.com/index.php?showtopic=384 .

  Published: November 8, 2005 9:15 AM

• P.M.Lawrence

  Actually, the best rule is not to freeze the money supply but rather to peg it to some key measures (seed corn in Heinlein's "Time Enough for Love", bullion in a gold or silver standard). Then there would actually be an increase in money supply to the extent that economic capacity actually grew; the seigneury from this should not be treated as a windfall gain but rather put into a sort of open ended sinking fund to cover any fluctuations by pulling in money if inflation loomed. If this fund were genuinely invested (as opposed to driving asset price limitation by buying up land, say), then it would generate productive capacity with genuine returns rather than wealth transfers.

  Of course, a fiat currency on even this basis is an occasion of sin, since the temptation would be to write off bad investments and to "invest" deliberately printed money in acquiring existing revenue streams without actually increasing productive capacity. This is the sort of temptation that otherwise sound sinking fund schemes have historically succumbed to.
  

  Published: November 8, 2005 9:24 AM

• Roger M

  After reading several articles on this web site about the benefits of deflation, I think a policy of sustained, mild deflation would give us most of what we want in a free country. It would limit the power of banks and government, while encouraging saving and manufacturing.

  Published: November 8, 2005 10:09 AM

• Paul Edwards

  In this article, the author states “…To find an answer to these questions, one has to start with a theory.� However, I think that it is just as important to start with a correct theory.

  The article continues:

  “A relation between money growth and inflation can be established through the equation of exchange. It can be written as follows:

  (1) M * V = Y * P

  “Equation 1 states that the stock of money (M), multiplied by the number of times a money unit is used for financing purposes (V), equals real output (Y) multiplied with the price level (P).�

  The usefulness of this approach has been refuted thoroughly by Rothbard in MES. Rothbard refers to the concept of price level, P in the above equation, as a “misleading fiction�. In reference to V, velocity, he indicates it is “absurd to dignify any quantity [V, in this case] with a place in an equation unless it can be defined independently of the other terms in the equation�.

  The assumption of equality in the equation above is misleading because we know that in market transactions there is never equality of valuations, but just the opposite. There is always inequality of evaluations and that is why transactions occur at all. This is why Rothbard regards the analysis surrounding MV=YP as “a tangle of fallacy and irrelevance.� According to Rothbard, the presumption of equality of values in exchange “has been a delusion of economic theory since Aristotle�.

  What the identity MV=YP boils down to is this: “the total money received in a transaction is equal to the total money given up in a transaction—surely an uninteresting truism.�

  I don’t think MV=YP can help us analyze the connection between money growth and price inflation. It is fortunate, therefore, that this article didn’t attempt to make much use of it throughout the analysis.
  

  Published: November 8, 2005 10:22 AM

• Paul Edwards

  P.M.

  Sounds like you are almost simply advocating a 100% commodity based money. It sounded good but then you said "the seigneury from this should not be treated as a windfall gain but rather put into a sort of open ended sinking fund to cover any fluctuations by pulling in money if inflation loomed".

  So now i'm thinking you're advocating a centrally planned money. I don’t really think we can beat a free market using commodity money. Do you?
  

  Published: November 8, 2005 10:37 AM

• Jim Bradley

  Austrian economists should get away from saying anything prescriptive about the size of the money supply other than we should have a free market in money... after all, a free market in money doesn't mean the money supply will remain fixed or rise or fall at any specific rate. A free market in money also doesn't mean that alternative financial assets won't be "monetized" thus increasing the pool of money.

  Free market money means there is additional profit to be gained by matching the demand for money with its supply. When new money is accepted by users as being well collateralized, the issuing entity (probably a bank) will be serving it's proper function as an intermediary. A decentralization of moneys would also mean that some money would tend to be better than others based on the soundness of the bank and the bank's investments.

  Banks, receiving signals to the relative values of moneys would respond appropriately, increasing and decreasing their supply as needed. Whatever the "ultimate money", whether it is a basket of goods selected to eliminate transitional changes in prices or whether it is just gold, the market would make the final call.

  Since payment of taxes is dictated in denominations of the state's money, an alternative would need to be proposed whereby taxes would be remitted in sound money.

  Published: November 8, 2005 11:02 AM

• J C Ernharth

  Another reason for the disconnect between money supply and CPI during the 1990's (in addition to asset inflation) is probably the ramping up of US global consumption with the expanded 1990s free trade policy -- we've vented many of those dollars into emerging markets / China, and in return have been the beneficiaries of cheap foreign made goods that drive down the CPI numbers. Only in the past few years are those economies now sufficiently developed, and has the money supply hit critical mass so that we are seeing global competition for natural resources and energy.

  Published: November 8, 2005 11:18 AM

• Bill R.

  I prefer to think of fiat currency inflation as a tax on the holders of that currency, be they foreign or domestic. Inflation is not the same as a general rise in consumer prices, which CPI purports to measure. However, CPI/PCE are as good a measure of "consumer prices" as GDP is of the "economy."
  http://www.gillespieresearch.com/cgi-bin/bgn/article/id=343
  http://www.gillespieresearch.com/cgi-bin/bgn/
  http://www.lewrockwell.com/orig6/karlsson1.html

  The removal of actual housing prices and its replacement with "owners' equivalent rents" in 1983 did a lot of work to disconnect the CPI from reality. Other disconnections take place between CPI and PCE deflator through substitution and chain weighting and through hedonic adjustments. I love that they give chicken more weight in the PCE when the price of beef rises, in order to reflect that consumers "substitute." This holds the price of groceries "down" in the PCE. Funny, most people eat chicken because the price of beef went UP! One solid example of how hedonics is used: cars. According to the BLS, CPI for new cars has not increased since 1996. This is because of hedonic adjustments for computer items, ABS, DRL, airbags, stability control, side impact protection regulations, etc. The manufacturers even SEND "suggested" hedonic adjustments to the BLS when they get their survey. They're in cahoots! Back in the day, the switch from leaded to unleaded, the addition of catalytic converters (which RAISED the nominal cost of a new car), computer controlled carburetors, all LOWERED the CPI for new cars through hedonics. None of which had any impact on the actual price paid in nominal dollars by the purchaser. Another example: from 1976 through 1996, the Cadillac Fleetwood Brougham, a four door V8 rear wheel drive sedan, increased in price an average of 6% annually. However, the CPI for new cars increased by 3% over that time period. Balderdash! Over the same time, M3 grew by an average of 7.1%.

  The stated purpose of these adjustments to CPI is to “overcome deficiencies.� IMO their actual purpose is to disguise the true level of price increases. These are government statistics, after all. The Mises Institute has a good lecture on tape (I believe Lew Rockwell narrates it) regarding the power of ideas, and the use of ivory tower types to justify governmental action. While the ideological cover for the CPI adjustments (owners’ equivalent rents, hedonics, substitution) is “overcoming deficiencies� the real purpose is to “tame� the CPI and PCE while allowing government to inflate with the populace being largely unaware.

  Concerning quality adjustments:
  (1) Quality is subjective, and what is an improvement to one is not, to another. Adding a subjective measurement defeats the purpose of the index. Subjectivity of measurement is one issue that Austrians have with the entire concept of indexing, why make it worse?
  (2) The improvements are, in most cases, not optional. It is impossible to buy a new vehicle in the U.S. today without dual airbags, catalytic converter, side-impact protection standards, etc. The net impact is that one on a COLA income pays more in nominal dollars than their income has increased, because the CPI for vehicles tells them the price is the same. This is one way the government uses the CPI and PCE for its own purposes, because so many government expenditures are keyed to COLA, and saving 2%+ off of those on the backs of pensioners helps the government out, you see ...
  (3) Hedonic adjustments have been used to reduce both the amount and volatility of CPI increase for the benefit of the politicians. This goes back to the issue of "ideological cover" and the "stated purpose" vs. the "actual purpose."

  The argument for substitution is as follows: "All economists, including Austrians, will argue that an increase in the relative price of one good will lead to a substitution away from that good toward other goods." While this is correct, it is beside the point. If the price of beef goes up, I may indeed buy more chicken. My total grocery bill may stay the same. However, the cost of my fixed basket of goods has gone up – which is why I am forced to “economize� with chicken. Since the stated purpose of the price index is to measure the increase in prices of a fixed basket of goods, changing the basket based on an increase of prices in the basket defeats the purpose, does it not? Check the cartoons linked below for good examples. If the price of gas gets so high that everyone bikes to work, and winds up spending the same amount on commuting expense, is that really just a “wash� in terms of cost of living? If the cost of meat rises so much that Americans return to eating cabbage and beans, but they spend the same amount on groceries, is there really no price inflation?

  THAT is why I always use M3 instead of CPI when adjusting for price over time. Google "hedonic cpi bls" and read for a while. Also please enjoy the cartoons about CPI and PCE located http://www.wallstreetfollies.com/government.htm .

  Who in America gets the newly created fiat money first? The government, banks, and the military-industrial complex, with (arguably) welfare recipients among the first to receive it. After all, the government creates money through credit primarily, and through deficit spending. So even in America, certain individuals get the usage of the money before the middle and lower classes do, hence it represents a transfer of spending power from them, to the “favored� class that either is directly involved in the creation of money, or is first in line at the feeding trough.

  Published: November 8, 2005 1:02 PM

• Marco de Innocentis

  However, the relation between money growth and price inflation [in the US] seems to be somewhat lower than in the euro area and Japan, and has become somewhat weaker since the middle of the 1990s.

  Heh, it's not really become weaker, all that's happened is that in the mid-1990's the US government changed the way it measured inflation.
  See Jim Puplava's article

  http://www.financialsense.com/stormwatch/2005/0624.html

  For a comparison between money supply growth and inflation, see also this

  http://www.financialsense.com/stormwatch/update.htm

  Published: November 8, 2005 1:29 PM

• Tim Elrod

  This is a beautifully written article and wonderfully balanced. The author's ideas and premises are measured, cautious, one may even say classic. He reaches back in time and pulls all the threads together and brings us up to date. For all that, in toady's world the approach seems too "Newtonian".

  What is inflation? What is money? What is price? The dictionary definition of inflation is: "A general increase in the price level od goods and services."
  Also, and this is interesting: "A brief exponential expansion of the universe(faster than the speed of light)postulated to have occurred after the big bang."

  What am I getting at? Simply that the ideas of money supply etc. though extremely valid, are no longer enough in the relativistic world of the Big Bang of Globalization and instant communication. The laws of gravity and equal and opposite reactions don't completely explain a world where trillions are traded in currencies at the speed of light. What about the relativity of price? The cash price of corn, a world commodity and the base of the pyramid of the human food chain is about $1.50 a bushel which is what it was in the 1960-70's. Measured in constant dollars and allowing for 25 years of inflation it's cheaper now (relatively) than at any time in history. In America if it weren't for giant subsidies it couldn't be grown. So what does that mean? It means that the price "$1.50/bu" is a useless number without a raft of qualifiers and is irrelevant in measuring the economic psychology in the Global world.

  I agree that money supply and monetary policy are important but more important in a relativistic world are the cycles of psychology. We should be thinking in electron-style probablities rather than formulaic absolutes. History shows that even more than race and religion, the great creator of wars is deflation. Tim Elrod

  Published: November 8, 2005 2:21 PM

• Bill R.

  When we refer to "inflation" or "deflation", when we really mean CPI, or equity prices, or general price levels, etc., we are doing the government's work for them. They have been on an intentional campaign for decades to divorce the concept of money supply from the fact of rising prices. They do this to hide their part in our economic woes - the fact that they rob us through monetary policy on a daily basis. We should not let the enemy win the war of words!
  
  My Webster's College, Home, and Office Dictionary (Self Pronouncing) published in 1929 doesn't even have the word "inflation."

  Since in 1929 the Fed had only been in existence for 15 years, we still had a gold standard, and we still had legal ownership of bullion coin (not to mention that all minted coins had specie value), this may not be surprising. The 1929 dictionary does have the word "inflationist" meaning "one in favor of an increased issue of paper money."
  
  My Webster's New World Dictionary published in 1962 has the word "inflation" meaning "1. an inflating or being inflated. 2. an increase in the amount of currency in circulation or a marked expansion of credit, resulting in a fall in the value of the currency and a sharp rise in prices."
  
  My Webster's College Dictionary published in 1991 has the word "inflation" meaning "1. a steady rise in the level of prices related to an increased volume of money and credit and resulting in a loss of value of currency (opposed to deflation). 2. the act of inflating. 3. the state of being inflated."
  
  In the vernacular, "inflation" means "higher prices." Why this shift? Take a look at this definition: "Inflation has been defined as a process of continuously rising prices, or equivalently, of a continuously falling value of money."
  
  Did that come from Webster's 2005 edition? No, it came from http://www.bls.gov/bls/glossary.htm#I.
  
  Don't let them win the war of words. Once they do, we will have lost the war of ideas.
  

  Published: November 8, 2005 2:39 PM

• John Christopher

  I was thinking that a low CPI rate (+0.5% for instance) does not necessarily mean there is no inflation.
  Thanks to general better production processes (hard-work, creativity, lot of savings...), costs per unit of money have decreased; the CPI should really be lower(-5% let'say). Now, central banks may have printed some money at the same time and the CPI pops up at 0.5% hidding a real inflation of 5.5%.
  Isn't that what could have happend during the last 10-15 years when Austrians were crying to high inflation due to monetary manipulations and were confronted to relatively low CPI numbers.

  Published: November 8, 2005 4:47 PM

• Paul Edwards

  John:

  Yup, I agree. The same thing was happening over the 1920's culminating in the crash of 1929. That decade saw lots of inflation, but small price increases due to increases in productivity and general prosperity. Combine that effect with today's changing criteron of what constitutes CPI, and you get an even more useless CPI.
  

  Published: November 8, 2005 5:20 PM

• Charles D. Quarles

  I'm with Rothbard. Inflation can't be measured. Whatever the CPI purports to measure, it isn't inflation. Money is the best use of gold. Gold doesn't rust (it is the least reactive metal naturally occuring in Earth's crust), is dense (substantial weight in a small volume), looks good (people will readily exchange things for it), is relatively rare (combined with its inertness, most of the gold that has been mined is still available for use, and the supply is relatively limited), and where it is found, can be found nearly pure (low processing costs). It is not easy to artificially expand the gold supply. You either have to find a new mine (most of the best finds are known) or alloy it (which is relatively easy to check since pure gold is soft and very dense). Bring back gold money and get rid of central banks.

  Published: November 8, 2005 7:14 PM

• Tim Elrod

  Charles,
  I understand your ideas on gold ---It's like an anchor on a ship that's sailing on an open ocean with no bottom. The chain isn't long enough and gold has become a quantum too. It hasn't worked in decades and when it did work it had a half-life of about 8 weeks in 1979-1980. Sugar was a better hedge than gold in the'70's. The world economy is like a giant Caldera covering a molten column of money. The central banks are frantically twisting dials in money supply and interest rates and propaganda and the leagues of currency fixers are busy too, but so far only a few geysers in paper, the Nasdaq,housing, energy have escaped. In the 70's big millionaires ruled but now we comb billionaires out of our hair. After the fall of Saddam the military found wharehouses full of "shrinkwrapped" $100 bills- billions- so who can say what the real money supply is. If you look at the CRB Index it looks like it's going to vibrate to a higher harmonic octave but don't look to gold to reflect it, it's a follower. Tim Elrod

  Published: November 8, 2005 10:53 PM

• P.M.Lawrence

  Paul Edwards, I wasn't advocating at all, I was following through what would happen in an idealised situation. The objections you raise have to do with human fallibility, and of course you have to bring them in the moment you start to address the practical side - but I was just laying groundwork. For what it's worth, the privately backed fiat currency in "Time Enough for Love" could have been run that way, in theory. The book does go on to show what happens when the state muscles in on the wise-from-experience Lazarus Long (value theft via inflation for the highest of motives).

  If you had a fiat currency run properly (which people don't do), it would have those characteristics. It's looking at the problem from the outside, like defining what a bicycle rider would have to do to keep his balance rather than examining what he actually does. When we look at what central banks actually do, we find that they actually don't keep their balance, and we find that actual historical sinking funds didn't work either because human beings kept raiding them.

  But that doesn't stop us examining the theoretical ideal, and it's a valuable exercise because it gives us a frame of reference to compare with what actually happens. It's as useful as the concept of absolute zero in temperature measurement.
  

  Published: November 8, 2005 11:27 PM

• billwald

  Two big differences between now and then. When Mises wrote the essay the Fed increased the money supply by shipping paper money to local banks. These days they mess with the interest rate they charge member banks.

  Second, in the 50's people actually invested in companies with the intent to invest in companies. These days the only investment in companies is IPOs and new bond issues. All the rest of the activity is gambling to beat the market trend.

  Third, in the 50's the working person could only increase his money supply by borrowing if he obtained a bank's permission. These days I create new money every time I use a credit card.

  Fourth, in the 50's, it was very, very rare to borrow money to buy toys and entertainment. Now days at least half of all purchases are stuff we don't need and that includes 3,000 square foot houses.

  Fifth, in the 50's the U.S. economy virtually controlled the world economy. These days the world economy is controlled by the commodities market and the money traders. All a local govt can do is mess with it's own people.

  In other words, it's a new world out there and the old rules don't apply.

  Published: November 11, 2005 10:56 AM

• Mike Sproul

  On a real bills view, when the Fed prints more money and buys bonds, the Fed's assets rise in step with the money supply. That means each additional dollar is adequately backed by a dollar's worth of bonds, so the new dollars do not cause any inflation. The same thing is true of corporate stock. Economists recognize that if GM printed up one more share and sold it for the going stock price, then GM's assets rise in step with the stock issue, and there is no change in the stock price.

  This means that there is no free lunch from issuing money, and as long as people are free to bring bonds to the Fed and get green paper dollars, the money supply will automatically move with the needs of business. Freezing the money supply causes recessions, as history has shown many times.
  

  Published: November 13, 2005 9:40 PM

• billwald

  Using prices to measure inflation might be useful to economists but doesn't have anything to do with real life. If I must work fewer hours to obtain basic necessities then my cost of living has decreased. Only the cost of toys and vacations has increased.

  Families on welfare these days have a higher standard of living than the average American family did in the 1940's.

  Only the cost of govt has been inflated.

  Published: November 14, 2005 11:53 AM

• Yancey Ward

  Mike Sproul,

  If you are correct, then couldn't the United States government simply borrow the entire federal budget every year by printing bonds and giving them to the Fed in return for reserve notes?

  Published: November 14, 2005 1:06 PM

• Paul Edwards

  You're on to something Yancey. This could be the key to the elimination of taxes once and for all! We’d have no taxes, no inflation, but still all the government we could ask for and more. (Just kidding, i agree with your point).

  Published: November 14, 2005 1:28 PM

• Mike Sproul

  Yancey and Paul:

  If the government printed bonds worth $100, sold them to the Fed for $100 in reserve notes, and spent the notes, then the Fed's assets would rise in step with its liabilities and there would be no inflation, assuming the government had enough net worth to pay off the bonds. If you multiplied the $100 by 1 trillion, the same remains true, except that the government becomes less likely to be able to pay the bonds, so the bonds drop in value and so do the FR notes. Assuming the government actually can pay the bonds, then the dollars will start piling up in bank vaults, drawers, mattresses, etc. The same thing would happen to GM stock if GM started issuing ridiculously large amounts of stock. But nobody denies that the value of GM stock is determined by its backing. By the same logic, I wouldn't deny that ridiculously large issues of FR notes can reduce their value, but since I believe that the value of the dollar is determined by its backing, logic dictates that more money (within bounds of reason) accompanied by more backing, will not cause inflation.

  Published: November 17, 2005 4:36 PM

• Paul Edwards

  "...except that the government becomes less likely to be able to pay the bonds"

  But Mike, the government will not become less likely to be able to buy the old bonds back, because in the meantime, it will issue new bonds and sell them to the FED which will monetize them also. And so the government will buy back their old bonds through the funds raised via a portion of the issue of the new bonds.

  Since the monetization of the new bonds can be no more inflationary than the monetization of the old bonds was (since the Fed's assets would [continue to] rise in step with its liabilities), it will be equally innocuous, and the whole scheme can continue adnauseum with no inflation, and no ill effects.

  Or do you see a flaw in this logic?
  

  Published: November 17, 2005 4:59 PM

• Paul Edwards

  I'm "just kidding", by the way. I actually think the first round of monetization of the first set of bonds would be inflationary, as would be all rounds that follow in my crazy little infinitely repeating scenario.

  Published: November 17, 2005 5:05 PM

• Mike Sproul

  Paul:

  I think it would help to mention a real-life example. In 1690, Massachussetts issued the first paper money in the English-American colonies. The reason for the issue was that unpaid soldiers were threatening to riot, and the colonial treasury was empty. The colony printed up paper notes that said "1 shilling", and agreed that the paper shillings would be acceptable at par with silver shillings in payment of taxes. The backing for those shillings was the net worth of the colony, which in turn depended upon the tax-collecting ability of the colony. Over the next 20 years, all the colonies issued paper money, either by spending it directly or by lending it to citizens. When colonies allowed the amount of paper money to outrun the assets of the colony (which included taxes receivable plus IOU's from borrowers), inflation resulted. When paper money moved in step with assets, prices were stable. Bruce Smith published a study of colonial currency that confirmed this. These episodes were consistent with the real bills view, and it would have made no difference if the colonies had issued the paper shillings in exchange for "government bonds" rather than "taxes receivable" or private IOU's. I wrote a paper on colonial currency at www.csun.edu/~hceco008/realbills.htm that gives a fuller explanation.

  Published: November 18, 2005 3:39 PM

• Paul Edwards

  But Mike. Was that a yes or a no? ;)

  Published: November 18, 2005 5:05 PM

• Mike Sproul

  Paul:

  So next will you be asking me if I've stopped beating my wife? I haven't heard anyone deny that the value of GM stock would be unaffected if GM issued new stock for equal-valued assets. And I think if we were talking about paper money that was always convertible into an ounce of silver, most people would agree that the issuing bank would not cause inflation if it issued new notes in exchange for assets worth one ounce (because of the law of the reflux). And even without convertibility into silver, all an issuing bank has to do is sell bonds whenever its notes fall below one ounce, and the value of its notes will be maintained at one ounce. (Note that this would not be possible for a bank without adequate backing for its notes.) So where do economists, and Austrians in particular, get the crazy idea that paper money can have value without backing?

  Published: November 19, 2005 9:00 PM

• Paul Edwards

  Mike:

  I did not know you had been beating your wife so I will just pretend you didn’t suggest otherwise.

  The question of GM issuing further stock is entirely different from central bank creating more money (inflation). You may think they are the same, but since i think they are different, humour me and stick with the central bank question for now.

  I noticed you didn't attempt to respond directly to my facetious answer to your "...except that the government becomes less likely to be able to pay the bonds" argument. Perhaps in the exercise of doing so, you would see the difficulty of your position.

  Using your basic and fallacious logic, i answered your point as follows: the government NEED NOT “become less likely to be able to� buy the old bonds back, because in the meantime, it could and would issue new bonds and sell them to the FED, which will monetize them also. Therefore, the government would be able to buy back their old bonds through the funds raised via a portion of the issue of the new bonds.

  Since there is no reason to think that monetization of the new bonds should be any more inflationary than the monetization of the old bonds was (since the Fed's assets would [continue to] rise in step with its liabilities), it will be equally innocuous, and the whole scheme can continue adnauseum with no inflation, and no ill effects. This is all in accordance with your invalid criterion that no inflation occurs if “the Fed's assets would rise in step with its liabilities�.

  To which i concluded with the rhetorical question: Or do you see a flaw in this logic?

  My question stands. Do you see a flaw in this logic? But let me cut to the chase because i do see a flaw in this logic, and it is in your premise that NO inflation can happen if “the Fed's assets would rise in step with its liabilities�. The flaw is that continued monetization of further government debt is in fact highly inflationary JUST AS the original round of monetization of government debt was also inflationary. Your intuition tells you that this cycle is not feasible because it would create a hyperinflation in a very short order. Your intuition in this case serves you better than your logic.

  Published: November 20, 2005 12:57 AM